Capital and Interest Theory: Recent Episodes
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Capital and Interest Theory includes works on the structure of production and theory of interest. Includes, the time preference theory of interest.
Peter Lewin joins Bob to discuss his work with Nicolás Cachanosky on uniting Austrian capital theory with mainstream finance.
Peter's New Book on Capital and Finance: Mises.org/LewinBookJoin us in Nashville on September 23rd for a no-holds-barred discussion against the regime. Use Code "HA23" for $45 off admission: Mises.org/Nashville23
Capital is the starting point of economic calculation.
Download lecture slides at Mises.org/MU23_PPT_13.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2023.
Time is an irreversible flux. Each moment has a unique place in the sequence of moments of time with respect to action.
Download lecture slides at Mises.org/MU23_PPT_11.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2023.
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community."
Download the slides from this lecture at Mises.org/MU23_PPT_06.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2023.
Bob walks through a recent interview of MMT champion Warren Mosler, in which he claims that Fed rate hikes lead to larger government interest expenses and hence support economic growth and inflation. Bob presents both theoretical and empirical evidence against Mosler's claims.
Bob's Debate with Warren Mosler: Mises.org/HAP403a Bob's Review of Stephanie Kelton: Mises.org/HAP403b Bob's EconLib Article on Austerity: Mises.org/HAP403c Technical Article on Why the Treasury Can't Overdraft: Mises.org/HAP403d
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
Progressive governments in the name of equity are calling for taxation of capital gains. They really are demanding destruction of capital through capital consumption.
Original Article: "Taxing Capital Leads to Capital Consumption"
Jeff Deist: First of all, congratulations on your new book The Price of Time. It was fantastic.
Edward Chancellor (EC): I’m glad you enjoyed it.
JD: I ask all authors this question, especially authors of weighty books. Was it worth it, in terms of the opportunity cost in your own life?
EC: Not financially [laughs]. I bet most of them say that. Heaven knows why people write books, really. The best you can say is that, you’re building up your own human capital and you’re making some contribution to civilization. And I work in the world of finance and investment, and on the whole, it pays for me to spend time building up my human capital. You never quite know when the payoffs come. Now that I’m toward the end of my career, it doesn’t really matter that much, anyhow. So, I wrote this earlier book called Devil Take the Hindmost: A History of Financial Speculation. That paid off, and it created career opportunities for me. I don’t think this book will, but perhaps it will have some influence on policy. I think of it like this: it’s a sort of testament to what’s gone on. It’s harder now to shovel these things under the carpet because people will be able to come back to this book and say, Can you answer these questions? So, we’ll see. I don’t regret writing it. One thing you’ll find about people who write books is that they’re tremendously relieved when they’re done.
JD: You received a nice review in the Wall Street Journal. How about reviews in the UK and Europe?
EC: Yes. So, it probably won’t particularly surprise you, given the polarization of the press today and in particular the polarization of economic questions, that the so-called right-wing press—the Wall Street Journal, Telegraph over here, Spectator over here, Times over here—they all liked the book, almost uncritically. The Left has completely ignored it. As I said, my previous book, Devil Take the Hindmost, actually sold hundreds of thousands of copies, established me reasonably well. Admittedly, it’s been a while, but I find it a bit strange that the New York Times, Washington Post, Guardian deigned to look at The Price of Time. And then you’ve got the policy-making media, the technocratic media, the Financial Times and columnists—they didn’t like it. Martin Wolf at the FT said that I obviously wished for a state of permanently high unemployment. You can imagine that argument. And both royal family economists reviewed my book alongside the latest offering by Ben Bernanke, coming down decisively in favor of Bernanke, which is fair enough, but what both of those reviews failed to do, needless to say, is to address my argument. It’s easier to disparage persons you disagree with than to address their arguments.
JD: I did not find the book ideological per se.
EC: You know, subjects on interest have always been fraught with political disagreements. And I suppose in the end, interest is always going to be a question of the distribution of income and wealth, and therefore people with different ideological positions have always had different views about the subject of interest and very strong views. If you’ve ever read Eugen von Böhm- Bawerk’s Capital and Interest, it’s a very splenetic work. It’s quite comic, in a way, how fiercely he denounces people whose views he disagrees with. My position, as I say at the outset of The Price of Time, drawing on a comment that Irving Fisher makes in his Theory of Interest, is that a lot of these different theories of interest are not actually as contradictory as they might appear.
JD: I liked that quote. Fisher said competing theories of interest are not in fact “mutually annihilatory.”
EC: I didn’t want to have a very clear ideological axe to grind. My own training is as a historian, not as an economist. That was my training at the university. But then later I worked as a banker and an investor and as a financial journalist. You can also say I’m an empiricist. Having said all that, yes, as you know, the book inclines quite strongly toward the Austrian interpretations, and many Austrian economists have slightly different takes on the subject. I suppose that Schumpeter’s view was perhaps sitting to the side of everyone else, but as you know, I’m a big fan of Hayek, and a big fan of Schumpeter.
Some of the ideas of this book were hatched years ago, when I was asked by the Institute of Economic Affairs, which, as you know, I contributed to. They were putting together a book on monetary policy in 2004–05 and asked me to write something, and I wrote a piece comparing Hayek’s arguments that price stability was not a sufficient goal or sound goal for monetary policy against the free monetarist view that price stability was the be-all and end-all of monetary policy. This was written in 2004. I said, We’re running a great experiment because they said, We’ve got this tremendous credit boom going on, real estate bubble. Hayek would have screamed blue murder, and Friedman was quite onboard with the policy, if you remember . . . Run a great experiment and we’ll see what the outcome is, and perhaps one of these different schools of thought will be validated by the experiment. An anonymous peer reviewer wrote back saying, If members of the Austrian church wish to be heard, it behooves them to relate more to the mainstream. I withdrew the piece. It didn’t make me lose faith, so to speak. It actually rather hardened my view.
JD: You left Cambridge and Oxford with an advanced degree in history but ended up working for the investment bank Lazard. Did your time in mergers and acquisitions plant the seed of a “financialized” economy in your mind, that investment bankers move money around but don’t produce much?
EC: To put it like that, yes. The reason I left corporate finance was that it didn’t seem, on the whole, a particularly useful function. I’m not saying that there shouldn’t be a market for corporate control, but if you see it from the side of the investment bankers, it’s largely . . . it’s solely about generating fees, regardless of whether the deals are necessary or not. And there was one French partner at Lazard’s in my time who when asked by one of his junior people what price he should advise the clients to bid, turned and said, “The price is right which hurts our clients.” You have to be pretty cynical to stay in an environment like that your entire career.
JD: Capital markets are supposed to be noble. They’re supposed to allocate capital to its best and highest uses, and make us wealthier and happier as a result.
EC: I’ve been thinking more about this that perhaps I didn’t spell it out clearly enough. You know how in modern finance theory—Modigliani, Miller—leverage doesn’t add value, it just increases volatility and therefore you shouldn’t really have financialization? You shouldn’t really have an incentive to leverage buyouts. Whatever advantage you get from leverage in a buyout case is offset by liquidity concerns and volatility around solvency. You shouldn’t have financial engineering if the interest rate is at the correct level. And in a way, I think that the financial engineering of the last thirty years or more has been pushed, and that’s pushed further and further by the very low interest. And that’s why you find people of the market-oriented persuasion like me coming to quite similar conclusions to the typical Marxist critics of Wall Street.
JD: The critique is that Western monetary systems create an unjust class of wealthy elites.
EC: I think they do. As I argue in the book, the finance sector is too large. Obviously it serves a function, but traditionally in the US, I think it ran 3 percent of GDP or below, probably the same in the UK, and in both of those countries, the financial sector is now more than three times that level. And as the finance sector rises, I think it becomes a bit of an incubus on the rest of society. It ceases to provide a benign function. Or better, it does continue to provide a benign function, but there are malignant effects from a bloated financial system. These become, I think, stronger as the system, as the finance section, grows larger. And then, as I point out in the book, the periods of very strong financial growth, whether the Gilded Age, the 1920s, or more recently, are also those associated with a very strong rise in inequality.
JD: Absolutely. I love the framing at the outset of your book, the Proudhon versus Bastiat debate in the French National Assembly. It’s still relevant today. The essential question remains whether interest rates should be set by fiat or by the market. Proudhon sounds an awful lot like central bankers since ’08.
EC: I think so. It was a gift to me when I came across the Proudhon-Bastiat debate because it did spell things out so clearly, and what’s interesting is that Proudhon very clearly comes from the long-running tradition of criticizing interest, but then sort of brings that critique of interest forward by going to the idea of a national bank providing more or less free credit. And then, Bastiat—being a brilliant and insightful economic thinker, considering unintended consequences and the claim of who would benefit and who would lose—Bastiat says that is absolute nonsense, that the poor man is not going to benefit. The poor man would lose income on his savings, but it’s the rich man who will be able to go to the bank and borrow very cheap because his credit’s good. I have a friend who’s a hedgefund—ex-hedge-fund—guy, and he told me seven or eight years ago that his mates were getting ready to buy him out. I can’t remember what they were, but high-yielding businesses, assets with regular income streams on extremely low cost of funding. And they were guys who were, I suppose, billionaires or near billionaires who were just minting it and it’s fair enough that they weren’t breaking the law, but the system had been tilted very much in their favor and as you know, the likes of Bernanke were sort of obtuse. They simply refused to recognize it. They claimed that what they were doing was helping the man on the street and that it would benefit him. I think it probably is true that unemployment was somewhat curtailed by central bank interventions in the immediate aftermath (2008, 2009) of the global financial crisis, but a whole load of other problems came to pass, to fester. . . I suppose that sort of goes back to the 1930s experience and the birth of Keynesianism, which is a period of unemployment and is seen as the highest and only evil and everything else is ignored.
JD: I know you’re friends with Jim Grant and you have a section in your book devoted to Walter Bagehot. Bagehot is sort of a lost figure these days. Jim Grant is one of his biographers.
EC: Bagehot’s a good financial journalist, quite intuitive, has a brilliant turn of phrase. Bagehot’s comment is that the financial world tends to fall to pieces when interest rates fall below 2 percent; as he puts it, John Bull can stand many things, but he can’t stand 2 percent. He says that when interest rates fall below 2 percent, people must either be less well off or they must be less secure, and what Bagehot understood was that people were choosing to be less secure. They probably wouldn’t realize it at the time, the security that they were sacrificing. So that’s the plus side of Bagehot. The negative side is Bagehot being associated with the so-called Bagehot rule and lender of last resort. I’m not necessarily against a lender-of-last-resort system. I’m against a financial system that requires a lender of last resort. And it’s amusing. I cite a contemporary of Bagehot’s, a former governor of the Bank of England, criticizing Bagehot’s arguments for a central bank action lender law, saying that it would create all sorts of moral hazard. If you then fast-forward 150- odd years, you can see that the principles of the original Bagehot rule of lending at high rates of interest against high-quality collateral for a short period of time have been more or less completely thrown out of the window. And we now have a system which is much more riven with moral hazard than in nineteenth-century England and which must therefore necessarily be more fragile.
JD: What about religious influences on the practice of charging interest rates? That could be a book unto itself. But you kept this pretty Western. EC: I discuss early in the book the religious strictures against lending and interest and usury in the Bible and then in ancient civilization. I didn’t really think that getting into the whole Islamic world was going to add very much.
EC: I discuss early in the book the religious strictures against lending and interest and usury in the Bible and then in ancient civilization. I didn’t really think that getting into the whole Islamic world was going to add very much.
JD: Some would claim we have usury in the US today. We have subprime borrowers, poor people who buy furniture or cars at or have credit cards with interest rates well over 20 percent.
EC: That slightly depends. As you know, from the Austrian view, the interest represents your time preference, and people’s time preference varies with individual acceptance times. I make the argument that a person who is getting paid the next day but wants to go out and have a great night before might be willing to pay 20 percent interest on an overnight loan and it’s not entirely crazy. Look at what happens to payday lenders—in particular, there was one in England, called Wonga, who was doing quite well. The archbishop of Canterbury, who is a sort of terse and sanctimonious figure, waged what came to be called the War on Wonga. This was an attack against all payday lenders. The archbishop instead proposed the church build up its own lending arm.
JD: Did they?
EC: The Church of England has made some of the worst investment decisions in the history of mankind. So, actually, if it had set itself up as some payday lender, I’m sure it would have failed spectacularly.
But Wonga failed in the end for not charging enough. I suppose if a business fails to generate a sufficient return, it’s hard to accuse it of usury. I think there’s another line by the English jurist William Blackstone where he says that charging money for a loan is known as interest by those who accept it and usury by those who don’t. In a way, the definition of usury is an interest rate. It’s actually rather subjective. It’s what an individual feels is an unfair rate of interest.
JD: Indeed. As for the poor, I think you make a good case in the middle section of the book that none of this financialization by central bankers has helped them. Average people can’t use a simple savings account. They have to go out and chase yield. Most average people are not wired to do that.
EC: I think it’s worse than that. The less money you have, the larger your precautionary reserves are going to be as a share of your total financial wealth. And in plain English, that means you’re going to have to hold more cash to deal with emergencies. And therefore, you’re not going to be going out and investing in some private equity fund. What you saw in the last decade is people sitting on cash that was yielding nothing. I think an estimated $500 billion a year was lost in interest, and we know, as I say in the book, that a lot of that interest was lost by well-off people who were more than making it back elsewhere. But if the poor had had relatively more of their resources in cash, they would have been relatively worse hit. And the other point I make is that the banks at the same time were told to tighten their lending standards, so they turned the screws on the subprime.
JD: In recent years, we’ve talked a lot about negative interest rates, but as you point out, we’ve had negative real rates in the US and UK for whole decades in the second half of the twentieth century. I’m not sure most people realize this.
EC: The period from the mid-sixties through to the early eighties, was one of negative real rates, and really, the time since the Fed cut rates after the dot-com bust in 2002 has been a return to negative rates. We haven’t had, until the last decade, such high inflation as occurred in the 1970s, even with relatively low interest rates. Real interest rates on average are more negative than they were in the 1970s. In other words, the depositor lost more money in the 2010s than in the 1970s.
JD: As an aside, would you rather live with the European Central Bank or the Bank of England? Are you glad to have the pound?
EC: I’m glad in principle to have the pound. I think the Bank of England is under extraordinarily poor management at the moment, and so, it’s not much consolation. I was reading today that the ECB is about to generate some massive losses, and that’s going to be huge. It will then come out who’s going to bear those losses. Is Germany going to pick them up? The German taxpayer? Are those losses going to be borne in relation to the public balances of all of the EU countries?
JD: How about the Greeks? (laughs)
EC: I know the Greeks will be paying.
JD: Your treatment of the US dollar in the third part of the book is superb. The dollar really has operated as a tool of imperialism. As Nixon’s Treasury secretary, John Connolly, said, “The dollar is our currency but your problem.” Ouch. America has enjoyed the privilege of essentially exporting inflation.
EC: Yes, and even before Bretton Woods. People have been critical of the gold exchange standard of the 1920s, in which basically US government liabilities were a substitute for gold in foreign exchanges. Bretton Woods—really, it’s the beginning of the dollar standard. You have the criticism of that system by Jacques Rueff. The “exorbitant privilege” of the dollar is when America can, in effect, run large balance of payments deficits, and the money comes flowing back, I don’t think in the long run it’s good for America, and it’s not very good for the rest of the world.
I refer somewhat to the Dutch disease. There was a period in the 1970s when the Dutch found some large offshore natural gas resources and the money that flowed into the Dutch economy from the gas resources was deemed to corrupt the economy. That was also true of Spanish gold and silver in the sixteenth century, and I think probably true also of the dollar. Look at the dollar standard, it’s nice to enjoy the benefits in the near term, but the question is, What happens in the longer period?
In the last twenty-five years, at the turn of century, America has largely deindustrialized and lost markets to China and, in effect, lost its strategic position relative to China, which looks like an epic mistake. But it all seemed fine when Americans were running these massive deficits and the Chinese were buying dollar securities and were sending the dollars back and buying more dollar securities. I think it was analyzable in real time; in other words, this is not just hindsight by us. It is almost driven by corruption in the body politic. Large businesses were happy to engage in this process because they could cut their costs and boost their profits in the near term. Even at the same time, they were making that long-term future vulnerable to the actions of the Chinese state. If they had read anything about Chinese history, they would have known that that was a foolish thing to do.
JD: Your chapter on Chinese financial repression was quite the cautionary tale. Did you write it before covid and all the draconian lockdowns in China?
EC: Yes, in a way. I was working around the time of the financial crisis and afterward for a Boston investment firm called GMO, and I took it upon myself to become the sort of in-house China expert, and so I’ve done a lot of work on China. At one stage, I was going to write a book on China, and then I didn’t really quite have enough specialist knowledge. And then I thought, Well, actually, many of the problems you see in China could also be explained by the distortion and corruption of interest. It’s curious; you read Chinese financial history and economic history, how the manipulation of money and interest have always been part of Chinese history, and that’s not surprising because China’s always been a powerful centralized state that’s disdained the merchants. So, in a way, yes, China has always been a cautionary tale in monetary and financial history.
JD: I particularly enjoyed the way you disabused readers of the vaunted Chinese savings rate. It turns out they juice their currency constantly and that rapid expansion of credit shows up as investment savings on one side of the ledger.
EC: Yes. Or that if you repress consumption, repress the income of depositors in the banking system, and you direct cheap savings to companies that then invest the money, you get an automatic rise in the savings rate, and if at the same time, you boost exports while suppressing imports, that appears to be what Bernanke would call a global savings glut. But I like the term of Claudio Borio, the economist who backed the Bank of International Settlements—Bernanke’s nemesis, really—who says it wasn’t a savings glut, it was just a banking glut.
JD: That’s an interesting way to put it. Do you worry these outright capital controls will become more common in the West?
EC: Yes, I do. I don’t quite know how the system is going to correct that. I think what we’ve seen in the course of this last year, it’s the early fault lines appearing, and they’re going to become more severe. And if what we’re looking ahead to is imposition of financial repression on a large scale, maintaining interest rates well below the rate of inflation, that’s okay if all countries have roughly the same level of inflation. There isn’t a particular interest in taking your money from one country to another. But wide disparities between countries, and capital flows will run from one country to another. And if that happens then you can only maintain your financial repression with capital controls. If the government wishes to take over private savings and direct them toward their own preferred uses, it’s much harder to do unless you have capital control.
JD: Is digital currency the mechanism for all of this?
EC: It could be. It’s conceivable that Switzerland could issue a standard digital currency that wasn’t going to track your every move, and we’d all rush into Swiss digital francs. But I think, on the other hand, that would also be grounds for imposing a digital currency. You know, digital currencies will be all right, but only our digital currency.
JD: On the last page of the book, you suggest that a rational monetary system in the future will need to be backed rather than fiat based, which could mean a role for gold in supporting a digital private currency. What would be your ideal?
EC: Well, the argument in the book is that we need to return to a world in which interest rates are set in the market, not by central bankers, because central bankers won’t have enough information and they’ll have their own preferences and they will make mistakes and we’ve seen they’ve made those mistakes. The current system does not work. There is cryptocurrency, but as I point out, a lot of cryptocurrency appears to be nothing more than Ponzi schemes. And a central bank digital currency [CBDC] in which the currency issuance is backed by government debt would come something quite close to the Chicago plan, wouldn’t it? Just in the CBDC mode.
I know you can’t leave aside privacy concerns, as they’re going to be the most important concerns, but if we leave that aside for the moment, if you had a CBDC that could only increase at a fixed rate, were constitutionally designed in that way, it would have, as I say, certain qualities of the gold standard. But the problem with the gold standard is there’s no real problem. The Austrians had some early insights into financial structures. The nice thing about a CBDC is it would suck up all deposits out of the banks, so you would actually end fractional reserve banking. We need to move to a different monetary system, away from fractional reserve banking. Fractional reserve banking allows the banker to create loans and earn the money on the spread, and then the system becomes dependent on the private banker’s monetary creation. And then the banker makes a whole load of mistakes, and his bank starts collapsing. Then he comes crying to the taxpayer that he needs a bailout and we all pick up the bill.
JD: Your term for commercial bank money creation is “fountain pen money.”
EC: We need to move away from fountain pen money. I’m very cognizant of Hayek’s comment that the invention of money is one of the greatest inventions for freedom of the individual in history, but having come through two-odd years of lockdowns, I think in this digital age, one’s pretty much aware that one’s freedom’s going to be taken away pretty quickly. So, you need to be wary.
JD: What do you think of the idea that as societies become wealthier over time and capital accumulates over centuries, we should expect interest rates to fall naturally? Even Marxists thought the capitalist thieves would have so much damn money that rates would have to go down over time.
EC: That’s quite right. I think there is an area where financial development probably does lower interest rates: the development of a banking system will bring down interest rates because, if you can imagine a world in which people stash their savings under their beds, when they move them into a bank, those savings become available as loans. So, I think that financial development is associated with falling interest, and we see that in medieval Europe, in Italy.
There is this argument—it was often referred to in Holland in the seventeenth century—that in a country with a very high savings rate and with a developed capital structure, interest would come down and people would then lend their money abroad. And that seems to be what happened in Holland in the seventeenth century and eighteenth century. But on the whole, capital wears out, so we save. And during the course of our lives, we save and in hard times we consume our capital. And the capital also needs replacing after a period of time. There isn’t any evidence to my mind that says a country like the US has been underinvesting; its capital stock has been aging, in the sense of not being replaced, and so I don’t think there is a long-term trend toward lower and lower interest. That was sort of the argument for the very low interest rates in the last decade, where you could draw a trendline over five millennia, with interest rates in Mesopotamia at 33 percent and suddenly get down to zero in 2010.
The trouble with all trendline analysis is it slightly depends when you start and when you end. The twentieth century saw the lowest interest rates, but it also saw the highest interest rates in history. It’s hard to think of it now, but under Volcker and in the aftermath of Volcker, US rates were pretty high in nominal and real terms. So these things move in cycles. They’re not very long, you know, I don’t see the long-term linear trend.
JD: Final question: Do you think the manipulation of interest rates—all the consequences from it—is one of the biggest untold stories of our time? It’s not headline news, despite all the extraordinary monetary policy we witnessed during both the Great Recession and covid.
EC: Yes, I suppose it is. You asked me at the beginning, Why does one write a book? And the reason I would write a book is if I felt that the subject hadn’t been adequately addressed. There is a lot of literature on interest over the centuries. All the writers, economic minds, have turned to it, some of them really not saying anything particularly interesting. Adam Smith wasn’t particularly insightful about interest. But yes, it did seem to me it was time to address it. The book seems to be selling reasonably well, but it’s not exactly a New York Times bestseller, so I’m not sure to what extent this subject catches the world on fire.
JD: We will use this interview to try to sell a few more copies!
EC: Well, you know, I’m pleased to have an association with the Mises Institute because I admire your work.
JD: Thank you, Mr. Chancellor.
For nearly two decades, business, academic, and political elites have spread the fiction that central banks can engineer prosperity by printing more money. Markets now are discrediting that fairy tale.
Original Article: "The Corporate Fairy Tale Is Dying as Economic Reality Sets In"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Mainstream economists claim that data alone can explain economic actions. Austrians know that without theory, data explains nothing.
Original Article: "Facts and Data Have No Meaning without a Theory to Explain Them"
This Audio Mises Wire is generously sponsored by Christopher Condon. '
Capital is the starting point of economic calculation.
Download the slides from this lecture at Mises.org/MU22_PPT_13.
Recorded at the Mises Institute in Auburn, Alabama, on 26 July 2022.
Time is an irreversible flux. Each moment has a unique place in the sequence of moments of time with respect to action.
Download the slides from this lecture at Mises.org/MU22_PPT_11.
Recorded at the Mises Institute in Auburn, Alabama, on 26 July 2022.
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community." Download the slides from this lecture at Mises.org/MU22_PPT_04.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
Download the slides from this lecture at Mises.org/MU21_PPT_13.
Recorded at the Mises Institute in Auburn, Alabama, on 20 July 2021.
Download the slides from this lecture at Mises.org/MU21_PPT_08.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
"The free market and the division of labor does not promote hyper-atomized individuals. It creates social harmony and community." Download the slides from this lecture at Mises.org/MU21_PPT_05.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
Bob gives a guest lecture for Jonathan Newman’s MA course for the Mises Institute, on the history of, and new developments in, the pure time preference theory of interest. After summarizing the work of Bohm-Bawerk, Fetter, and MIses, Bob explains his own perspective and then how Jeff Herbener partially agreed with Bob’s critique.
This episode sets the table for Bob’s interview with Herbener in ep. 199.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this lecture (which has the PowerPoint slides)Information on the Mises Institute’s online Master’s ProgramBob’s dissertation on Austrian capital theoryBob’s interview with Jeff Herbener (BMS ep. 199) For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Stitcher, Spotify, and via RSS.
Jeff Herbener is a Senior Fellow with the Mises Institute and an economics professor at Grove City College. At the 2021 Austrian Economics Research Conference, Jeff presented a defense of the pure time preference theory of interest, and mentioned Bob’s critique of it. This episode is a very informative discussion of their views.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this lecture (which has the PowerPoint slides)Jeff Herbener lecture on interest at Mises UniversityBMS ep. 198 (which provides context for this discussion)BMS ep. 119 with Guido Hulsmann (who also tries to replace the Pure Time Preference Theory)Bob’s dissertation (which is technical) on Austrian capital theoryBob’s article (for the lay person) explaining BB’s critique of the naïve productivity theoryAn intermediate difficulty paper, in which Bob explains problems with viewing interest as “present goods are more valuable than future goods”Bob’s 3-part series (one, two, three) on Capital and Interest in the Austrian tradition For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Stitcher, Spotify, and via RSS.
Savings are the foundation for a productive and advanced economy. Unfortunately, governments insist on policies that make it harder for ordinary people to save.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The Saving Problem in America: Alternatives and Reforms".
Negative interest rates lead to zombie firms, rampant consumerism, and growing obstacles to entrepreneurship.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The Social and Economic Side Effects of Negative Interest Rates".
The Human Action podcast with Jeff Deist continues tracking Rothbard's Man, Economy, and State, this time focusing on the role of entrepreneurs in the production process (Chapter 8).
Hunter Hastings joins the show with great insights into the social benefits of profit vs. interest, entrepreneurial risk, progressing and retrogressing economies, and the bunkum known as the "Paradox of Saving." This chapter presents Rothbard's exposition of the individual's (or firm's) role in bringing goods and services to us—while Keynesian and classical economists see capital as a homogenous blog and try to wedge entrepreneurs into mathematical models. You'll also hear why Jeff Bezos is not the devil, why rich kids tend to waste the fortunes created by their parents or grandparents, and why Marx was dead wrong about the little guy.
Read the book free of charge in searchable HTML format here.
Use the code HAPOD for a discount on Man, Economy, and State from our bookstore: Mises.org/BuyMES
Additional Resources Economics for Entrepreneurs Podcast: Mises.org/E4Epod
Dr. Joe Salerno's introduction to Man, Economy, and State: Mises.org/SalernoMES
Man, Economy, and State: Mises.org/MES
Kristoffer Hansen joins the show to discuss everything about interest rates, as detailed by Rothbard in Chapter 6 of Man, Economy, and State.
Hansen and Jeff Deist cover the "pure" rate of interest, expressed via time preference, and why the temporal nature of production helps us understand the premium for present goods relative to future goods. Far from exploiting workers or borrowers, capitalists actually advance money today in exchange for a more risky and uncertain return tomorrow—in the process making us all wealthier based on our individual subjective preferences. At every stage of production, interest helps producers get the capital they need now to bring us, the consumer, all the goods and services we enjoy. This show explains why we can't understand the productive economy without understanding interest rates.
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Additional Resources Dr. Joe Salerno's introduction to Man, Economy, and State: Mises.org/SalernoMES
Man, Economy, and State: Mises.org/MES
AOC and Paul Krugman are wrong: we can't just pay people money to stay home and expect "stuff" to materialize around us. This show explains why—as we cover Rothbard's Man, Economy, and State Chapter 5, "Production: The Structure," with our great friend Dr. Shawn Ritenour from Grove City College.
Don't miss a great discussion of that critical missing link in mainstream economics—capital theory—and its corollaries, from the temporal and uncertain nature of production to cost fallacies. This show also features plenty of examples from today's economy and a short but dynamic exposition of the evenly rotating economy by Dr. Ritenour.
Read the book free of charge in searchable HTML format here.
Use the code HAPOD for a discount on Man, Economy, and State from our bookstore: Mises.org/BuyMES
Additional Resources Dr. Joe Salerno's introduction to Man, Economy, and State: Mises.org/SalernoMES
Man, Economy, and State: Mises.org/MES
As Japan has shown, ultralow interest rates can greatly affect a society that was once impressively focused on innovation and investment.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The Social Consequences of Zero Interest Rates".
Download the slides from this lecture at Mises.org/MU20_PPT_10.
Recorded at the Mises Institute in Auburn, Alabama, on 14 July 2020.
The forces of anticapitalism have long latched on to whatever best suits them for pushing their agenda. Whatever the latest injustice may be—from a polluted environment to poverty to racism—the solution is always the end of capitalism.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "How the Left Exploits Antiracism to Attack Capitalism".
Download the slides from this lecture at Mises.org/MU20_PPT_04.
Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
Abstract: Since Samuelson’s (1966) reswitching example in the 1960s, it became clear that the Average Production Period (APP) is not necessarily a decreasing function of the interest rate. Recently, Fillieule (2007) and Hülsmann (2010) have shown that Samuelson’s example is not a mere curiosity. They showed that in a reasonable production structure model, the length of production increases with the interest rate instead of decreasing. However, their model did not present “reswitching” behavior. In this paper a generic model of the structure of production, in which both Fillieule’s and Hülsmann’s models are specific cases, is presented. It shows that the APP has a nonmonotonic dependence on the interest rate, which resembles a “reswitching” behavior: it increases for low-interest rates up to a maximum value, and then decreases back to almost the initial value. The decrease occurs within a relatively narrow range of interest rates, which may explain why it was missed in the literature.
business cycle — interest rate — structure of production — austrian economics — reswitchingJEL Classification: B53, E43, L11, L16, D24, B25, L23
Er’el Granot (erel@ariel.ac.il) is a professor at the Department of Electrical and Electronics Engineering, Ariel University, Israel.
INTRODUCTION Recently, there has been a revival in the interest in the reswitching debate. The debate is part of the Cambridge capital debate, which took place during the 1960s and 1970s (Harcourt 1972, 1976; Cohen and Harcourt 2003). While the capital debate did not end with a clear conclusion, Samuelson (1966) used a nice pedagogical example to illustrate the problem, in what was considered to be one of the main pillars of economics. One of the conclusions of Böhm-Bawerk’s intratemporal studies was that the players’ time preference determines the pure rate of interest (PRI), and therefore when the PRI decreases the entrepreneur seeks more productive roundabout production processes (Böhm-Bawerk 1959). Consequently, it seems that the natural conclusion is that when the PRI decreases, the structure of production lengthens.
This conclusion affected not only the neo-classical school but significantly influenced the Austrian school of thought. Hayek (1933, 1935) developed Jevons’s structure of production and Böhm-Bawerk’s analysis in his business cycle studies. Rothbard (2008) developed Hayek’s treatment by integrating the interest rate in the structure of production. The general structure appears in more modern writings.See, e.g., Skousen (1990), de Soto (2006).
The reswitching debate did not have a considerable impact on the Austrian school, probably because it was not regarded initially as more than a mere curiosity. Moreover, it is true (see Murphy [2003]) that the validity of reswitching does not fundamentally contradict Böhm-Bawerk’s claim that the entrepreneurs’ time-preferences is directly related to their willingness to lengthen or to shorten the production process. In fact, the reswitching effect does not contradict any fundamental praxeological law. However, does it affect the structure of production?
Fillieule (2007) constructed a simple model for the structure of production. In his model the structure of production consists of infinite stages of production, i.e., the structure of production begins at the dawn of humanity. Moreover, it was taken that in every stage the ratio between the amount of money invested in original factors of production (labor and land) and the amount of money invested in capital goods is a given constant ratio.
Under these fundamental propositions, the structure of production has an exponential shape. That is, the structure of production decays exponentially the higher one goes in the production’s stages, since the ratio between the amounts of investment in adjacent stages is fixed. An example of such a production structure is illustrated in Fig. 1.
Figure 1.
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Due to the fixed ratio between adjacent stages of production, the calculation is relatively simple and straightforward. In this case, the Average Production Period (APP) was found to be (Fillieule 2007)
(1)
where λ is the APP, I stands for total investment, C is the amount of consumption and r is the interest rate per stage of production.
It should be noted that in the literature the stages are usually numbered by positive numbers, however, to be consistent with the fact that stage 0 is the final stage, I chose to present them as negative numbers. This notation is also consistent with the terminology: “1st stage of production”, “2nd stage of production” etc. 1st cannot correspond to 9, but it may correspond to -9.
Hülsmann (2011) took a similar approach, but with several differences, which have to be stressed. In Hülsmann’s production structure model, there is a finite number of production stages. Furthermore, it is assumed that capitalists pay for original factors of productions (land and labor) only at the beginning of the production process. In the intermediate production stages, capitalists pay only for capital goods plus interest. Furthermore, his research focuses on a low interest rate, in which case the structure of production has a trapezoidal shape (as in Hayek’s model). An example of such a production structure is presented in Fig. 2 (again, one can see that I use negative numbers to represent the stages of production because production takes place in the present).
To simplify the discussion, Hülsmann (2011) did not present a formula, and instead, numerical results were presented. However, straightforward derivation reveals that in the low interest regime (the most relevant one, and the one which creates the trapezoidal shape), the dependence of the number of production stages (N) on the interest rate (r) is (see Eq. 6 in Appendix A)
(2)
Figure 2.
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A more accurate derivation, which is valid for 0 < r < C/I, shows that (these expressions do not appear in the original paper, but are derived in Appendix A as Eqs. A5 and A6).
(3)
Both the numerator and denominator of Eq. 3 increase with the interest rate, however, since in the numerator r is multiplied by a larger numberIC 1 then the number of stages is an increasing function of the interest rate. Moreover, as r increases and tends toward CI from below, then the number of stages diverges, i.e., N—> ∞.
Therefore, we recognize that in both models the length of production (LOP) increases with the interest rate, which, as was emphasized by Hülsmann, is in clear contrast to the Austrian understanding of the structure of production.
Machaj (2015, 2017) tried to solve the inconsistency between these results and the Austrian literature by emphasizing the importance of the Intertemporal Labor Intensity (ILI) in the production’s structure. According to this terminology, ILI indicates the amount of money being spent on original factors of production in the earlier stages of production relative to the later stages.
High ILI corresponds to the case where most wage payments, i.e. labor investment, are concentrated in the early stages of the production process. Low ILI corresponds to the opposite case, where most wages are paid in the last stages of production. Machaj does not quantify the relation between the ILI and the correlation between the LOP and the interest rate; however, it seems that he relates low ILI with negative correlation and high ILI with a positive one. This tool helps him to explain the positive correlation between the LOP and the interest rate in Hülsmann’s and Fillieule’s model, since, according to him, in both models the ILI is high (see Machaj [2017, 78]).
Clearly, the ILI has an important impact on the structure of production. However, how can it explain the inconsistency between the Austrian literature and the results of Hülsmann and Fillieule? After all, contrary to Machaj’s claim, the ILI is completely different in the two models.
In Hülsmann’s case, the ILI is clearly high (since labor is invested only in the first stage of production). However, in Fillieule’s model, most of the labor investment is concentrated in the last stages of production (after all, there are infinitely many stages, but the labor investment increases exponentially), and therefore the ILI is definitely low, regardless of the interest rate.
Nevertheless, both models present a positive correlation between the LOP and the interest rate (provided the ratio between investment and consumption is fixed).
Therefore, knowing the ILI is insufficient to determine whether the LOP increases or decreases as a function of the interest rate.
Moreover, the ILI is not a well-defined quantity. If ILI is a measure of the average period of labor investment, then it is almost identical to the Böhm-Bawerkian definition of the APP. Then it is clear that the APP is low whenever the ILI is low and vice versa. Therefore, the ILI does not add information to the question about whether the APP will increase or not; the ILI is the solution to this question. But, as we will see below, the situation is even more complicated than that.
Hülsmann emphasized that it is not surprising that in both models the same positive tendency appears, i.e., LOP increases with interest rate, because, according to him, they basically followed the same methodology. However, a close inspection reveals major differences.
Nevertheless, despite the differences between the two models, they are, basically, two specific cases in a more generic one.
CONSTRUCTING THE GENERIC MODEL The generic model, is the case where there is a finite number of production stages N (like Hülsmann’s, Hayek’s and Rothbard’s models), but in every production stage the investment consists of capital investment, whose fraction is (1-a), investment in original factors (OF), whose fraction is a (as in Fillieule’s model) and interest fraction r (it should be noted that only when the time period of a single stage is one year does r stand for the annual interest rate). Mathematically, it means that the amount of money capitalists spend in the -nth stage is I-n and the consumption at the final stage (stage zero) is equal to c, i.e.,
(4)
In the first production stage of high-level goods, the investment is equal to
(5)
In general, the expenditure on OF of production at the nth stage of production is
(6)
that is, in the intermediate states only a fraction a out of the entire investment is dedicated to OF, while in the first production stage all investment is directed to it.
Therefore, the investment in capital products at the -nth stage of production is
(7)
(note that we adopted Fillieule’s notations except for the stages’ numeration).
Consequently, the relation between the investments in adjacent stages is (for 2 ≤ n ≤ N)
(8)
The structure of production of this generic model is presented in Fig. 3.
Figure 3.
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This is a generic model: Hülsmann’s model is a specific case, which can be derived by taking the limit of zero expenditure on original factors, i.e. a —> 0, while keeping the number of production stages finite, i.e., N < ∞. Fillieule’s model can be reconstructed by keeping a constant percentage of the expenses on original factors, i.e., a > 0, but taking an infinite number of stages, i.e. N —> ∞. In both models, the interest rate is taken to be non-zero, i.e., r > 0. It should be noted in passing, that the generic model encompasses a third kind of structure, which is reminiscent of Hayek’s (1935) model of the structure of production in that it does not take the interest payments into account, i.e., r = 0. However, it is not the same kind of structure because Hayek’s structure is linear, while the generic model is exponential.
Now, since the LOP in both models (Eqs. 1 and 2) is independent of a we find a problem. Nevertheless, before we explain the problem, we must emphasize again the point that r in our model (as in Fillieule’s and Hülsmann’s) is not the annual interest rate, but rather the interest rate paid in a single production stage. Therefore, if one chooses very short production stages (in the possible range), r can be arbitrarily small regardless of the interest rate (note that the ratio I/C is independent of the length of the stages). In this limit, Fillieule’s result reveals only a negligible dependence on the interest rate.
In fact, if one follows Fillieule’s derivation with a single difference: omitting the interest rate at the last stage of production, the prefactor (1+r) vanishes, i.e., λ = I/C. Therefore, the dependence on the interest rate (1+r) is a result of the last stage and has nothing to do with the entire (infinitely long) structure of production.
If the number of production stages is finite, then it is clear that in the limit of low interest rate rN << 1 Hülsmann’s model is retrieved, because then Hülsmann’s trapezoid shape appears. However, in the limit of high-interest rate rN >> 1, Fillieule’s model is retrieved, since in these cases the amount of investment in the early stages (n > 1/r ) is minuscule, and therefore for any practical purposes N can go to infinity without affecting the distribution of investment.
Consequently, the parameter which determines in which domains we are is the product Nr. If Nr >> 1 then the model enters Fillieule regime (the production structure is approximately exponential), while when Nr << 1 the model enters Hülsmann’s domain (the production structure is approximately trapezoidal). Clearly, however, our model is richer than the two independent regimes.
Now, we can turn to and explain the problem:
When the interest rate is low, then the APP can be approximated by Eq. 2, i.e. , however, since I/C > 1 then . However, , as was explained above, should be valid for higher interest rates, when the number of stages diverges. Therefore, for any given interest rate, Hülsmann’s model APP is higher than Fillieule’s, which means that eventually, the APP must decrease. Below we will present this behavior in detail.
The inevitable conclusion is that the two formulae do not present the same reality, and not even the same tendency. In fact, these results show that for low interest rates, the LOP increases with the interest rate, while for high interest rates the LOP must decrease. The mathematical proof for this will be presented below.
There is no monotonic dependence on the interest rate. Therefore, not only do these models contradict the Austrian and neo-classical literature, but a reswitching >musteventually occur. Reswitching is, then, not an anomaly or a mere curiosity, but it is the norm (provided the ratio between consumption and investment is fixed).
It should be stressed, however, that this “reswitching” is not equivalent to Samuelson’s original one. This is because the reswitching does not occur between two different production methods, but rather a reswitching occurs in the sense that for low interest rates the production structure is short; when the interest rate increases the structure of production lengthens. However, it shrinks again when the interest rate keeps increasing.
One of the reasons that this unexpected conduct was overlooked is that there are inconsistencies in the definitions of the LOP.
In what follows, we will solve this model analytically, and present the reswitching result. However, before we do that, we have to clear up the confusion regarding the definition of the LOP.
Jevons, Hayek, Rothbard, and Hülsmann identified the LOP with the number of production stages. When the number of stages is low, i.e., when N(α+r) << 1, the number of stages is indeed a very good estimation to the LOP. However, when the number of stages increases, the amount of money invested in the early stages of production, i.e., where higher-level goods are produced, is small in comparison to the aggregate investment. Therefore, the contribution of these stages to the LOP is negligible. Clearly, when the number of stages is infinite, i.e., when the production process begins at the dawn of humanity (as in Fillieule’s model), it is clear that the number of stages is an inadequate evaluation of the LOP.
It should be stressed that taking the production stages to infinity is not merely an academic exercise. In fact, as was stressed by Machaj (2017), any modern production process begins with capital goods. It is almost impossible to reconstruct a production process that does not require capital goods in its initial production stage. Therefore, an infinite number of stages does not seem to be the exception, but rather seems to be the norm, and should not be disregarded.
Ironically, it seems that Böhm-Bawerk has realized this problem, and used the average period of production, which is defined as the “average time interval occurring between each expenditure of originary productive forces and the final completion of the ultimate consumption good.” Therefore, instead of using the ambiguous term LOP, we would use the more clearly defined term “average period of production” (APP). This term can easily be implemented in all three models by
(9)
where Ln is the amount of money invested in labor during the nth stage of production, while
(10)
is the aggregate investment in original factors (labor and land).
Hereinafter we will adopt Fillieule’s assumption that in the intermediate stages all the investment on OF consists of labor’s salaries. This is a reasonable assumption because it is very rare that the industries utilize unprocessed OF, i.e. non-capital goods, during intermediate stages of production. Moreover, it is not a restrictive assumption, and the model can easily be generalized.
CALCULATION OF THE APP From Eqs. 5 and 8, the investment in the nth stage can easily be calculated:
(11)
for n ≥ 1, where, for simplicity, the following notation was used
(12) .
Then, aggregate saving is (see Appendix A)
(14)
Similarly, the aggregate income of owners of OF is
(15)
where
(16) ,
are the incomes of owners of OF in the -nth stage, which is a manifestation of the fact that in the Nth production stage all money is invested in OF, while in the intermediate stages only part (a) of the money is invested in them.
Similarly, the aggregate income of owners of capital goods is equal to
(17) .
Using Eq. 9 the APP is (see Appendix A)
(18)
which can be solved as
(19)
The dependence of the APP on the interest rate is via the auxiliary parameter q.
According to Eq. 19 when the parameters a and N are fixed then λ (the APP) decreases when the interest rate r increases. However, when the interest rate varies, so does the aggregate investment I (according to Eq. 14).
In order to keep the aggregate investment fixed, the number of stages of production N must increase accordingly. Therefore, in order to keep the ratio between consumption and investment fixed, one can substitute the number of stages N from Eq. 14 into Eq. 19, i.e., to substitute
(20)
in the expression for λ, (note that Eq. 3 is a specific case when a=0). But before we do it, it is useful to adopt the following definition of the critical interest rate
(21) .
Using this terminology, the number of production stages, i.e., Eq. 20, can be written
(22) .
which clearly diverges when r —> rc.
By substituting Eqs. 12, 21, and 22 in Eq. 19 the APP can finally be written as (see Appendix B for elaboration)
(23)
When a —> 0 then λ —> N, i.e., the APP converges to the number of stages. In fact, as long asr << rc and a << r then λ ≅ N (see Eq. B2 in Appendix B), i.e., in this case, the number of production stages is indeed a good approximation of the APP. This is the interest rate regime, which was investigated by Hülsmann.
However, as the interest rate approaches the critical interest rate, i.e., r ≅ rc, then the number of stages N diverges, while the APP, i.e. λ, does not (see Fig. 4). In fact, the APP finally decreases and converges to (note that all the terms (rc-r) in Eq. 23 vanish)
(24)
which is exactly Fillieule’s (2007) result for r ≅ rc .
In context of the generic model, which is presented in this paper, we see that Hülsmann and Fillieule investigated different regimes of the interest rate. Hülsmann’s model agrees with the generic model at the low interest rate regime, while Fillieule’s model agrees with the generic model only around r ≅ rc, where the number of stages diverges.
As can be seen from Fig. 4, there is an interest rate level r, below which the APP increases, and above which the APP decreases. This is the point where APP receives its maximum value λmax = λ(r) (see Fig. 4).
Figure 4.
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In Fig. 5, the APP as a function of a and r is presented in a contour plot. As can be seen, for any given 0 < a < C/I there is an interest rate, which is lower than the critical one, in which the APP receives its maximum value, and above which it decreases to almost the initial value.
Figure 5.
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This maximum effect is especially noticeable when the fraction of OF’s investment is very low, i.e., a << 1 (For details, see Appendix C).
This “reswitching” phenomenon occurs due to the following reasons. In the low interest rate regime, any increase in the interest rate forces the APP to expand in order to compensate for the reduction in the high-level stages of investment. However, this process cannot last for long, since when the interest rate increases beyond a certain level (r*), the reduction in the low stages’ investment reduces the APP beyond the increase caused by the additional stages. Thus, in this regime, the APP decreases. Beyond the critical interest rate (rc) the reduction in the low stages’ investment cannot be compensated by the negligible investment in the high stages of production.
It should be emphasized that when r < rc the interest rate can increase while both I/C and a are fixed, because the number of stages can increase. However, beyond rc, since the number of stages is already infinite, it is impossible to raise the interest rate without affecting either a or I/C. In this regime, if the ratio I/C is fixed, then λ = (I/C)(1+r) (Eq. 1), in which case the APP mildly increases with the interest rate (see the dashed curve in Fig. 6). However, if a is fixed, then APP obeys the equation λ = (1+r)/(r+a) (see Fillieule [2007]), in which case the APP decreases with the interest rate (see the solid curve in Fig. 6).
Figure 6.
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A further important and original result is, that the APP does not have a simple monotonic decreasing dependence on the ratio between consumption and investment (as wrongly predicted in the literature, see, for example, Chapter 8 in Murphy [2006]). If the fraction a and the interest rate r are fixed, the APP initially increases with the ratio (C/I), and only after receiving its maximum value, it begins to decrease (as N does); see Fig. 7.
Figure 7.
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In countries like the United States where C/I ≈ 0.5 (see Skousen [1991, 45]) the difference between rc ≡ C/I a, and r (the interest rate with the longest APP) is very small (see Fig. 8 where r was calculated numerically).
Figure 8.
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This fact can explain why this “reswitching” was missed in the literature, and how it became common knowledge that the APP must decrease when the interest rate increases.
SUMMARY AND CONCLUSION A generic model of the structure of production was presented and studied. Hülsmann’s and Fillieule’s models are two limiting cases of the generic model. The low interest regime of the generic model can be approximated by Hülsmann’s model, while the high interest regime of the generic model can be approximated by Fillieule’s model.
Thus, the generic model leads to a result that is different both from the older Austrian literature and from the recent one.
Therefore, this model predicts that when the interest rate increases, the APP does not decrease as the neo-classical models (and the old Austrian literature) predict. Moreover, the APP does not increase as the new Austrian models predict.
In fact, the main prediction is that when the ratio between consumption and investment is fixed, the APP increases for low interest rates, but beyond a certain value, it decreases.
This conduct resembles a “reswitching” behavior when the APP is low for both low and high interest rates, but it grows for intermediate interest rate levels.
However, this conduct can occur only if the ratio between consumption and investment (C/I) and a are both fixed, which is possible to maintain only within a narrow range of interest rate values. Whenever the interest rate exceeds this range, at least one of these parameters, either (C/I) or a, must vary as well. If the former (C/I) is fixed, then the recent Austrian prediction holds, but when the latter (a) is fixed, then the older Austrian prediction is valid.
Abstract: Ulrich Fehl was an Austrian scholar from his graduate school days, and made contributions to our understanding of capital theory, market process theory, and Austrian and evolutionary economics. Influenced by Ernst Heuss, Fehl added the total market perspective to Huss’s theory of the succession of market phases. Leaving behind standard equilibrium theory, Fehl focused on learning and the resulting change in human action. As chair of General Economic Theory at Marburg University, and a master theoretician, he was always careful to convey to his students the practical uses of economic reasoning for solving everyday problems in society. With his clear writing and teaching, Prof. Fehl left a legacy that should remain inspiring for Austrian economists far into the future.
austrian economics — evolutionary economics — market process — capital theory
Peter Engelhard (petengelha@gmx.net) is a private scholar living in Germany.
Prof. Ulrich Fehl, emeritus at Marburg University, died on November 9, 2019 at the age of 80 years. He was buried in the cemetery on Wiesenweg, Marburg. Ulrich Fehl left behind his wife Barbara and daughter Vera. Standing by Prof. Fehl’s open grave, we struggled with our deep grief and admired his family’s firm composure. Almost comforting as prayer and the good words of the pastor, however, was the German tradition of gathering after the funeral. Goulash soup and sandwiches, served according to old custom, brought pleasant memories of Ulrich Fehl to family, friends, former colleagues and students. Memories not only of a scientist with the broadest of scholarly interests, but memories also of a great personality of benevolence, respect for everybody and a fine dry humor, the friendly elegance with which he parried in discussion and conversation. Memories of long, never tedious, and most inspiring discourses with our academic teacher. Everyday work with Prof. Fehl came to our mind again, as when he arrived in his 18-year-old green Audi sedan at the campus always precisely 10 minutes behind the agreed time—nevertheless making it always exactly on time to the lecture hall. Talking on such topics in increasingly good spirits, we became aware: Prof. Fehl will be among us as long as we remember him as a man and as long as we cultivate his scientific heritage.
Ulrich Fehl was born on January 27, 1939 as the son of a miner’s family in Bochum. After graduation, he first completed a commercial apprenticeship at the German oil company ARAL, now part of BP. Only then did he acquire a university entrance qualification and finally studied economics in Münster, Giessen and Nuremberg. Ulrich Fehl was already extremely well read as a young man. No wonder he easily fulfilled the strict requirements of a German government scholarship. He graduated with two degrees—business and economics. His calling, however, was to live and work as a scholar. In 1971 he received his Ph.D. from Philipps University at Marburg. His thesis, “Produktionsfunktionsfunktion und Produktionsperiode” (1973) deals with fundamental issues of Austrian capital theory. In 1981 he achieved the venia legendi for economics with a major elaboration on competition processes in Walrasian perspective. Carl von Ossietzky University at Oldenburg appointed him full professor of economics in 1981. Finally, Fehl returned to Marburg in 1987 to hold the chair for General Economic Theory until his retirement in 2004. He also served as director of Philipps University’s Institute of Cooperatives. Fehl left behind a comprehensive scientific work, whose emphasis lies in the theory of capital, market process theory as well as Austrian and evolutionary economics.
Ulrich Fehl’s methodology was much influenced by his academic teacher Ernst Heuß (1922–2010). Heuß’s theory of the succession of market phases combines the theory of entrepreneurship with market development, and incorporates the development of knowledge and strategic behavior in the market place. Fehl added the total market perspective to this approach, thus achieving an important improvement. The core of his theory is the discovery and emergence of new knowledge in the process. His formal mathematical analyses also leave behind standard equilibrium theory. The focus is on learning and the resulting change in human action. This idea not only shaped his academic research, but also shaped the textbook on basic microeconomics which he published in 1976 together with Peter Oberender (1941–2015). The didactics are based on Ernst Heuß’s “Grundelemente der Wirtschaftstheorie“ (1970) which—unlike the “Grundelemente”—also contains a part on macroeconomics. Fehl himself had worked on a textbook on macroeconomics that is consequently based on micro-foundations. His university lectures on macroeconomics were structured like this, but he could not finish a second textbook on this subject in his lifetime. Fehl’s didactic approach to microeconomics, however, consequently takes its starting point in the market process and dispenses of, unlike many other textbooks, a lengthy declination of the entities and categories of this subject matter.
During the 1980s, Ulrich Fehl got into personal contact with important protagonists of neo-Austrian economics such as Ludwig M. Lachmann and Israel M. Kirzner, which gave important new impulses to his reasoning on the market process. He was particularly proud of the fact that he had been invited to contribute a piece on the Lachmann-O’Driscoll problem to Kirzner’s anthology of essays in honor of Ludwig M. Lachmann on his eightieth birthday (Fehl 1986). Furthermore, Fehl dove deeply into Friedrich A. von Hayek’s work. The emergence of an economic order out of persistent equilibration and disequilibration in the market process was a truly Austrian and pivotal element in his thinking.
Ulrich Fehl’s approach to capital theory is based on the Austrian temporal methodology which may be considered as an alternative to the neo-classic capital theory. In “Produktionsfunktion und Produktionsperiode” he analyzes how far the concept of production period may be used to measure capital, given that processes of capital formation are circular, i.e. capital is used to create capital. Furthermore, Fehl evaluated the Wicksell effect in a process perspective. Another contribution to capital theory is his analysis of technical progress, employment, and production (Fehl 1975, 1976).
Connected to his chair of economic theory at Marburg University was the office of being a director of the local institute for research on cooperatives. This office opened another field of fruitful economic thinking for Ulrich Fehl. He perceived cooperatives as spontaneous associations of independent market actors with very particular modes of organization and operating challenges. Cooperatives are vehicles for problem solving and testing economic hypotheses in the market place and, hence, became part of Fehl’s research program in evolutionary economics.
Ulrich Fehl was a universally educated scholar. His teaching and writing covered the full range of micro- and macroeconomics. Holding the chair of General Economic Theory at Marburg University offered the opportunity of making full didactic use of the manifold synergies between the different branches of economics—a situation which has become rare nowadays against the backdrop of increasing specialization and intellectual fragmentation in academic life. Despite playing—at his time—the role of a master theoretician on the faculty, he always made it very clear to his students that economic theory does not have its value in itself. Rather, he always demonstrated the very practical use of economic reasoning for solving everyday problems and issues in society. Fehl transferred this straightforward approach also to the field of economic policy. The anthology “Dimensionen des Wettbewerbs” (“Dimensions of Competition”) which he edited together with Karl von Delhaes in 1997—his last major publication—frames the interaction of competition, entrepreneurial and society’s institutions in a very realistic way and demonstrates the role of these factors for the design of alternative economic systems (Fehl and von Delhaes 1997).
Ulrich Fehl’s intellectual interests, however, expanded far beyond economics and covered natural science, history, philosophy and theology. For instance, Fehl was a connoisseur of Martin Luther’s works. He loved to involve his students in witty discussions on history in front of a large map of Germany which for years used to hang on the wall of his office. Writings such as his essay on the issue of “just” pricing (Fehl 1989) or another on the relationship of thermodynamics to social order and innovation processes (Fehl 1983) reflect his ability to connect economic thought with reasoning in ethics or natural science. His broad knowledge together with his crystal-clear style of writing and teaching gave his scientific work its unique twist.
Ulrich Fehl’s numerous contributions to journals and anthologies are rather dispersed. For easier access, Kerber and Schreiter presented a collection of Ulrich Fehl’s most important contributions to economic theory on the occasion of his 65th birthday (Kerber and Schreiter 2004). A summary of his work on capital theory was published in this journal on the occasion of his 70th birthday (Engelhard 2009). Ulrich Fehl’s scientific legacy should remain inspiring for Austrian economics long after his passing.
Abstract: Ulrich Fehl was an Austrian scholar from his graduate school days, and made contributions to our understanding of capital theory, market process theory, and Austrian and evolutionary economics. Influenced by Ernst Heuss, Fehl added the total market perspective to Huss’s theory of the succession of market phases. Leaving behind standard equilibrium theory, Fehl focused on learning and the resulting change in human action. As chair of General Economic Theory at Marburg University, and a master theoretician, he was always careful to convey to his students the practical uses of economic reasoning for solving everyday problems in society. With his clear writing and teaching, Prof. Fehl left a legacy that should remain inspiring for Austrian economists far into the future.
austrian economics — evolutionary economics — market process — capital theory
Peter Engelhard (petengelha@gmx.net) is a private scholar living in Germany.
Prof. Ulrich Fehl, emeritus at Marburg University, died on November 9, 2019 at the age of 80 years. He was buried in the cemetery on Wiesenweg, Marburg. Ulrich Fehl left behind his wife Barbara and daughter Vera. Standing by Prof. Fehl’s open grave, we struggled with our deep grief and admired his family’s firm composure. Almost comforting as prayer and the good words of the pastor, however, was the German tradition of gathering after the funeral. Goulash soup and sandwiches, served according to old custom, brought pleasant memories of Ulrich Fehl to family, friends, former colleagues and students. Memories not only of a scientist with the broadest of scholarly interests, but memories also of a great personality of benevolence, respect for everybody and a fine dry humor, the friendly elegance with which he parried in discussion and conversation. Memories of long, never tedious, and most inspiring discourses with our academic teacher. Everyday work with Prof. Fehl came to our mind again, as when he arrived in his 18-year-old green Audi sedan at the campus always precisely 10 minutes behind the agreed time—nevertheless making it always exactly on time to the lecture hall. Talking on such topics in increasingly good spirits, we became aware: Prof. Fehl will be among us as long as we remember him as a man and as long as we cultivate his scientific heritage.
Ulrich Fehl was born on January 27, 1939 as the son of a miner’s family in Bochum. After graduation, he first completed a commercial apprenticeship at the German oil company ARAL, now part of BP. Only then did he acquire a university entrance qualification and finally studied economics in Münster, Giessen and Nuremberg. Ulrich Fehl was already extremely well read as a young man. No wonder he easily fulfilled the strict requirements of a German government scholarship. He graduated with two degrees—business and economics. His calling, however, was to live and work as a scholar. In 1971 he received his Ph.D. from Philipps University at Marburg. His thesis, “Produktionsfunktionsfunktion und Produktionsperiode” (1973) deals with fundamental issues of Austrian capital theory. In 1981 he achieved the venia legendi for economics with a major elaboration on competition processes in Walrasian perspective. Carl von Ossietzky University at Oldenburg appointed him full professor of economics in 1981. Finally, Fehl returned to Marburg in 1987 to hold the chair for General Economic Theory until his retirement in 2004. He also served as director of Philipps University’s Institute of Cooperatives. Fehl left behind a comprehensive scientific work, whose emphasis lies in the theory of capital, market process theory as well as Austrian and evolutionary economics.
Ulrich Fehl’s methodology was much influenced by his academic teacher Ernst Heuß (1922–2010). Heuß’s theory of the succession of market phases combines the theory of entrepreneurship with market development, and incorporates the development of knowledge and strategic behavior in the market place. Fehl added the total market perspective to this approach, thus achieving an important improvement. The core of his theory is the discovery and emergence of new knowledge in the process. His formal mathematical analyses also leave behind standard equilibrium theory. The focus is on learning and the resulting change in human action. This idea not only shaped his academic research, but also shaped the textbook on basic microeconomics which he published in 1976 together with Peter Oberender (1941–2015). The didactics are based on Ernst Heuß’s “Grundelemente der Wirtschaftstheorie“ (1970) which—unlike the “Grundelemente”—also contains a part on macroeconomics. Fehl himself had worked on a textbook on macroeconomics that is consequently based on micro-foundations. His university lectures on macroeconomics were structured like this, but he could not finish a second textbook on this subject in his lifetime. Fehl’s didactic approach to microeconomics, however, consequently takes its starting point in the market process and dispenses of, unlike many other textbooks, a lengthy declination of the entities and categories of this subject matter.
During the 1980s, Ulrich Fehl got into personal contact with important protagonists of neo-Austrian economics such as Ludwig M. Lachmann and Israel M. Kirzner, which gave important new impulses to his reasoning on the market process. He was particularly proud of the fact that he had been invited to contribute a piece on the Lachmann-O’Driscoll problem to Kirzner’s anthology of essays in honor of Ludwig M. Lachmann on his eightieth birthday (Fehl 1986). Furthermore, Fehl dove deeply into Friedrich A. von Hayek’s work. The emergence of an economic order out of persistent equilibration and disequilibration in the market process was a truly Austrian and pivotal element in his thinking.
Ulrich Fehl’s approach to capital theory is based on the Austrian temporal methodology which may be considered as an alternative to the neo-classic capital theory. In “Produktionsfunktion und Produktionsperiode” he analyzes how far the concept of production period may be used to measure capital, given that processes of capital formation are circular, i.e. capital is used to create capital. Furthermore, Fehl evaluated the Wicksell effect in a process perspective. Another contribution to capital theory is his analysis of technical progress, employment, and production (Fehl 1975, 1976).
Connected to his chair of economic theory at Marburg University was the office of being a director of the local institute for research on cooperatives. This office opened another field of fruitful economic thinking for Ulrich Fehl. He perceived cooperatives as spontaneous associations of independent market actors with very particular modes of organization and operating challenges. Cooperatives are vehicles for problem solving and testing economic hypotheses in the market place and, hence, became part of Fehl’s research program in evolutionary economics.
Ulrich Fehl was a universally educated scholar. His teaching and writing covered the full range of micro- and macroeconomics. Holding the chair of General Economic Theory at Marburg University offered the opportunity of making full didactic use of the manifold synergies between the different branches of economics—a situation which has become rare nowadays against the backdrop of increasing specialization and intellectual fragmentation in academic life. Despite playing—at his time—the role of a master theoretician on the faculty, he always made it very clear to his students that economic theory does not have its value in itself. Rather, he always demonstrated the very practical use of economic reasoning for solving everyday problems and issues in society. Fehl transferred this straightforward approach also to the field of economic policy. The anthology “Dimensionen des Wettbewerbs” (“Dimensions of Competition”) which he edited together with Karl von Delhaes in 1997—his last major publication—frames the interaction of competition, entrepreneurial and society’s institutions in a very realistic way and demonstrates the role of these factors for the design of alternative economic systems (Fehl and von Delhaes 1997).
Ulrich Fehl’s intellectual interests, however, expanded far beyond economics and covered natural science, history, philosophy and theology. For instance, Fehl was a connoisseur of Martin Luther’s works. He loved to involve his students in witty discussions on history in front of a large map of Germany which for years used to hang on the wall of his office. Writings such as his essay on the issue of “just” pricing (Fehl 1989) or another on the relationship of thermodynamics to social order and innovation processes (Fehl 1983) reflect his ability to connect economic thought with reasoning in ethics or natural science. His broad knowledge together with his crystal-clear style of writing and teaching gave his scientific work its unique twist.
Ulrich Fehl’s numerous contributions to journals and anthologies are rather dispersed. For easier access, Kerber and Schreiter presented a collection of Ulrich Fehl’s most important contributions to economic theory on the occasion of his 65th birthday (Kerber and Schreiter 2004). A summary of his work on capital theory was published in this journal on the occasion of his 70th birthday (Engelhard 2009). Ulrich Fehl’s scientific legacy should remain inspiring for Austrian economics long after his passing.
Abstract: Karl-Friedrich Israel (2018) sees “obvious tension” in a book chapter (Salerno 2018) in which I argue that the Hicksian income effect plays no role in the causal-realist approach to the demand curve. Israel’s reconstructed “wealth effect” is an effort to solve this perceived problem. This comment addresses the expositional gap in my analysis, and resolves the perceived tension. I then outline the problems with Israel’s proposed solution, which involves a wholesale reconstruction of demand theory that, in the end, implies a denial of the law of demand.
income effect — demand curve — austrian economicsJEF Classification: B53, D11
Joseph T. Salerno (salerno@mises.org) is Academic Vice President of the Mises Institute and John V. Denson II Endowed Professor in the Department of Economics at Auburn University.
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INTRODUCTION In his article, “The Income Effect Reconsidered,” Karl-Friedrich Israel (2018) perceives a tension in a book chapter (Salerno 2018) in which I argue that the Hicksian income effect plays no role in the causal-realist approach to the demand curve. In section 2, I address the ambiguity in my exposition which leads to this perceived tension and show how it can be readily resolved. Section 3 presents a critical analysis of Israel’s attempt to solve the problem by drastically minimizing the substitution effect in favor of a reconstructed “wealth effect,” which Israel (2018, 384) claims is “more fundamental” to demand analysis. In section 4, I consider Israel’s reformulation of the wealth effect in more detail and argue that it implies a denial of the law of demand. Section 5 offers concluding remarks.
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THE CAUSAL-REALIST DEMAND CURVE: A CLARIFICATION OF ASSUMPTIONS When I derived the demand curve in my original article I assumed that the following remained constant: 1. the buyer’s value scale; 2. the prices of all other goods; 3. the buyer’s stock of money balances; and 4. the purchasing power of money. The third and fourth assumptions together imply that the buyer’s real money balances are constant. I argued that the stock of real money balances must remain unchanged for units of money to attain an ordinal ranking against goods on the value scale. If the purchasing power of money and hence the stock of real money balances were permitted to vary as the money price of the good in question changed, the buyer would not be able to compare the marginal utility of goods against that of money, and a demand curve based strictly on the law of marginal utility could not be traced out. I thus maintained that there is no “income” or, more accurately, “purchasing-power” effect because the value of money does not increase (decrease) as the price of a good falls (rises) along the demand curve. I concluded that there is only a substitution effect when demand curve analysis is based on the law of marginal utility.
Israel argues that, as stated, my conclusion contradicts my second assumption that the prices of all other goods remain constant. As Israel (pp. 380–81) puts it,
[W]henever some money price is allowed to change ceteris paribus, it has a direct effect on the purchasing power of money. When a money price increases along the demand curve, then the exchange value of money and hence its purchasing power decreases, and vice versa. If, however, the demand curve for a specific good is itself contingent on the purchasing power of money, a price change along a given demand curve is contradictory as it destroys the underlying assumption on which the demand curve is based.
It was to avoid just such a contradiction that I explicitly stated that it is the ex ante or anticipated purchasing power of money today—based on the individual’s experience of yesterday’s structure of money prices—that is assumed constant. The expected purchasing power of money is used to establish the individual’s marginal utility ranking of money relative to goods that is relevant to today’s market activities. From this value ranking of goods and money is derived the individual demand curve for a particular good.
Israel (2018, 381) recognizes my inclusion of the temporal element in the analysis but rejects it as “unconvincing.” I see now that there is an expositional gap in my analysis that requires repair, but I reject Israel’s proposed solution, which involves a wholesale reconstruction of demand theory that has not been thought out to its logical conclusion. Before proceeding to evaluate Israel’s attempt to resolve the “obvious tension” in my argument, let me present the simple and obvious solution that is ready to hand.
In order to maintain the expected purchasing power of money constant along the demand curve it is necessary only to restrict my second ceteris paribus assumption to the prices of closely related goods and to interpret the fourth assumption as implying that the general prices of all other goods move inversely to the price of the good in question so as to offset the change in the value of money entailed by the initial price change. This is simply another way of saying that the relation between the supply of money and the demand for money remains constant. Thus interpreted, the assumption of a constant purchasing power of money is no more unrealistic than assuming that all prices but the price of the good under consideration remain constant while the value of money varies. In fact, Milton Friedman ([1949] 1953, 51), following Marshall, considers this assumption as one—although not his preferred—way of generating the “income-compensated demand curve.” Accordingly, he assumes that the price of “the commodity in question” changes while holding the prices of “closely related commodities” constant but allowing the “average” price of “all other commodities to rise or fall with a fall or rise of the price of [the commodity in question], so as to keep the ‘purchasing power of money’ constant.”Austrian economists would of course replace Friedman’s concept of an “average” of prices of all other commodities with that of an “array” of particular prices of all other commodities.
Revising the set of assumptions underlying my approach in this way has the virtue of enabling analysis of the substitution effect in isolation from the purchasing-power effect. From an economy-wide perspective, this demand curve construct allows the economist to analyze the effect on a good’s price of a change in its supply (a movement along the demand curve) in abstraction from the effect on its price of a change in money demand or money supply (a shift in its demand curve). For if we allow the purchasing-power effect to manifest itself when, for example, the price of a good falls along an individual’s demand curve, then it implies that either the overall demand for money in the economy has risen or supply of money has fallen.
Now this solution does not deny that a change in the price of a good may cause both a substitution effect and a wealth or purchasing-power effect. It merely permits the two effects to be analyzed separately in order to isolate the operation of the law of marginal utility. Holding the purchasing power of money constant permits the substitution effect to be portrayed as a movement along the demand curve. With respect to the purchasing-power effect, under my revised set of assumptions, we would treat this effect as we would any change that exogenously alters an individual’s real money balances, that is, as a “real balance effect.” For example, in the case of a fall in price, real balances would rise, causing a rightward shift of the agent’s demand curves for various (normal) goods including the good in question. Using this analysis, we could also show, for example, that in the case of a big enough drop in the price of an inferior good that absorbs a large part of a household’s budget, the purchasing-power effect (shift to the left of the demand curve for the inferior good) outweighs the substitution effect (a movement down along the demand curve), which would result in less of the good being purchased by the household at the lower price. This allows us to explain Giffen’s Paradox without invoking an upward-sloping demand curve.
Alchian and Allen (1977, 69) give a very similar analysis of the “income effect.” As the price of a good falls, there occurs what they call an “expenditure-releasing effect”—that is, an increase in the purchasing power of money—because less money now is spent on the good at the initial quantity demanded. This “released purchasing power” causes a rightward shift of the individual’s demand curves for (normal) goods, including the good whose price has fallen. The substitution effect is then represented as a sliding down along a higher demand curve.For a similar analysis, see also Alchian and Allen (1972, 69–70) and Alchian and Allen (2018, 119–20), although these treatments do not explicitly mention the important concepts of the “expenditure-releasing effect” and “released purchasing power.”
- A CRITIQUE OF ISRAEL’S SOLUTION Israel offers a very different resolution of the tension he perceives in my article. He suggests that what must remain constant is “the opportunity costs of expending a given sum of money in exchange for the good in question” or, more precisely, “the purchasing power of money with respect to other goods that the person values and might want to acquire.” He argues that the fulfillment of this condition will lead to the “important assumption” for deriving the demand curve, namely, a fixed ordinal ranking of money and the good in question. There are several problems with Israel’s approach.
First, a fixed ordinal ranking is exactly what results from my revised set of assumptions above. With the purchasing power of money constant, the relative ranking of units of money and units of the good demanded will remain unchanged. Second, Israel (2018, 282) is curiously reluctant to explicitly state the assumptions about the external, objective conditions that underlie the internal or subjective prerequisite for deriving the demand curve, namely, that “the subjective value of money does not vary relative to the subjective value of the good in question.” He explains his disinclination to do so by asserting that because a fixed ordinal ranking is subjective “we cannot boil this assumption further down.” But this is a non sequitur. Surely we can specify which objective conditions in the economy are or are not consistent with this assumption. For example, allowing the prices of a good’s complements and substitutes to vary would be inconsistent with maintaining intact the individual’s ordinal ranking of the good in question and money. Israel (2018, 283) seems to realize this when he acknowledges that his precondition of a fixed ranking is consistent with Hicks’s assumption that all other prices in the economy are constant. He then appears to back off such a strong assumption two sentences later by declaring, “strictly speaking, what has to be held constant for the construction of the demand schedule are the opportunity costs of expending money on the good in question, whatever the influencing factors of this subjective notion may be.” Later in his article, Israel (2018, 394, 396) seems to reverse his field yet again by explicitly using the Hicksian assumption in an example in which he derives the demand curve and then conceding in his conclusion that his own “assumption for the derivation of the demand curve essentially boils down to Hicks’s original assumption.”
Israel’s strange reluctance to clarify the assumptions he uses in deriving the demand curve is inconsistent with causal-realist analysis, which is predicated on a tight and consistent connection between single-market or “partial equilibrium” analysis and general interdependence analysis. As the prominent monetary theorist, Arthur Marget ([1938-1942] 1966, 166), pointed out:
To say that the “demand schedules for particular industries can only be constructed on some fixed assumption of the nature of demand and supply schedules of other industries” is to say nothing more than... what has come to be called “partial equilibrium” analysis is continually subject to the limitations imposed upon it by “general equilibrium” analysis of the Walrasian type.Marget ([1938–42] 1966, 170, fn. 55) is here using the term “general equilibrium analysis of the Walrasian type” in a loose sense that includes Austrian-type general interdependence analysis. He thus notes the similarity between the early 20th-century American “Austrian” price theorist Herbert J. Davenport and his “system” and that of the Lausanne school in Davenport’s “insistence in stressing the limitations set by the fact of the general interdependence of prices to [partial equilibrium] analysis.” [Emphasis is in the original.]
In any case, Israel’s failure to fully and forthrightly state the assumptions underlying his derivation of the demand curve renders his solution inadequate at best. If he does not completely embrace Hicks’s assumption, then he needs to provide a different assumption about the constancy or variation of other prices in the economy that are required for the fixity of the ordinal ranking of money and the good in question. If he is unable to articulate an alternative assumption, then I think he is compelled to assume the constancy of the purchasing power of money as I have explained above.
This brings me to the third problem with Israel’s solution, which is closely related to the second. Israel (2018, 396) accepts my point that causal-realist demand analysis entails that “money is treated as an actual good that is valued as such and that is demanded or retained. It is not simply a numeraire.” But once it is admitted that money as a valued good plays a key role in deriving the demand curve, assumptions about its own supply and demand must be made explicit. According to Israel (2018, 380–81): “When a money price increases along the demand curve, then the exchange value of money and hence its purchasing power decreases, and vice versa.” In Israel’s analysis, therefore, a variation of the price of the good along the demand curve involves a disturbance in the market for money balances. If the price of the good in question falls, it does so because either: 1. There has been an increase in the reservation demand for money on the part of other buyers who increased their cash balances by reducing the market demand for the good; or 2. The overall supply of money in the economy has contracted with a particular incidence on those who were former purchasers and who reduce their demand for the good.
Israel neglects to state the assumption about the market for money balances necessary to his argument that the purchasing power of money changes as the price of the good in question varies along the demand curve. But once this assumption is explicitly stated, it raises the question of why the demand curve cannot be derived simply by assuming that the price of the good in question varies solely as a result of a change in relative demands for goods in the economy while leaving the market for money balances undisturbed.We would of course need to assume, as mentioned above, that the change in relative demands does not affect the prices of direct substitutes and complements of the good in question but only of unrelated goods. The demand curve yielded by the latter assumption, which is the one I propose above, would be different from the demand curve derived using Israel’s method of tacitly supposing changes in the market for money balances.
For Israel, the change in quantity demanded associated with the change in price thus conflates two factors: the effect of the law of marginal utility and the real balance effect. It is precisely because purchasing power and substitution effects are in reality inextricably intertwined that we assume that the purchasing power of money remains constant along the demand curve. This enables the causal-realist theorist to isolate the two effects for purposes of analysis. The effect of a price change on substituting between goods is illustrated as a movement along the demand curve; the effect of a variation of real money balances is shown as a shift of the demand curve. This analytical distinction is especially useful in explaining the step-by-step process of adjustment to a change in the money supply in a closed economy or the balance of payments in an open economy in which both effects play a crucial role (Hayek [1937] 2008, 351–66; Salerno [1984] 2010).
Marget ([1938-42] 1966, 301), an early critic of the Hicksian income effect, supports this point by arguing that the “response of a given consumer’s demand for a particular commodity” may differ depending on whether it is induced by “an increase in ‘real income’ as the result of a fall in the money price of a given commodity” or by “a change in the level of money income with money prices remaining the same.” The Hicksian approach, which is based on “the interpretation of a fall in a given money price as an increase in the ‘real income’ of income recipients,” brings with it “pitfalls” associated with the index-number problem. According to Marget ([1938–42] 1966, 301), these pitfalls are avoided by
...the ‘older’ method of dealing with the effect of a fall in a given money price in relation to income.... For, according to this method, the fall in a given money price is regarded as affecting the quantity of particular commodities demanded either by causing a movement along a given demand schedule or by changing the conformation [i.e., shape] or position of a given demand schedule. [Emphasis added].
Israel ignores such considerations of analytical practicability because, at bottom, his position rests on a single-minded quest for greater realism in the derivation of the demand curve. But the demand curve is a mental construct just like the Evenly Rotating Economy (ERE), and the assumptions for constructing both are chosen by the theorist for analytical convenience. An economy operating under the complete absence of uncertainty and change as depicted by the ERE is not only unrealistic but unrealizable and self-contradictory. And yet this construction of a static economy enables us to disentangle the dynamic real-world phenomena of profit and interest for separate causal analysis. Similarly, the individual demand curve is merely a tool of thought that permits us to disentwine and separately analyze the substitution and real balance effects of a price change. The unrealism of the assumptions of the ERE and the demand curve are irrelevant to their respective functions. After all, the Hicksian assumption that all other prices remain constant in the face of a change in the price of one good is also highly unrealistic. For it heroically assumes that a change in the market for money balances exerts its full effects in the market for a single good, while leaving all other markets for goods undisturbed. Why is it somehow less realistic to assume that the purchasing power of money remains constant along the demand curve?
In fact, realism of assumptions has nothing to do with the matter because the demand curve is a mental construct, which selectively embodies some elements of action while abstracting from others. As Mises (1998, 65, 237–38) describes it,
An imaginary construction is a conceptual image of a sequence of events logically evolved from the elements of action employed in its formation. It is the product of deduction, ultimately derived from the category of action, the act of preferring and setting aside. In designing such an imaginary construction the economist is not concerned with the question of whether or not it depicts the conditions of reality which he wants to analyze. Nor does he bother about the question of whether or not such a system as his imaginary construction could be conceived as really existent and in operation. Even imaginary constructions which are inconceivable, self-contradictory, or unrealizable can render useful, even indispensable services in the comprehension of reality....
Furthermore, as Rothbard (2009, 576 fn. 15) insightfully points out, “The constructs are imaginary because their various elements never coexist in reality; yet they are necessary in order to draw out, by deductive reasoning and ceteris paribus assumptions, the tendencies and causal relations of the real world.” Thus, the demand curve does not exist in reality because changes in prices cannot coexist with the absence of income or wealth effects. Yet the demand curve, despite the unrealism of its assumptions, is essential to grasping the separate effects on the quantity of the good demanded of a change in its own price and a change in all other factors, including the purchasing power of money, despite—or rather, because of—the fact that these factors operate together to produce a composite effect in reality. Indeed, when the fictive assumptions that underlie the derivation of the demand curve are successively dropped, we retain the truth of an inverse relationship between price and quantity demanded. We then add to it further truths utilizing shifts in the demand curve to elucidate the causal relations between the demand for a good and changes in prices of closely related goods, future price expectations, the stock of money balances, and so on. Proceeding in this manner, we achieve progressively closer approximations to an account of the full reality of the pricing process.5
Philip Wicksteed ([1933] 1957, 439–527) presented the most profound and extensive analysis of the nature and function of the demand curve encountered in the literature. He clearly recognized that the method of imaginary constructs was necessary in deriving individual demand curves, or what he called “total utility” curves. Wicksteed ([1933] 1957, 474) argued that the curves: 1. are “purely abstract,” to be derived in the absence of other causes “that might be supposed in actual experience” to change the price or quantity demanded of the good under consideration; 2. are “isolated,” in that “we cannot conceive of a system of such curves” for a given individual “to be valid simultaneously”; and 3. are not constructed so that we can “read on them the effect of a rise or fall in the consumer’s income.” All these curves can do is “represent the subjective value attached by a consumer to each increment of the commodity, or the amount he would purchase at any given price.” And yet, he asserted, “their form has a high theoretical significance.”
In particular, Wicksteed emphasized that that an individual demand curve for a commodity cannot coexist with changes in the individual’s “total resources” or “income.” Thus, for Wicksteed ([1933] 1957, 482–85), as price increases along the individual demand curve toward its intersection with the price axis, we assume the individual’s “total resources or income are to remain the same, but that this particular market is to be closed to him,” i.e., the price rise surpasses his maximum buying price for the first unit. But if income is assumed to change as a result of the price movement, the demand curve vanishes because “this will affect the whole system of his scale of preferences.” And this is true whether income varies as a result of exogenous factors or as an endogenous effect of the movement along the demand curve, because “every curve is changed by a change in the supplies of other commodities as well as that to which it specially refers.” In the phrase I emphasized in the foregoing quotation, Wicksteed is referring to the additional supply of the good purchased at a lower price due to the income effect. In considering two demand curves for the same good for the same individual under the alternative suppositions that the person is “rich” and “poor,” Wicksteed concluded, “The two curves... would have no significant relation to each other.” In other words, an income effect, which renders an individual richer or poorer, is inconsistent with the derivation of a given demand curve.
Wicksteed ([1933] 1957], 486–87) also considered the effect of changes in the expected purchasing power of money caused by a variation of price along an individual demand curve to violate ceteris paribus assumptions:
[A]n attempt to trace an individual demand curve back towards the origin [i.e., the price axis] is legitimate, and its results are interesting, suggestive, and enlightening in proportion as the condition “other things remaining the same” is observed.... [Such] curves must depend for their construction on imaginative estimates of the value we ourselves should under present conditions attach to small increments of the commodity at given margins; not on attempts to reconstruct conditions that might really raise the market price to a high figure.
Here the “conditions” that Wicksteed is referring to are those in a besieged city in which the price of a staple such as bread suddenly rises substantially due to the good’s greater scarcity. A ceteris paribus demand curve for bread cannot be constructed if, as is realistically the case, this rise in price evokes expectations of an imminent rise in the prices of related goods and an impending collapse of the purchasing power of money and shrinkage of real incomes.
Wicksteed ([1933] 1957], 487) anticipated and responded to the objection that the restrictiveness and unrealism of the underlying assumptions of the demand curve make it worthless for analysis of real-world phenomena:
It may well be asked whether a method that needs so much guarding and explaining is worth adopting at all. The answer is that the principle of declining marginal significances is absolutely fundamental. The doctrine of surplus value in the thing bought over and above the value of the price paid [i.e., consumer surplus] is an inevitable deduction from it. The awakened mind must, and as a matter of fact does, speculate upon it.... It is intimately connected with the relations of Economics to life. A want of a clear understanding of it brings perpetual confusion into our speculations and entangles the student in perplexities and contradictions.
- ISRAEL’S WEALTH EFFECT: OVERTURNING THE LAW OF DEMAND Israel (2018, 384–95) appears to enmesh himself in such “perplexities and contradictions” when he attempts a radical reformulation of the derivation of the demand curve based on what he terms the “wealth effect.” According to Israel (2018, 384) the wealth effect is “a type of income effect” and is “more fundamental” than the substitution effect, which manifests itself “only in cases where demand is price elastic.” Israel goes beyond the neoclassical conflation of the substitution and income effects and enshrines the wealth effect as the core of demand analysis. In his zeal for realism, Israel (pp. 396–97) characterizes the demand curve as a concept directly intuited from raw experience,
...an easy and direct illustration of a very real phenomenon that most people intuitively understand, namely, that consumers are made better off when a given good can be acquired at a lower money price. The wealth improvement with respect to the cash balance may be used to finance an increase in the quantity of the good demanded.
In lieu of a detailed analysis of the wealth effect, the explanation of which takes up more than half of Israel’s article, I will restrict myself to two general comments. First, as argued above, the demand curve, at least in causal-realist theory, is a heuristic device that is designed to elucidate the operation of the law of marginal utility in the pricing process by tracing out the effect of a change of price on the quantity demanded, while all other factors influencing the amount of the good purchased are impounded in the ceteris paribus clause. In Israel’s formulation, in contrast, the demand curve mainly illustrates the direct effect on quantity demanded of a change in wealth, albeit a change caused by a change in the price of the good itself. The wealth effect, Israel (2018, 384) asserts, “...is a direct consequence of any price change along the demand curve.” But, as Wicksteed ([1933] 1957, 474, 483–84) emphasized, one cannot “read on [demand curves] the effect of a rise or fall in the consumer’s income” because a variation in wealth “will affect the whole system of his scale of preferences.” This holds true even if wealth varies exclusively as a result of a change of the price of the good to which the demand curve “specially refers.”
This brings us to a second objection to Israel’s conception of the demand curve. While arguing that the wealth effect dominates the substitution effect in determining the shape of the demand curve, he presumes that the demand curve is downward sloping. Let us take the example that he gives of a farmer’s demand schedule for beer, which is presented in Table 1. The farmer is supposed to be initially endowed with 200 monetary units and to trade them for volume units of beer, let us say dollars and liters, respectively.Israel (2018) uses euros and Masskrugs.
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Now if we assume prices of all other goods remain constant, as Israel does, then a decline in the price of beer brings about an increase in wealth. That is, at the same quantity demanded, a lower price enables the buyer to afford more preferred combinations of beer, other goods, and retained cash balances. However, Israel’s demand schedule implies that the buyer would always either use a portion of this “released purchasing power” to increase the amount purchased of beer or maintain the quantity demanded of beer constant and expend the entire windfall on additional units of other goods or building up his cash balance or both. Israel thus illustrates the wealth effect with discrete, downward-sloping demand curves with vertical segments, as exemplified in the demand schedule in Table 1.
In causal-realist theory, however, a change in an individual’s wealth revolutionizes his preference scales and, therefore, the entire structure of his demand curves. As Wicksteed ([1933] 1957, 483) wrote:
[L]et us suppose that a man’s income increases or diminishes. This will obviously affect the whole system of his scales of preference. Possibly “pop and cockles” [i.e., clams] may completely fall out of his list of purchases, and “champagne and oysters” may appear on it; but in an ordinary case... while some modes of expenditure will probably be dropped and some almost certainly introduced, a large number will be extended.
In other words, an individual’s demand curves for a given good before and after winning $10 million in a lottery or receiving a $10,000 bonus from an employer are derived from different preference scales and therefore bear no relationship to one another. In theory, this is also true of an increase in real money balances accruing to an individual as a result of the “wealth effect” caused by a fall in price of a particular good in his budget. Thus Israel’s assumptions that the purchasing power of money is not constant along the demand curve and the wealth effect dominates the substitution effect conflict with his presumption that demand curves are always downward sloping with vertical segments. In fact, the demand curve may just as well be configured like the one depicted in Table 2 as the one in Table 1, with upward-sloping segments of the curve reflecting differences in scales of preference at varying levels of wealth. At the price of $11.25 per liter the buyer may reduce his beer consumption below the quantity demanded at $20.00 or $40.00 per liter because the additional wealth in the form of “released purchasing power” permits him to attain the higher level of satisfaction of a top tier bottle of bourbon and a beer chaser.As noted above, (p. 5) Alchian and Allen (1977, 69) calculate released purchasing power as the difference between the total expenditure on the good at the initial higher price and the new lower price for the quantity demanded at the higher price. For example, based on Table 2, if the price for a liter of beer falls from $20.00 to $11.25, then total expenditure on 3 liters of beer falls from $60 at the price of $20.00 to $33.75 at the price of $11.25, yielding released purchasing power of $26.25. At $6.00 per liter, his beer purchases increase because he is able to attain an even more preferred combination of goods and money balances that includes displaying his generosity by buying a round of beer for his friends at his local pub. A price of $3.33 per liter would put him in the position to enjoy a more preferred bundle of consumption goods and cash balances that includes one quick beer with friends and treating his wife to dinner at a new restaurant.
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We conclude that when the wealth effect, as Israel describes it, is proposed as the fundamental concept of demand analysis, the presumption that the price of a good and its quantity demanded, ceteris paribus, move inversely to each other no longer holds. In addition, the substitution effect thus becomes completely extraneous. The latter effect is not necessary to explain the response of quantity demanded to changes in price, even along elastic segments (e.g., between $11.25 and $6.00 in Table 2) as Israel claims. It may be fully explained by the change in wealth. The substitution effect can only be offered as a definite explanation for the shape of the demand curve when “wealth” or real cash balances and, hence, the scale of preferences remain unchanged.
- CONCLUSION Israel is to be credited for pointing out my lapse in expounding the assumptions underlying the derivation of the causal-realist demand curve. His insightful criticism has led to what I hope is a more satisfactory exposition. However, as I have tried to demonstrate, Israel’s attempt at a wholesale reconstruction of demand theory in the space of a few pages of a comment is both unnecessary and not carefully thought out. It reflects a misleading and self-defeating quest for realism that, in the end, leads—unwittingly—to a denial of the venerable law of demand, one of the most important and useful theoretical constructs for interpreting economic reality. That said, I am not completely dismissing Israel’s conception of the wealth effect as valueless for economic analysis. But in order to persuade mundane, workaday economists of its value, he needs to reframe it strictly in terms of its analytical usefulness rather than invoking an appeal to realism as the pivot of his argument.
Dr. Joe Salerno joins the show for a dynamic look at Human Action Part Four, arguably the meatiest part of the book.
Chapters 18, 19, and 20 are where Mises presents the idea of pure time preference, his expanded theory of interest, and the parameters of business cycle theory and malinvestment. Salerno and Jeff Deist consider how time relates to capital; gratitude for society's accumulated wealth; convertibility of capital thanks to stock markets; why holding cash can be productive; originary interest as a ratio, the fallacious classical and Marxist notions of interest, and the boom/bust cycle created by politicians, voters, and bankers who see that inflation "works" for awhile. This is a great discussion of Mises at his best!
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
In a 2006 journal article, “On Hayekian Triangles,” Walter Block and William Barnett list 14 separate objections to the popular device used (in various forms) by Hayek, Rothbard, and Roger Garrison to illustrate how artificially low interest rates lead to an unsustainable boom. Block concludes that the Hayekian triangle can be salvaged, while Barnett thinks it should be abandoned altogether.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
A private graduate seminar, recorded at the Mises Institute in Auburn, Alabama, on 18 July 2019.
Download the slides from this lecture at Mises.org/MU20_PPT_08.
Recorded at the Mises Institute in Auburn, Alabama, on 14 July 2020.
Austrian Capital Theory (ACT) sounds arcane, academic, and complicated. In fact, it’s the key to modern organizational design, cutting edge business structures, and the high-response business models leading entrepreneurs deploy to win in today’s business environment. Hunter Hastings and Per Bylund discuss how to apply Austrian Capital Theory in modern organizational design, contemporary business structure, and a high response business model.
Show Notes Austrian economics recognizes that capital and resources are so varied and different today that agile entrepreneurs can combine them and recombine them in ways that are highly differentiated — even unique. Every firm is a capital structure that is in continuous flux, as the entrepreneur changes and adjusts to create new value in response to marketplace and environmental changes. Therefore, the whole economy is a changing, rapidly evolving capital structure, generating economic growth. It is the appreciation of the need to continually shuffle the firm’s capital combinations, and the mastery and agility in doing so, that marks the Austrian Entrepreneur. He or she is an orchestrator of capital, buying and selling capital goods and combining them with new and retrained workers to change production processes, scale up to new levels of efficiency, and to solve customers’ problems in new ways.
The purpose of the orchestration function is to achieve the highest return on capital by creating the most customer value. The value of capital is the future revenue streams it generates from customers, and revenues are a reflection of value created. Entrepreneurs examine every piece of capital, and every capital combination, to measure how much value creation it contributes. Could it do more? Can the entrepreneur render the capital more productive in maximizing value at the end of the production chain?
How can entrepreneurs assess whether their combination of capital assets is right? The managerial accounting of Austrian entrepreneurs is not identical to formal financial accounting. A conventional balance sheet is not going to tell the truth about the money-value of assets, since it is not based on assessing future revenue streams. And this year’s P&L is of little use since it is static and backward looking. How can entrepreneurs differentiate between assets that it merely feels good to own and assets that genuinely create consumer value and future revenue streams? It’s not easy, but there are two useful steps, both of which focus you single-mindedly on the consumer.
Root out those assets that clearly do not contribute directly to consumer value, or clearly contribute very little. An office building might be one such example. It’s nice to have a central office, but couldn’t your employees contribute as much from a remote location, so that you can eliminate the cost of centralization?Examine capital combinations that could contribute more if they are rearranged. A server + software + trained personnel is a productive combination. What if the entrepreneur could ditch the server and rent computing power from AWS? What if the savings could be reinvested in more training for the person or better software? Would this rearrangement contribute more to consumer value? Renting rather than owning assets is one way to add dynamic flexibility to the firm. The entrepreneur should focus the firm on what it alone can uniquely do for its consumers and customers. Outsource everything else. The firm is a necessary vehicle for the entrepreneur to take ideas to market to earn a profit. It is at its most efficient when it is 100% focused on what it does uniquely: its unique brand, its unique processes, its unique recipe, its unique design, its unique functional and emotional benefits for the consumer. Everything else should be stripped away. The necessary infrastructure can be rented or outsourced. If you own 10 computers and have 10 people sitting at them every day, it’s hard to identify what productivity you are getting out of each of them every day. If you don’t own them, and you are thinking rigorously about the future streams of consumer value your firm is producing, you won’t feel locked in to your current capital structure.
A “capital-lite” structure in no way reduces the market value of the firm — in fact, it can increase it. In the past, companies were valued based on the assets they owned, as captured on the balance sheet. But this valuation method was based on an assumption that the assets were owned because they produced consumer value and contributed to profits. What if the assets are not contributing to future profit? They become a liability. Firms like GE are finding this out today — they own a lot of non-contributing assets and face major transaction costs in shedding them.
There is no need to own consumer value-producing assets. You need to control then and have the rights to utilize them to produce value, but not to own them. In venture capital markets, it is common to see firms change hands at a price that represents a high multiple of revenues or of earnings, even if the traditional capital base is insignificant. Assets that don’t appear on the balance sheet, like brand and a loyal customer base, are more important than those that do.
Actionable Insight The Austrian Entrepreneur reviews combinations of capital and labor and non-capital resources at every moment, seeking ways to improve that combination for the consumer’s benefit. The single-minded focus is on consumers and their changing preferences and the consequent implications for responsive change in the capital structure of production.
Additional Resource Austrian Capital Theory at Work (PDF): https://Mises.org/E4E_19_PDF
Bob finishes his three-part series by first reviewing the contributions of Böhm-Bawerk, Fetter, and Mises to the modern Austrian explanation of interest, namely the “pure time preference theory” (PTPT). Then Bob explains some of the problems for the PTPT, especially for Austrian economists. Instead, Murphy offers a much more straightforward—and Austrian!—approach, which explains interest as the premium placed on present versus future units of money.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Bob continues his series on capital and interest theory. In this episode he explains Böhm-Bawerk's solution to the problem of interest, namely that present goods are more valuable than future goods. Bob also explains Böhm-Bawerk's three separate causes for the higher valuation of present over future goods, including the notorious third cause, which is the higher physical productivity of more roundabout processes. Finally, Bob addresses the criticism of Böhm-Bawerk's theory coming from Keynes, Fisher, Frank Fetter, and Mises.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Bob begins his three-part series devoted to Capital and Interest Theory in the tradition of the Austrian School. This is his area of expertise, and the focus of his doctoral dissertation. In this episode, Part 1, Bob explains Böhm-Bawerk's critique of the "naive productivity theory" of interest, and also reconciles it with the standard approach in modern economics models of equating the real rate of interest to the "marginal product of capital."
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
While Ocasio-Cortez has a degree in economics, she apparently never learned the lessons stressed by Hernando de Soto in his The Mystery of Capital.
Suggested Reading "The 'Green New Deal' Debunked (Part 1 of 2)" by Robert P. Murphy"The Economic Role of Saving and Capital Goods" by Ludwig von Mises"The Plight of the Underdeveloped Nations" by Ludwig von Mises
Original Article: "Capital is a Mystery to Alexandria Ocasio-Cortez".
What are interest rates, where do they come from, and what purpose do they serve? Smith, Marx, and Keynes got these questions wrong; Turgot, Böhm-Bawerk, and Mises got them right. Economist Jeffrey Herbener from Grove City College explains.
Readings "The Brilliance of Turgot" by Murray RothbardProfile of Böhm-Bawerk by Roger Garrison
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The Economic Theory of Costs: Foundations and New DirectionsMatthew McCaffrey, Ed.London and New York: Routledge, 2018, xiv + 270 pp.
Karl-Friedrich Israel (KF_Israel@gmx.de) is lecturer at the Department of Law and Economics at the University of Angers, France.
Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.
This collection of essays edited by Dr. Matthew McCaffrey deals with one of the most fundamental fields of economic research: The Economic Theory of Costs. Indeed, it is so fundamental because of its close connection to all other central areas of research in theoretical economics, such as the theory of choice, value, price, capital, production, risk, uncertainty, and entrepreneurship. All of these are covered in some way in the book.
It spans over 263 pages and is separated into five parts, each containing two essays. Only the last part includes a third essay by the editor himself. Almost all of the eleven chapters are published for the first time in this collection and constitute pieces of original research. The one exception is chapter 4. It contains the first but ultimately discarded draft of Rothbard’s fifth chapter for Man, Economy, and State that was uncovered in the Rothbard archives at the Mises Institute a couple of years ago by Dr. Patrick Newman. He has re-edited and published it previously in this journal (Rothbard and Newman, 2015).In the volume it is also indicated that chapter 5 by Dr. Guido Hülsmann is a reprint of an earlier publication in the Quarterly Journal of Austrian Economics. This is incorrect. Hülsmann’s essay has only been published very recently as a GRANEM working paper (Hülsmann, 2017). The provided reference actually corresponds to the earlier publication of Rothbard’s draft chapter (fn. , p. 144). The page numbers in the earlier reference to the first publication of the draft chapter given in the book are wrong (fn. , p. 126). The reviewer earnestly promises that the rest of the review will be less pedantic. In fact, these are the only errors of this sort that have been spotted.
McCaffrey sets the stage with an introductory chapter, explaining that the contributions contained in the volume stand in the “causal-realist” tradition (McCaffrey 2018, p. 2), which is closely related to the distinctly Mengerian variant of the Marginalist Revolution and the research program that emerged out of it: Austrian economics. The purpose of the book is “to showcase a variety of research strands within the modern Mengerian tradition that relate in some way to the theory of cost” (p. 3). Menger and his intellectual heirs reconstructed economic theory on thoroughly subjectivist grounds, showing that costs in their various forms are derivatives of the subjective values of ends pursued or foregone. The subjective nature of costs is highlighted directly in the first part of the book entitled “Cost and Choice.” From there on the contributions proceed to different areas, applying the basic insights of the theory of costs to some relevant theoretical problems. We will go over them in the order maintained in the book, expanding on a number of selected issues that are of particular importance according to the undoubtedly subjective assessment of the reviewer.
PART 1 – COST AND CHOICE In the first chapter of the book, Dr. Jonathan Newman clarifies some of the foundations of the notion of costs, which he ultimately always considers to be opportunity costs. In particular, he highlights their subjectivity and forward-looking nature: “The ordinality and subjectivity of preferences applies to both value and cost. Just as value is appraised in action ex ante, so are costs” (p. 12). An opportunity cost, in this >ex ante sense, is the subjective value of the next best perceived alternative course of action, all expected consequences taken into account.
Newman identifies two common but contradictory notions of opportunity costs in the standard literature. The first simply defines them as the subjective value attached to the next best choice alternative. According to the second they are objective physical production trade-offs. Both notions are typically presented side by side in modern standard textbooks. This might account, as Newman persuasively argues, for some of the confusion on the topic identified in the literature and by experimental research (Ferraro and Taylor, 2005).
Probably more interesting for readers of this journal, however, is Newman’s discussion of George Reisman’s stance on opportunity costs as well as the recent back-and-forth between Dr. Eduard Braun and Dr. David Howden on the topic (Howden, 2015, 2016b, 2016a; Braun, 2016a, 2016b). Howden criticized Braun in a review of his book Finance Behind the Veil of Money (Braun, 2014), for among other things abandoning the opportunity cost concept. This critique triggered the debate. Newman sides with Howden and reiterates and expands on his convincing arguments for why the notion of opportunity costs, understood as forward-looking subjective expectations of the value of alternative courses of action, is important and useful to analyze human choice. Howden also showed why the ex post evaluation of opportunities is indispensable to find out whether one could have done better than one actually did. Yet these points are not even disputed by Braun. Both Howden and Newman fail to appreciate the actual problem hinted at in Braun’s analysis, namely, the identification of profit in human action and, more specifically, the ex post identification of monetary profits.
Taking ex post opportunity costs as the relevant benchmark for identifying monetary profit leads to a very strange result: A profit could only be made if one had actually invested in the best (or shall we say most profitable) project out there. Imagine tech investor Pete who happens to have picked the project FB for his investment. FB turns out to be the best among all the projects. Pete strikes it rich and actually makes a monetary profit. The latter is determined by the difference between the generated monetary income from FB and the unrealized monetary income Pete could have earned by investing an equal amount of money in the next best alternative.
Now assume that instead it turned out that there was an even better project. Let us call it Twttr. It has generated, for some other investors, an even higher monetary return than FB. This means that Pete would have made a loss instead, as Reisman and Braun lament by providing a number of other examples of this kind. Under this notion of opportunity costs, only investments in Twttr would have generated a monetary profit. This led Braun to focus instead on costs understood as historically incurred monetary outlays for his analysis of financial markets and interest rates. In fact, Newman implicitly acknowledges that Braun has a point when he considerably narrows down the applicability of the opportunity cost concept by stating “that opportunity costs cannot be identified in hindsight and that opportunity costs may only be identified for one choice at a time” (p. 20). If that is so, then good for Braun that he got rid of it for his purposes.
Moreover, it is not quite correct to accuse Braun of denying the importance of alternative uses of resources and foregone opportunities altogether. They are precisely what determines the monetary outlays necessary to acquire the means of production for any given investment project. The higher the expected subjective value of the alternative ends, to the attainment of which those factors could have been dedicated instead, from the perspective of the relevant market participants, the higher will be their money prices, and hence the monetary outlays necessary for the realization of the project.This argument is made, for example, in chapter 10 of the book by Dr. Per Bylund. The investor thus has to compensate for the alternative ends forgone. Costs understood as monetary outlays are indeed, in this very important sense, opportunity costs.
In the second chapter of McCaffrey’s book, Dr. Joseph Salerno presents a very dense theoretical discussion of the “unitary valuation process” (p. 32) that gives rise to money prices paid for goods on the market. He tries to show why there is no such thing as an income effect as a result of price changes along the demand curve for a specific good in causal-realist price theory, and thus responds to a long-standing debate in neoclassical economics.
He argues first of all, following the causal-realist approach to price theory, that an individual’s demand curve for a certain good is a higher-order abstraction. It can be derived on the basis of an ordinal value scale, on which all relevant goods including money are ranked, as well as the existing stocks of these goods in possession of the individual at the given moment. Second, the ranking of money relative to other goods presupposes a given purchasing power—“or rather, a definitely anticipated purchasing power of money” (p. 36). In other words, the purchasing power of money has to be held constant in order to derive the demand curve at the given moment in the first place.
All that happens in response to changes in prices along the demand curve are then substitutions with other goods according to the value scale of the agent. There is no income effect, or as Salerno terms it, purchasing power effect>, because a given purchasing power is a prerequisite for the derivation of the demand curve. The income effect is then merely an “illusion” (p. 35) stemming from the misapplication of demand curves.
However, the reviewer is puzzled by the question of how a price change could be possible without also changing the purchasing power of money. If the purchasing power of money is to be understood as the array of goods that can be bought with a given amount of money, then surely a price change for some good necessarily changes the purchasing power of money. But if a constant purchasing power is presupposed for the derivation of a demand curve, must the very idea of a price change along a given demand curve then not be considered bogus? Rather, under these assumptions, an exogenous change in the supply curve of a good that causes “price changes along the demand curve” must also trigger an alteration of the demand curve itself, to the extent that the subjective value of money changes in light of changes of its purchasing power.
To the reviewer it seems wrong to assume that the purchasing of money as such needs to be held constant in order to construct the demand curve for a specific good. Rather, one has to hold constant the purchasing power of money with respect to other goods and of course the actor’s subjective value scale. In other words, the opportunity costs of spending money on the specific good for which the demand curve is derived need to be held constant. If that is done, there seems to be a way to reconcile a kind of “income effect” with causal-realist price theory. In the reviewer’s eyes, a better term would be “wealth effect.”This idea is further developed in Israel (2018).
Salerno goes on to show why his result does not contradict the possibility of a backward-bending labor supply curve. The latter is possible without an income effect, solely on the basis of the law of marginal utility and a given value scale on which leisure is ranked against money balances. Salerno thus counters a critique raised by Caplan (1999) against Rothbard’s denial of the income effect, while still assuming that the backward-bending supply of labor is possible.
PART 2 – THE EVOLUTION OF CAUSAL-REALIST PRODUCTION THEORY The next two chapters are dedicated to production theory in the causal-realist tradition. Dr. Patrick Newman provides a review of Rothbard’s evolving thought on the topic in chapter 3, which is geared to Rothbard’s original draft chapter on production theory for Man, Economy, and State (Rothbard 2009), republished as chapter 4 in this volume. Rothbard ended up thoroughly revising his production theory and rejected this early version of the chapter. It therefore illustrates the evolution of Rothbard’s thought on the topic. Newman’s accompanying chapter is of great value for the student as well as the historian of economic thought as a brief comparative outline of different approaches to production theory.
Rothbard’s original draft chapter is much closer to the Marshallian partial equilibrium approach to production theory, although it already emphasized a number of weaknesses, such as the fact that one cannot develop a robust theory of investment from the perspective of an isolated firm. Rothbard’s final theory of production, however, adopts an Austrian general equilibrium approach as described by Newman. The latter is distinct from the Walrasian general equilibrium approach and essentially characterized by four features.
First, Rothbard rejects the conceptual distinction between competitive and monopoly prices for the analysis of a market economy as being arbitrary. The formal conditions that define a competitive situation are never met in the real world. As Rothbard pointed out even in his earlier draft chapter: “In this interpretation, every seller of an individualized commodity is a ‘monopolist’” (p. 85). Second, no firm can be a mere price taker. Every firm has some impact on the prices of its products and in that sense always acts under imperfect competition in neoclassical standard terminology.
Third, the standard isocost-isoquant derivation of factor demand curves is rejected as it obfuscates the causal link of price determination that runs from the money prices of the final product to the prices of the factors of production by backward imputation. In the causal-realist analysis, actual and expected output prices explicitly determine the capitalist-entrepreneur’s willingness to pay for factors of production according to their discounted marginal revenue product.
Lastly, the perspective taken in causal-realist production theory is not the one of a manager of some selected firm who in isolation—that is, at specified and constant factor costs—expands production until marginal revenue equals marginal costs. Instead, the vantage point of the capitalist-entrepreneur is taken, who can invest in a variety of different lines of production, which in a dynamic setting will have unequal rates of return. For any individual project it might therefore not be optimal to actually expand production to the point of optimality derived in the Marshallian partial equilibrium approach.
PART 3 – RISK, UNCERTAINTY AND COST In chapter 5 of the book, entitled “The Myth of the Risk Premium,” Dr. Guido Hülsmann sets out to defend a rather bold theoretical claim. He argues that
the prevailing conception of risk as related to the gross rate of interest is ill-founded. It is wrong to conceive of the gross interest rate as the sum of separate components. A closer analysis reveals that the whole idea of a risk premium within the gross rate of interest is a myth and should be discarded from economic science. (p. 134)
His analysis of risk is based on the Misesian distinction between class and case probability as well as the principle of subjective value. The most fundamental claim in Hülsmann’s essay is that probability is not an ontic category, but an epistemic one—that is, probability and more specifically risk is nothing out there in the real world, but it instead refers to our imperfect state of knowledge about the latter. The real world and its transformation is simply what it is: “It is subject to the inexorable laws of cause and effect” (p. 136). These laws are not risky or probable as such, but there is risk involved as far as our knowledge and value judgments about them are concerned.
Case probability refers to the type of imperfect knowledge relevant in the sciences of human action. It refers to cases where actors know some causal relationships, but they know neither all of the related causal chains nor everything there is to know about the relationships that they are aware of, such as their relative importance as compared to other casual factors. Hülsmann explains that subjective value judgments function as a filter through which our partial knowledge becomes relevant for human action. To the extent that one subjectively conceives of a case-probable risk associated with some investment project—that is, a factor that would negatively change its outcome—one attempts to eliminate or diminish that risk as far as possible. At the same time, one tries to amplify the factors that positively influence the outcome. This is the task of entrepreneurship or, as Hülsmann calls it, “the production of success” (p. 138). To the extent that subjectively conceived case-probable risks cannot be eliminated, they have an impact on one’s ex ante subjective assessment of the future value of that investment, and on the assessment of the marginal value product of related factors, but it has no impact on the discounting of these values as such.
Hülsmann argues that the differences in observable gross interest rates can thus not be explained by a risk premium as part of the gross interest rate. Instead, they simply “result from different subjective appreciations of available investment opportunities” (p. 142). He concludes that
the risk component in the gross interest rate is a sort of optical illusion. Different prices for different assets result from the fact that buyers and sellers appreciate them subjectively. From a microeconomic perspective, the implied differences in yield might be called risk premia. And one might use such premia in computations with an internal interest rate, to distinguish more interesting ventures from less interesting ones. But this does not alter the fact that the idea of a risk premium is an intellectual short-cut. It does not correspond to any real object. (p. 144)
The following essay by Dr. Jeffrey Herbener presents the theory of cost as an “example of the mistreatment of time in economic analysis” (p. 147). He incorporates cost curves, which Rothbard thought would not add anything, into the causal-realist framework of the analysis of production decisions and factor pricing. Herbener uses them very effectively to illustrate two implications of the passage of time.
In a pedagogically useful reconstruction of the theory of factor pricing, he first contrasts the timeless neoclassical general equilibrium theory, in which prices of factors of production correspond to the factor’s marginal revenue product and are determined simultaneously with final output prices, with the Austrian analysis of price determination in the evenly rotating economy (ERE). The latter takes production time, or the time structure of production, into account. Hence, factor prices correspond to the discounted marginal revenue product (DMRP). Future output prices determine the capitalist-entrepreneur’s demand for factors of production and thus determine factor prices in the present. Since there is no uncertainty in the ERE, the capitalist-entrepreneur’s factor demand is always such that the money prices paid for the factors used in production correspond to the DMRP and are thus consistent with future output prices. Any change in consumer preferences alters the equilibrium state as output prices change and hence factor demand and factor prices adjust accordingly.
As Herbener points out: “In actual markets, this adjustment process is rarely, if ever, completed, because the underlying causal factors are continuously changing” (p. 160), and because there exists uncertainty of the future. Uncertainty is the second implication of the passage of time for the theory of costs. The passage of time implies change, and change implies uncertainty. According to Herbener, this had not yet been satisfactorily incorporated into the theory of cost in the causal-realist tradition (pp. 160, 165). Capitalist-entrepreneurs discount the MRP, but in the real world they can only anticipate the latter. Hence, factor prices in the present are determined by the factor’s anticipated discounted marginal value product (ADMRP).
It is in Herbener’s words the “spectrum of foresight possessed by the various entrepreneurs” (p. 166) that determine the “speed and accuracy” of the adjustment process toward the equilibrium state as well as the distribution of profits during that process. As he summarizes:
Those with superior foresight move earlier into what prove to be profitable lines of production and earn profits which will then be capitalized into the prices of assets more specific to that line of production as the less-astute entrepreneurs follow suit. Even when the adjustment process reaches its climax and no additional profit can be earned from a further expansion of production because cost structures have been pushed up by rising prices for the more-specific assets used, the entrepreneurs with superior foresight will have earned capital gains by buying the more-specific assets earlier in the process than less-astute entrepreneurs. (p. 166)
PART 4 – CAUSAL-REALIST PRICE THEORY: DEBATE AND SYNTHESIS Chapter 7 of the collection contains a revision of the theory of monopsony, a concept that has been dismissed almost completely by both Mises and Rothbard. Dr. Xavier Méra argues that they and their followers “may have gone too far” (p. 170). Méra offers a brief overview of theories of monopsony, arguing that the new standard theory is essentially at a dead end in that it defines a monopsony in very much the same way as a monopoly is commonly defined, namely, in terms of a deviation from the pure and perfect competition model—that is, a situation in which supply and demand schedules from the perspective of the individual buyers and sellers, respectively, are less than perfectly elastic. Méra argues that this criterion “implies a nirvana fallacy,” since “such perfection is beyond anybody’s reach” (p. 174). Instead, in Rothbardian spirit, monopolies and monopsonies are to be regarded as the result of government intervention, whereby sellers or buyers are granted privileges over potential competitors. The consequences are to be analyzed in terms of more or less elastic supply and demand curves and how the interventions affect these elasticities.
Elaborating on one of his earlier publications on the topic (Méra, 2010), he argues that, when dealing with a producer, monopoly and monopsony are separable from each other only in so far as there could exist perfect competition on the other markets—that is, either the factor markets in case of a monopolist or the output markets in case of a monopsonist. Since perfect competition never exists, a producer is always both a monopolist and a monopsonist, or indeed neither of the two. A monopsony privilege on the factor markets always amounts to some form of monopoly privilege on the output market, albeit not in the absolute sense, and vice versa. Méra explains:
If it is often noticed that a monopoly is a monopsony or a monopsony is a monopoly, this is rarely considered a necessity. And it is true that, with an exclusive grant of monopoly privilege on the sale of a good, one may be its sole seller while still one among many buyers of its non-specific factors of production. However, even in this case competition is hampered on the factors’ markets since no competitor is allowed to hire them for the production of the monopolized good. With an exclusive grant of monopsony privilege, one may be the sole buyer of a factor of production while still one among many sellers of a good it helps to produce, provided this factor is not indispensable to its production. Yet even in this case competition is hampered in the product market, because competitors are not allowed to produce the product using this factor. (p. 178)
The important question is to what extent the granted privileges increase the price differential between factors of production and output in response to a restriction of output and factor demand, and thus to what extent they allow for monopoly-monopsony gains. Thus, Méra develops a “theory of monopoly price-gap” (p. 176).
In his discussion of non-specific factors (e.g., labor), Méra makes a very valuable theoretical contribution within the causal-realist framework. He shows that a monopolist-monopsonist could conceivably push money prices even for non-specific factors (e.g., wages) under certain conditions below the market-clearing rate. If the demand for the output that the monopolist-monopsonist sells is inelastic, then the buyers’ overall sum of money spent on that output will increase in response to a restriction of supply. This implies a reduction of money spent on other goods. The selling prices of those goods will fall along with the other producers’ demand for the non-specific factors of production. Hence, prices of the non-specific factors will, as a result, be pushed downward.
This, however, in and of itself, does not seem to be a sufficient condition for what Méra attempts to show. He neglects a potential offsetting effect. While nominal expenses of the buyers of the monopolist-monopsonist’s product on other goods will go down, nominal expenses of the monopolist-monopsonist on various other goods, in his or her capacity as consumer or investor, will go up as a result of the realized monopoly-monopsony gains. This will have exactly the reverse effect, increasing monetary revenues of other producers and hence their demand for the non-specific factors of production. It is not clear where the net effect lies.
Of course, this does not change the fact that Méra has nicely illuminated the mechanism by which prices for non-specific factors, such as wages, might be pushed below the market clearing level as a result of monopoly-monopsony power.
In the next essay, Dr. Mateusz Machaj deals with some Post-Keynesian criticisms of the neoclassical marginalist theory of product pricing and shows that the Austrian theory is mostly immune to those criticisms. Yet, he holds that “in some cases the Post-Keynesian contribution to price theory strengthens Austrian arguments about the market process, especially in those aspects where Post-Keynesians are anti-neoclassical” (p. 195).
Post-Keynesians tend to highlight the relative importance of quantity and inventory adjustments instead of price adjustments in response to changing conditions of demand. Prices tend to be more or less “sticky.” Moreover, they argue that output prices are rarely set in such a way that marginal revenue equals marginal cost. Machaj shows that Austrians have at least implicitly already addressed these considerations, which he argues could be interpreted as being “the result of a plain state of rest perspective” (p. 196). In contrast, neoclassical economists “seem to talk about the final state of rest,” which is another way of saying that they abstract from uncertainty, change and time as shown and discussed in Herbener’s essay in chapter 6 of the volume. The Post-Keynesian qualms stem from these unrealistic assumptions in the standard neoclassical theory, but “economic reasoning can rely on the realistic momentary equilibrium of the plain state of rest for analyzing the pricing process,” (p. 196) as Machaj argues.
In his discussion of the imputation process (pp. 198–200), Machaj gives the hypothetical example of shirt production. He supposes that blue and green shirts are produced and sold at the same price even though demand for blue shirts is much higher. Sellers have adjusted quantities instead of prices. He argues correctly that such a case would not prove the limitations of the marginalist approach, but his explanation strikes the reviewer as somewhat unsatisfactory. He writes:
According to Böhm-Bawerk, the law of costs is actually an idea about marginal utility in disguise. In the shirts example, for instance, it does not matter that demand (and marginal utility) for blue shirts is higher relative to green shirts. What matters are the marginal utilities of other goods and services that would have to be given up in order to reproduce blue shirts. And since green and blue shirts require basically the same sacrifice, virtually the same marginal utility would have to be lost. If we lose the last-produced blue shirt, we only have to give up the production of the last green shirt and switch green dye for blue (just as when we lose the most important blue shirt we only have to use the marginal shirt as the first). Therefore we have a perfect explanation of why the costs of both shirts are the same—in the end, their marginal utilities of reproduction are the same. (p. 199)
This does not really explain why their selling prices remain the same. In the plain state of rest analysis, they remain the same because of the price-elasticity of demand anticipated by the producers. If they anticipate that price-elasticity is high for whatever reason, they might not raise the price for blue shirts, and instead start to expand blue shirt production as far as this appears to be profitable—that is, simply to the point where marginal revenue equals marginal costs or demand is anticipated to be satisfied at the prevailing price. This in turn increases demand for blue dye and exerts upward pressure on its price. Whether or not “in the end, […] [the] marginal utilities of reproduction” of green and blue shirts are the same, depends on whether or not blue dye production can be expanded without significant increases in marginal costs.
In the end, the pricing of the factors of production depends on the prices of the final output. Indeed, Machaj puts this fundamental Böhm-Bawerkian insight very vividly:
From the perspective of an individual producer, it may seem that sellers practice cost-based pricing. Yet at the same time, this fact in no way validates the broad marginalist point that costs themselves result from other potential investment avenues that could be undertaken. Once we look at the economy as a whole, we see price-based costing despite the fact that firms attempt to engage in cost-based pricing. (p. 200)
PART 5 – ECONOMIC ORGANIZATION, ENTREPRENEURSHIP AND THE FIRM The first chapter of the last part of the book is by Dr. Mihai-Vladimir Topan. It contains a discussion of the compatibility of Austrian economics and “transaction cost economics” as developed most notably by Ronald Coase and Oliver Williamson. Topan comes to the conclusion that transaction cost is a “chameleonic instrument which raises more questions than it solves” (p. 220). Consequently, incorporating transaction costs as a general abstract notion into Austrian economics would in his eyes not improve the theoretical analysis, neither in the areas of economics of property rights nor the theory of the firm, which he specifically investigates.
The most obvious problem with the notion of transaction costs is that it is not well-defined. Topan argues that it is based on a misleading dichotomy between production and exchange, or the firm and the market. Transaction costs are somehow related to the latter but not the former. Topan explains the problem:
Praxeologically, as Mises would say, any human action has the structure of an exchange—autistic exchange or interpersonal (direct or indirect) exchange—involving the giving up of a certain state of affairs in favor of another that is expected to be more satisfactory. […] Thus, the general category of costs, understood as opportunity costs of the actions undertaken by human agents, cannot theoretically be split into two categories—production costs and exchange (or transactions) costs. They are simply part of the same general category of cost with no substantive difference to set them apart. (pp. 209–210)
The vague notion of transaction costs has thus been applied to all kinds of questions in economics. There is what Topan calls a “transaction cost imperialism” (p. 217), in which attempts are made to explain not only firms, but markets themselves as well as all kinds of market phenomena, such as money, in terms of transaction costs. The notion ends up proving too much: “Coase suggests that the effects of transaction costs are ‘pervasive in the economy.’ The problem is that if transaction costs explain everything, they end up explaining nothing” (p. 218).
The next essay in McCaffrey’s volume does not deal with the elusive concept of transaction costs, but rather applies the more common notion of opportunity costs in order to show, in a first step, that value logically precedes costs> even if understood as outlays for production. Indeed, Dr. Per Bylund explains that it is the anticipated value of investment projects that leverages the costs in existing lines of production in an entrepreneurial economy. This is because the demand for factors of production increases when new lines and methods of production are explored. This is again an application of Böhm-Bawerk’s theory of factor pricing via imputation that was discussed and applied previously in the book.
The new element in Bylund’s chapter, with respect to the rest of the book, is his discussion of entrepreneurship and management as distinct economic functions. He draws certain implications from this distinction for the socialist calculation debate. His analysis seems to be targeted towards rebutting a recent contribution to the debate by Denis (2015). The latter has argued that one could have public ownership of, but decentralized decision making and control over, the means of production. This arrangement, which he terms “several control,” would provide market prices and thus allow for economic calculation.
Without having studied Denis’s contribution and judging solely from Bylund’s brief description, the reviewer suspects that such an arrangement of “several control” could strongly resemble what we observe in the real world today, for example, in Sweden or the US. After all, there is no full-blown private property, but rather a “fiat property” arrangement. There is decentralized “ownership” or control over the means of production and their revenue product only to the extent that a centralized state, or, if you like, a democratic collective, grants it.
Bylund argues that in Denis’s world there could be no entrepreneurship. There would merely be management. The validity of this claim depends, of course, on the definition of the terms. However, from Bylund’s outline, one gets only an intuition, and by no means a clear-cut answer as to where exactly the line is drawn. At one point, he states: “The entrepreneurial function is here one that provides value creation relative to other types of production that already exist in the market” (p. 230). The entrepreneur develops “new supply functions that disrupt the market and discover previously unknown demands […] [T]hey require new uncertainty-bearing and are consequently entrepreneurial” (p. 232). In contrast,
within the firm’s production process, the manager can improve its technical efficiency […] or the effectiveness of the already-established production process by reducing waste and lead times, and consequently increasing overall resource utilization. […] The product can also be refined in its functionality, features, and quality, particularly as the firm learns about its customers’ specific wants and can therefore better target those most highly valued. (p. 235)
What precisely distinguishes refinement of an existing good and the creation of new ones is not perfectly clear, but surely both, if successful, create value and thus economic growth. So does the reduction of waste.
At one point, the distinction is made more specific, when Bylund claims that entrepreneurship, that is, the “creation of a new supply function entails the withdrawal of capital from its existing use and the subsequent investment in the new endeavor, which requires ownership” (p. 232). If ownership is a necessary condition, then indeed in Denis’s world there can be no entrepreneurs by definition.
However, a lot seems to depend on how such an arrangement of “several control” is exactly exercised. As mentioned above, it could look more or less exactly like the US or Sweden today, where presumably there are at least some entrepreneurs. To what extent there will be interference with the free exchange of rights to control, exchange, and combine resources and factors of production in different endeavors is simply an extra layer of uncertainty. Successfully bearing this uncertainty requires entrepreneurial skill.
Now, one might not want to call that entrepreneurship, but this is a semantic issue and actually not the most important point of the essay. More importantly, Bylund argues that a pure management economy would be regressing or shrinking even if there are market prices. It is important to note that he does not directly criticize and reject Denis’s claim that one could have market prices under “several control.” Thus, Bylund seems to accept the idea that a pure management economy could have market prices.
It seems to the reviewer that a well-managed economy without entrepreneurial innovation, where market prices exist, would not necessarily be shrinking. It could expand and grow in at least three respects, namely, as mentioned above, by the reduction of waste, the refinement of existing goods, and through the accumulation of capital and the expansion of the physical output of known goods in existing lines of production. If the relative demand in terms of known goods changes, a well-managed economy would also be capable of redirecting factors of production from one existing line to another. The managers who are confronted with increases in demand could bid away factors of production from others.
There are, of course, undeniable problems if there truly is no innovation in the economy. Exhaustion of non-renewable resources might serve as an example. But this does not change the fact that Bylund’s conclusion that in a management-driven economy “value will not only not be created but will be actively destroyed” (p. 239) is exaggerated. The theoretical discussion does not suffice to support this claim.
The last essay is entitled “Economic Calculation and the Limits of Social Entrepreneurship.” It is written by the editor of the volume. McCaffrey links the Misesian theory of economic calculation to aspects of “social entrepreneurship.” In the introduction, social enterprises are defined as follows:
Social enterprises are business organizations that are not motivated by the desire to generate monetary profits for traditional shareholders. Instead, the profits of social enterprise are used to solve “social” problems, often by addressing the same kinds of needs as charitable organizations. Social enterprises are special, however, because they support their missions through successful commercial ventures rather than through donations. (p. 244)
Indeed, the weasel word “social” requires further explanation here. McCaffrey explains that “action is ‘social’ to the extent it fosters cooperation and thereby encourages specialization and the division of labor” (p. 245). It is thus ultimately “inaccurate to contrast social with non-social enterprises” (p. 246) in this broad sense of the word. Enterprises are always social, but may be so in different ways.
Moreover, using Fetter’s notion of psychic income, and the Misesian derivative of psychic profit, McCaffrey shows that it is likewise untenable to call any enterprise strictly “not-for-profit.” Social enterprises are bound up with a kind of profit motive too. If the “social cause” pursued by the enterprise involves giving money in some form or another to certain groups, it must generate monetary income if it attempts to be more than a mere charity organization, as McCaffrey points out (p. 249).
These considerations show that it is much more difficult to clearly distinguish the social and mundane types of entrepreneurship. There is no clear-cut theoretical distinction between them that makes their analysis in terms of economic calculation fundamentally different. This is the underlying point of McCaffrey’s essay. He nonetheless maintains that “[e]conomics provides wide-ranging theories of social interaction, value, calculation, profit, and pricing that can be used to rigorously define the domain of social entrepreneurship” (p. 259). However, the “social element” is ultimately simply one form of consumption, which has to be financed in some way.
McCaffrey discusses complementary social enterprises, which operate exactly like mundane enterprises, except that they donate their profits to some “social” cause and let their costumers know it. Yet, when it comes to integrated social enterprises, the pursuit of the “social” cause is tied up into the production process itself. In practice, this means that the entrepreneurs are willing to pay morefor some factors of production. They might hire homeless workers and pay them a salary above their discounted marginal revenue product (p. 257).
In so far as the pursuit of the “social” cause is valued by the customers, the entrepreneurs will attract additional revenue. It might turn out after all that the homeless workers are really not paid above their marginal revenue product as McCaffrey shows. If the pursuit of the “social” cause does not attract additional revenue from costumer spending, it must be financed out of other sources. These could be the “entrepreneur’s profits, the capital of the enterprise, the land of the enterprise, or the wages of other employees if they are willing to forego part of their potential earnings, as in the case of volunteers for a charitable cause” (p. 257).
McCaffrey thus shows in his article that enterprises in pursuit of a “social” cause are limited by profit and loss and hence by economic calculation, just like mundane enterprises. If they generate monetary profits, they can better promote the cause. If they incur losses, the continued existence of the enterprise and promotion of the cause becomes a matter of charity on the part of the entrepreneurs or other stakeholders. One way or the other, the subjective value creation, that is, the psychic income or want satisfaction, created by the enterprise has to be strong enough to attract finance of its expenses.
A strong member of the “second generation of the Austrian school of economics,” Eugen von Böhm-Bawerk (1851–1914) and his works are discussed by Peter Klein. Böhm-Bawerk did much to extend and further develop Menger’s theories of value, price, capital, and production. Included in his work of the two volume Capital and Interest is a devastating critique of Marx’s exploitation theory. Böhm-Bawerk explained that far from being exploited, the workers are actually accommodated, being paid in advance of the produced goods being sold.
In the second volume of Capital and Interest, Böhm-Bawerk explained the time consuming nature of production and how it relates to interest. Roundabout production methods are more productive but come at a cost of forgoing current consumption during the process of accumulating the capital. This became the basis for his time preference theory of interest as well as the foundations for the Austrian theory of the business cycle. Böhm-Bawerk also presented a clear example diminishing marginal utility and explained how real prices, as opposed to hypothetical equilibrium prices, are determined.
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ABSTRACT: New product R&D, which precedes post-launch production, is a three-stage process. First comes idea prospecting, which leads to working prototypes. Second comes productization—the conversion of working prototypes into manufacturable products with reasonable prospects of being profitable. Thirdly, firms produce pre-launch inventories. This process often involves high risk, not only due to the large amounts of time and capital investment, but also because the secrecy maintained across lateral competitors stifles market signals that ordinarily foster economic efficiency. Reconsideration of the Austrian theory of the business cycle in this light leads to additional insights about: 1) the capital consumption that occurs during the cycle; and 2) the timing of the bust that follows a boom inspired by excessive credit expansion. Our empirical study of return volatility for the period from 1996 to 2017: 1) confirms the results of a Journal of Finance study of the preceding period from 1975–1995; and 2) validates our analysis of new-product R&D as the earliest component of the capital structure.
KEYWORDS: research and development, R&D, business cycle, capital structure, capital consumption JEL CLASSIFICATION: E14, E32, O30 Our friends up north [at Microsoft] spend over five billion dollars on research and development and all they seem to do is copy Google and Apple. — Steve Jobs
I. INTRODUCTION Austrian economics emphasizes the idea that the price and production signals of competing firms coordinate capital use across the stages of production. This idea makes perfect sense for firms whose priced products are competing on the open market. For example, the price and production decisions of competing automobile manufacturers influence one another. On the other hand, the decisions of firms engaged in new-product research and development are largely uninformed by the decisions of other firms engaged in the research and development of similar products. Because, by definition, new-product R&D occurs prior to the pricing and open market sale of products, competing firms within this stage of the capital structure are largely ignorant of each other’s preparations.
In this paper, we deepen the understanding of the capital structure by unpacking the process that coordinates capital within the new-product R&D stage of the capital structure. The dearth of capital-coordinating signals emanating from the earliest stage of the capital structure is unique to the new-product R&D process. Signals, within the new-product R&D stage, are sparse for three reasons: 1) price and production signals do not exist for products still under development or prior to launch on the open market; 2) pre-launch inventories have minimal impact upon the market price of products already on the market; and 3) entrepreneurs, engaged in new-product R&D and seeking “first mover” advantage, have incentives to shroud their operations and discoveries in secrecy.
The evidence of entrepreneurial secrecy in new-product R&D can be found in the body of law dealing with trade secrets. Firms, engaged in new-product R&D, routinely require employees to sign: 1) “non-disclosure agreements” whereby employees obligate themselves to keep research and development activities secret; and 2) “invention agreements” that pre-specify the sharing arrangement for anything that employees invent during or as a result of their work on the firm’s new-products.“...[T]he term ‘trade secret’ means all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if—(A) the owner thereof has taken reasonable measures to keep such information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information….” 18 U.S. Code § 1839. Definitions accessed online at: https://www.law.cornell.edu/uscode/text/18/1839. Together, the overt secrecy of entrepreneurs regarding new-product R&D and the absence of price and production signals reduce and/or delay the cost-dampening impact of inter-firm competition.
We organize the remainder of this paper as follows. In Section II, we present time lines that facilitate the understanding of: a) the roles that time and money play in sustainable new-product R&D processes; and b) the system-wide costs of entrepreneurial secrecy and the absence of competition-constraining price and production signals. In Section III, we explain how our more explicit discussion of new-product R&D: a) deepens understanding of “capital consumption” in Austrian business cycle theory; and b) offers new insights into the trigger and timing of credit expansion booms and busts. Section IV presents an empirical study that validates our emphasis upon new-product R&D as the earliest component of the capital structure—our study demonstrates for the period 1996 to 2017 the same positive association between share price volatility and R&D intensity found in a Journal of Finance study pertaining to the preceding period, from 1975 to 1995. A summary follows in Section IV.
II. SUSTAINABLE NEW-PRODUCT R&D The process of new-product research and development consists, by definition, of new product research followed by new product development. We define new product research as prospecting for new and viable innovations (the search for working prototypes). New product development is pre-launch production consisting of: (a) the productization of cost-efficient working prototypes; and (b) the production of enough initial inventories to meet the anticipated demand for products launched onto the open market.
The timeline shown in Figure 1 illustrates the process by which new-product R&D successfully delivers new products to consumers. Successful processes begin with idea-prospecting that leads to working prototypes. Next, working prototypes evolve into products with costs that end up, after product launch, to be sufficiently low for the products to generate at least normal expected returns. Finally, firms produce sufficient quantities of pre-launch inventories to meet expected demand and be competitive on the open market. The arrow in Figure 1 shows the successful start-to-finish new-product R&D process: from idea prospecting, to prototype, to productized pre-launch inventory, to marketing and distribution of the completed products on the open market, and finally into the hands of consumers.
Not all investments into new-product R&D will be successful; in fact, many are likely to fail. This is because across the new-product R&D stage shown in the Figure 1 timeline, there is, as mentioned in the introduction, a dearth of market signals. Again: 1) neither price nor production signals can exist for products in pre-production; 2) pre-launch inventories have minimal impact on the market price of products already on the market; and 3) in the pursuit of “first mover” advantage, firms engaged in new-product R&D routinely stifle signals about their operations.
Figure 1: Timeline of How New Products Reach Consumers
The dearth of market signals within the new-product R&D stage does not mean that no market signals inform capital use within this stage. Most importantly, as emphasized by renowned Austrian school thinkers (Mises, Hayek, Garrison, etc.), the interest rate at which firms borrow has its most significant impact upon the capital structure’s earliest components. Also price, production, and other signals from active markets, outside the new-product R&D stage, provide crucial guidance that usefully informs, directs, and constrains new-product R&D. Summarizing, the three market signals that most clearly inform capital usage in new-product R&D are: (1) the interest rate on loanable funds; (2) the price and production signals of related products (substitutes and complements) currently being exchanged on the open (post-launch) market; and (3) the prices of the inputs available on the open market.
In line with standard Austrian business cycle theory (ABCT), so long as these market signals from outside the new-product R&D stage are free from artificial constraints or subsidies, we anticipate that entrepreneurial error in new-product R&D will be constrained sufficiently to preclude malinvestment booms. But given the absence of lateral signals within the new-product R&D stage, again consistent with standard ABCT, there is every reason to suppose that an excessive expansion of credit will drive the interest rate below the natural rate, and swell entrepreneurial errors in new-product R&D, leading to an unsustainable malinvestment boom. Before discussing such an unsustainable boom, we begin below by first discussing sustainable levels of the entrepreneurial errors that occur—when investment is constrained by free market prices and the natural rate of interest. In particular we discuss three types of errors: (1) superfluous discovery; (2) duplicative discovery; and (3) duplicative development. We discuss each of these in turn.
Superfluous Discovery
Superfluous discovery occurs within the idea prospecting (research) phase of new-product R&D. Superfluous discovery occurs when prototypes, or models: 1) do not work; or 2) are economic dead-ends (because the costs of productizing and launching exceed the prototypes’ expected future returns. For example, in the academe, all those who have conducted significant amounts of research have made arguments that simply do not “work out.” There are a variety of reasons for unpublished academic research; among them: 1) the implications of the model are grossly inconsistent with observable, real-world behavior; and 2) the argument is unclear and/or unpersuasive to peer reviewers.
Duplicative Discovery
Duplicative discovery occurs when more than one entrepreneur, engaged in research, discovers the same working prototype, or model, simultaneously (or nearly simultaneously). Matt Ridley (2017) explains that many versions of the light bulb existed before Thomas Edison “invented” it:
Suppose Thomas Edison had died of an electric shock before thinking up the light bulb. Would history have been radically different? Of course not. No fewer than 23 people deserve the credit for inventing some version of the incandescent bulb before Edison, according to a history of the invention written by Robert Friedel, Paul Israel and Bernard Finn.
Ridley goes on to cite a famous example in the history of science—Darwin’s and Wallace’s simultaneous discovery of the theory of evolution.“Charles Darwin was a methodical man. Twenty-two years after the voyage of the Beagle, he was still working on his definitive study. Darwin, in fact, almost waited too long. In 1858, Alfred Russel Wallace also formulated a theory of evolution, based on his studies in Brazil and the East Indies. … [W]hen Wallace sent the manuscript of his findings to Darwin for his opinion, Darwin was astounded. Although Darwin’s first instinct was to give Wallace full credit for the theory, the two men agreed to present their papers in the same issue of the Journal of the Linnean Society. The next year, 1859, Darwin finally finished his book, On the Origin of the Species by Means of Natural Selection, or the Preservation of Favoured Races in the Struggle for Life; the popular title is The Origin of the Species.” (Ritchie and Carola, 1983, p. 509)
Duplicative Development
Duplicative development occurs when, following the awareness of increased demand for a product, a “swarm” of firms, not all of which will ultimately survive, make investments to bring similar products to market. For example, in early January of 2007, Apple Computer announced and demonstrated the iPhone. Shipment of the new device began in June of that year with great fanfare and significant market adoption. The success of the new smartphone served as an impetus for other firms to engage in developing competitive products. One after another, Palm, Blackberry, Microsoft, Samsung, Nokia, and the browser company Mozilla (creator of Firefox) among others, invested heavily in the development, prelaunch inventories, and launch of their smartphone offerings. The result of this entrepreneurial swarming into the smartphone space was a successful Samsung/Google Android phone and the original leader, iPhone from Apple. The others, unable to compete successfully in the crowded space, dropped out of the race or fell into obscurity.
The three entrepreneurial errors (again, superfluous discovery, duplicative discovery, and duplicative development) can reduce the overall ex post net benefit of the new-product R&D stage of the structure of capital. However, there is no reason to think that the market signals from outside this stage (i.e., prices of related goods, the prices of inputs, and the interest rate) will, absent distortions in these outside signals, so insufficiently constrain these errors as to cause the ex post net benefit of new-product R&D to be negative. Schumpeter’s oxymoron, “creative destruction,” is famous because new-product R&D has repeatedly delivered net benefits that are palpably positive.
This in mind, we argue that the new-product R&D process, absent governmental and/or credit distortions, will be sustainable—meaning that the ex post net benefits are positive. In Figure 2, we modify Figure 1 (which only addressed sustainable new-product R&D), to include the entrepreneurial errors of superfluous discovery, duplicative discovery, and duplicative development.
Figure 2: Sustainable New-Product R&D Timeline
As depicted in Figure 2, entrepreneurial errors appear in lengths and widths intended to depict sustainable levels, (that is, levels that result in the overall net benefit of new-product R&D being non-negative). As shown in Figure 2, the superfluous discovery arrow ends at the prototype line—this is the sustainable level, meaning that resources are not invested into productizing uneconomic prototypes or non-working innovations.
Similarly, the “duplication” arrow in research (this arrow represents the duplicative research) ends at the “Prototype” line. Once there is proof of the viability of a prototype, concept, or model, no more resources go to re-discovering it. In the case of the light bulb, as Ridley explained in his APEE presentation (2017), it resurfaced many times only because worldwide communications at the time limited the knowledge of the various inventors. Subsequently, once knowledge of the invention of the light bulb became widely known, reinvention of the basic bulb ceased.
Finally, Figure 2 features a “Duplication” arrow above “Devel-opment.” This arrow illustrates the level of duplicative initial inventory creation that is consistent with a sustainable new-product R&D process. Notice that this arrow ends at the launch line. This is not because duplicative products never reach final consumers, but because they soon cease to reach consumers—crowded out by the relatively more successful new product(s).
Returning to the cell phone example mentioned above, although many companies offered alternatives, today, only a few types remain on the market. In the period of a few decades, market competition winnowed the field. We do not know of any economist who argues that the costs of this winnowing process (the costs of duplicative development) are so large as to cast significant doubt about whether the research and development process that created cell phones delivered positive net benefits. In other words, the process that created cell phones was a sustainable one.
III. R&D MALINVESTMENT: ANOTHER SOURCE OF CAPITAL CONSUMPTION The original Mises/Rothbard/Hayek renditions of Austrian Business Cycle Theory (ABCT), as Salerno (2012, p. 15) explains, all agreed that 1) “malinvestment,” excessive investment in the earliest stages of the capital structure, is an essential component of the boom; and 2) “overconsumption” is an essential component of the boom, albeit with Hayek being “less emphatic.” In addition, “capital consumption” resulting from overconsumption during the boom, Salerno (p. 21) explains, is what ultimately leads entrepreneurs to abandon the “wholly new investment projects” undertaken during the boom.“[T]he increase in the prices and profitability of consumer goods diverts factors from higher stages to consumer goods’ industries, thereby restricting the supply of resources available to add to or even replace the stock of capital goods. This is what Austrian economists call “capital consumption,” which is a pervasive feature of the boom.” (Salerno, p. 16)
Our focus and more explicit discussion of new-product R&D, as the earliest component of the capital structure, provides a complementary explanation for the “capital consumption” that takes place during the boom (setting up an inevitable bust). Salerno’s emphasis that it is “wholly new investment projects”, in the earliest stages of production, that will be incentivized by the credit expansion (many of which will have to be abandoned due to “capital consumption”), dovetails with our focus on new-product R&D as the earliest component of the capital structure.
The additional source of capital consumption, that our unpacking of new-product R&D exposes, is straightforward. An artificially low interest rate, caused by the overexpansion of credit, will result in the bloating of Figure 2’s sustainable levels of superfluous discovery, duplicative discovery, and duplicative development (levels that were sustainable at the natural rate of interest) into unsustainable levels (levels incentivized by the artificially low interest rates). For complete clarity, Figure 2’s depiction of the sustainable R&D timeline is modified in Figure 3’s depiction of an unsustainable R&D time line.
Comparing Figures 2 & 3, the bloating of superfluous discovery, duplicative research, and duplicative pre-launch production is obvious. As documented and emphasized by Salerno (p. 5), “Austrian theory is not an ‘overinvestment theory’ of the business cycle and was never construed as such by its most notable proponents.” In line with Austrian theory and tradition, this means that the bloating of the arrows in Figure 3, relative to Figure 2, is not overinvestment, but rather malinvestment.
Figure 3: Unsustainable R&D (bloated Superfluous Discovery and Duplication)
In one crucial respect, malinvestments specific to the new-product R&D stage are like malinvestments in early stages of the capital structure generally. All malinvestments arising from credit expansion contribute to what Salerno (p. 22) aptly describes as the “... ‘hole’ in the middle stages of the structure of production, which is ‘papered’ over by profits and capital gains caused by the falsification of monetary calculation.” In one important respect, however, malinvestments in new-product R&D are unique. As we explained earlier, lateral competitors engaged in new-product R&D, with their products not on the market, are in the dark because they are literally uninformed by the price and production signals of one another.Recall from our earlier discussion that: 1) products under development are not yet on the market; and 2) in the pursuit of “first mover” advantage entrepreneurs in new-product R&D maintain secrecy about their activities.
The uniqueness of new-product R&D malinvestment is important because it offers new insights into: 1) why new-product R&D malinvestments will tend to pile up for a longer period than will malinvestments where price and production signals are present; and 2) what can trigger the bust, and when it will occur. Current Austrian explanations of what will trigger the bust, and when, are unspecific. Garrison (2001, p. 72), for example, explains only that “at some point in the process. . . entrepreneurs encounter resource scarcities that are more constraining than was implied by the patter of wages, prices, and interest rates that characterized the early phase of the boom. Here, changing expectations are clearly endogenous to the process.”Similarly, Salerno (p. 22) explains:As the boom continues, firms confront an increasing scarcity of the resources necessary to [for example] fully utilize the new mining and oil drilling equipment to construct the hydroelectric plant and to engineer and mass produce the new generation of aircraft. In a strictly metaphorical sense, then, we may say that the lengthened structure of production cannot be ‘completed.’ The anticipated demands for the products of the higher stage investment projects... do not materialize because of the greater scarcity and costliness of the complementary labor and capital needed to profitably transform these products into lower order capital goods.... From an economic point of view, malinvestment and capital consumption cause the structure of production to disintegrate into pieces that cannot be fitted back together again without a protracted recession-adjustment process.
Inspection of Figure 3 suggests an explanation of what can trigger the bust, and when. Recalling from our previous discussions that the capital usages within the new-product R&D stage are non-signal emitting, it becomes apparent that the “launch” line is key to understanding what triggers the bust. Again, prior to launch, there are no price and production signals to constrain lateral competitors. It is at the time of product launch, that price and production signals for newly developed products first emerge and begin to constrain and coordinate capital usage across the stages of production. All that need occur to trigger a crisis is for an excessive amount of duplicative pre-launch inventory to hit the market simultaneously, or nearly so, in a Schumpeterian swarm.An anonymous referee indicated that he/she, in discussing R&D as the earliest stage, emphasizes “the bringing to market of new capacity as a critical trigger (rather than pre-launch inventories).” Both are important, because both new capacity and the pre-launch inventories hitting the market can, if of sufficiently large magnitude, cause the price of competing products to collapse—and the price collapse is the defining characteristic of the bust. Empirical assessment of the relative importance of the new capacity relative to the launch of new inventories is beyond the scope of this paper. This insight can improve our understanding of the timing of monetary inspired crises as illustrated by the two cases examined in the next section.
IV. EVIDENCE OF GREATER VOLATILITY IN R&D-INTENSIVE FIRMS According to Austrian business cycle theory, excessive credit expansions drive the interest rate below the natural rate and, thereby, incentivize overinvestment in the earliest components of the capital structure. In line with this theory, it is expected that the uses of capital in the earliest stages would be more volatile over the business cycle as the interest rate deviates from the natural rate. In this paper, we have focused attention upon new-product R&D (pre-production investment) because it is the earliest component of the capital structure and because the activities of businesses in the new-product R&D space are sequestered—the price and production signals that ordinarily constrain and coordinate the stages of post-product-launch production literally do not exist to coordinate and constrain pre-production enterprises. If this focus is apt, then, empirically, we should expect to see greater volatility in the values of firms that are more heavily engaged in new-product R&D.
A. Extant Empirics on R&D Intensity and Return Volatility, 1975–1995
A relatively recent study in the Journal of Finance provides evidence on the impact of new-product R&D on return volatility over the period 1975 to 1995. Chan, Lakonishok and Sougiannis (2001, p. 2431) find that “R&D intensity is positively associated with return volatility.” Their explanation? Consistent with our discussion of new-product R&D as sequestered capital, they point out that research and development activity is, under “accepted U.S. accounting principles,” treated as an “intangible asset” and that this results in a general “lack of accounting information” which greatly “complicates the task of equity evaluation” (op cit.) for firms that are highly R&D intensive.Furthermore, studying the impact of this lack of information upon stock market valuations is important, they argue, because of the recent, “dazzling growth” in R&D intensive industries—“at year-end 1999, the technology sector and the pharmaceuticals industry together account for roughly 40 percent of the value of the S&P 500 index.” (op cit., pp. 2431–2432). To verify that these findings extend beyond the period from 1975 to 1995, the remainder of this section empirically investigates the relationship between R&D intensity and return volatility for the period from 1996 to 2017.
B. A Study of R&D Intensity and Return Volatility for 1996–2017
The purpose of this empirical study is to test the hypothesis
that the sequestered nature of new-product R&D implies that firm share-price return volatility increases as R&D intensity rises. Our study presents a series of four OLS panel-data regressions that estimate, for alternative specifications, the statistical and economic significance that new product R&D has on firm volatility. The regressions estimate the coefficient of three-year trends in the new product R&D (RD_Trend) of 3,668 publicly traded firms as a predictor of the dependent variables, Market_Beta and Total_Volatility.
Investors regularly rely on Market_Beta as a measure of potential risk, reflecting the volatility of a firm’s stock price compared with that of the market as a whole. A beta of 1 indicates that the firm’s volatility mimics the volatility of the market, while a beta greater than 1 reports the percentage increase in volatility of a stock above the volatility of the market. A beta less than 1 indicates a percentage decrease in volatility in comparison to that of the market.
To control for potential omitted variable bias, we have included the natural log of each firm’s annual total revenues as well as annual net income as a percentage of total revenues. All regressions include both year and firm fixed effects, to control for aggregate movements in the market (business cycles) and for attributes of firms and industries.
The data we use are from WRDS-Compustat. Table 1 presents descriptive statistics on the variables used in the regressions. As shown in the table there are 32,121 observations of which, for each firm, there are up to 21 annual observations (1996 to 2017.) The years 1993 to 2017 are included in the data. The years 1993 to 1995 are included to calculate the three-year averages of total revenues and total R&D expenses used in the regressions. The market beta values range from 0 to 16.42, representing a broad range of volatility compared to the market volatility of 1.
Table 1: Summary Statistics
Total Volatility represents the range of volatility on a firm basis over a three-year period. The Net Income values represent the actual net income divided by Total Revenues or a percentage of Total Revenues. The natural log of Total Revenues is calculated by taking the natural log of the Total Revenues in millions. The RD_Intensity variable is computed by taking the total R&D expense for the current year and the two prior years and dividing the total by the total of revenues over the same three years.
- Estimation Methods
To assess the relationship between share-price volatility and R&D intensity, we estimate the model
(1) yit = βRDIntensityit + αXit + μi + νt + εit,
where yit, depending on the specification, is either the Market Beta (a standard measure of performance volatility) or Total Volatility of each firm (i) in year (t). The vector RDIntensityit includes the average of the new product R&D as a percentage of total revenues for current year (t) and the previous two years. In estimations in which Market_Beta is the dependent variable, the coefficient estimates on RDIntensityit measures the percentage impact of an increase in R&D as a percent of total revenues on Market Beta—a 1 percent increase in RDIntensityit, the estimated coefficient is the predicted increase in Market Beta. When the dependent variable is Total_Volatility, a 1 percent increase in RDIntensityit results in an increase in the total volatility of the firm’s value by the percentage reflected by the coefficient.
All regressions include firm and year fixed effects, μi and νt respectively. Year fixed effects capture price movements in the market that are largely systemic and often representing business cycle impact. Firm fixed effects capture time-invariant firm observable and unobservable variables, such as product market focus. The identifying assumption in our model is that firm trends are parallel.
The Xit vector in the regression model includes firm financial variables such as the log of total revenues and net income as a percent of total revenues, aggregated to the firm and year level. We include these variables to control for the possibility that changes in firm size and profitability might affect volatility.
- Results
The estimation results of our empirical study are shown in Table 2. The table includes two sets of regressions run against Market Beta (regressions 1 and 2) and two run against Total Volatility (regressions 3 and 4.) In the first regression, column (1) of Table 2, the control variables for Total Revenue and Net Income are omitted to provide a comparison for evaluating their impact when included as shown in regression (2). The coefficient of RD_Intensity is 0.928 and is significant at the one percent level, suggesting that an increase of one percentage of total revenues expensed on R&D will result in an increase in the firm’s market beta of 0.928 or approximately 92.8 percent—an economically significant increase.
In the second regression, column (2) of Table 2, the control variables for Net Income and Total Revenue are added into the model. The coefficient on RD_Impact declines from the first regression to 0.629, remaining significant at the one percent level and suggesting that an increase of 1 percent in the percentage of total revenues expensed on R&D will increase the firm’s market beta by 62.9 percent. The control variables suggest, as expected, that firms with higher revenues and profits will have lower beta values and thus lower volatility.
Table 2: Empirical Findings, 1996–2017; Effect of Research and Development Intensity on Stock Volatility
In the third regression, column (3) of Table 1, the control variables for Total Revenue and Net Income are omitted to provide a comparison for evaluating their impact when included as shown in regression (4). The coefficient of RD_Impact is 0.136 and is significant at the one percent level, suggesting that an increase in the percentage of total revenues expensed on R&D will result in an increase in the firm’s total volatility by approximately 13.6 percent—an economically significant increase.
In the fourth and final regression, column (4) of Table 1, the control variables for net income and total revenue are included in the model. The coefficient on RD_Impact declines from the first regression to 0.0469, remaining significant at the one percent level and suggesting that an increase of 1 percent in the percentage of total revenues expensed on R&D will increase the firm’s market beta by 4.69 percent. As in regression (3), the control variables suggest a lower level of total volatility when a firm has higher revenues or net profits.
- Summary of our empirical findings for the period 1996–2017
The empirical results of the four panel-studies reported in Table 2 strongly suggest a causal correlation between increases in the percentage of revenues expended on new product R&D and significantly higher levels of price volatility. This finding is consistent with our hypothesis that the sequestered nature of new product R&D will lead to greater error on the part of investors in forecasting—resulting in greater volatility.
V. OVERALL SUMMARY According to Austrian business cycle theory, excessive expansions of monetary credit cause malinvestment in the earliest component of the capital structure. In this paper we have analyzed the implications of new-product R&D in its role as the earliest uses of capital. As we have explained, new-product R&D can be broken down into three sequentially occurring stages: 1) a research stage that discovers potential new products; 2) a development stage to turn the potential products into working prototypes and productize them; and 3) a final stage to develop (produce) pre-launch inventories. Throughout these three stages, capital is sequestered—for these pre-production stages laterally competing firms are in the dark about the prices and production that will, following product launches, emerge onto the open market. Consistent with this sequestration of capital in the earliest stages, we find that, consistent with a previous empirical study for the period 1975 to 1995, higher return volatility is associated with higher R&D intensity. By identifying three stages of new-product R&D as the earliest component of the capital structure, greater insight is possible into what will trigger malinvestment busts and when they are likely to occur.
Private Graduate Seminar. Recorded at the Mises Institute in Auburn, Alabama, on July 19, 2018.
Private Graduate Seminar. Recorded at the Mises Institute in Auburn, Alabama, on July 19, 2018.
[Full issue of the Quarterly Journal of Austrian Economics 20, no. 4 (2017)
ABSTRACT: Although Austrian literature does not usually dwell on this particular aspect, there are differences between the direct investment of savings and adding to one’s personal cash balance (hoarding). Following Bagus’s (2016) critic of my original article, the present paper will introduce supplementary qualifications. I will argue that in the course of ordinary business activity, there is no (plausible) reason why hoarding should imply disinvestment. Furthermore, I claim that the market rate of interest is the main indicator for entrepreneurs in a developed society which uses an advanced credit system. Finally, the paper will summarize the differences between investment and cash building and put these differences in connection to economic growth in order to see whether any of the two methods offers additional benefits.
KEYWORDS: Austrian school, market rate of interest, structure of production, investment, economic growth, hoardingJEL CLASSIFICATION: B13, B53, E14, E22, E31, E41, E43, O40INTRODUCTIONIn “A Comparison of Direct Investment of Savings and Cash Building of Savings” Philipp Bagus (2016) makes a thorough critique of my original article which attempted to analyze the intricate relation between hoarding, investment and economic growth. Interestingly enough, it appears that we generally agree regarding the differences between hoarding (or cash building, as Bagus [2016] prefers to call it) and investment, but we are at odds concerning the demonstration I employed in the original article, which was meant to show that investment would be more swift in promoting growth.
The original article (Pătruți, 2016) employed a Wicksellian framework that focused on the divergence between the natural rate of interest (NRI) and the market rate of interest (MRI) in order to point out the different effects of hoarding and respectively investment. This type of investigation is customary to the Austrian school, since it supplies the keystone for business cycle theory (Mises, 1998; Hayek, 2008). It is certainly not new, but it has not been applied, to my knowledge, to this specific issue in a coherent fashion.
The general claim I made was that the real movements in the structure of production could be affected by monetary frictions determined by individual hoarding. In this sense, directly investing the savings through the banking system would appear as a “preferable” alternative that could temper these short-term frictions.
In his reply to my original article, Bagus (2016) first raised a number of critical remarks regarding the two scenarios1 I used and afterwards identified, correctly in my opinion, additional differences between the two phenomena. In the present paper I will first restate my thesis by incorporating as much as possible of the pertinent observations made by Bagus, in the belief that our differences are not as many as would originally appear. Secondly, I will attempt a rejoinder of the conclusions regarding the differences between hoarding and investment and their effect on potential growth.
THE CRITIQUEThe main observations raised by Bagus (2016) are, to my understanding, the following: that (1) I overstressed the importance of the MRI, that (2) cash building by saving does not necessarily imply a longer time period and that (3) cash building does not necessarily stem from saving. I will try to address all of them in an orderly fashion.
Restating the original analysis comprising the two scenarios would be superfluous, since I believe that generally Bagus should find it acceptable. The only critique I could find was that I was somewhat “vague” regarding the explanation of the real adjustment process of the structure of production in the second scenario (Bagus, 2016, p. 364). If this was the case, the only reason I had for that was brevity. I fully agree that the real processes of readjustment in the structure of production are the fundamental phenomena and that monetary processes are derivatives. I fully concede to his additions in this sense to my text. However, just claiming that “These spreads between buying and selling prices are the most fundamental phenomenon. The market rate of interest is just a derivative of this phenomenon” (Bagus, 2016, p. 365) does not solve the problem. It is clear that the natural rate of interest is the fundamental phenomenon, but entrepreneurs have no knowledge of this magnitude, which is more or less a theoretical concept. The signal they can use in practice is the market rate of interest. As Hayek (2008, p. 264) puts it:
But there is one medium through which the expected ultimate effect on relative prices should make itself felt immediately, and which, accordingly, should serve as a guide for the decisions of the individual entrepreneur: the rate of interest on the loan market.
This is the reason why I stress the importance of the market rate of interest (1), even though the pure rate of interest is the fundamental phenomenon. The belief that adjustment of relative prices in the structure of production is a slow and time consuming process is also documented by Hayek2 (2008, p. 264):
As the initial changes in relative prices which are caused by a change of the relative demand for consumers’ goods and producers’ goods give rise to a considerable shifting of goods to other stages of production, definite price relationships will only establish themselves after the movements of goods have been completed. For reasons which I shall consider in a moment, this process may take some time and involve temporary discrepancies between supply and demand.
This additional argument should suffice, in my opinion, to show why I stress the importance of the MRI and why it would be a faster tool in promoting growth. Would it be impossible for entrepreneurs to anticipate/speculate the change in cash balances? Of course not. As Bagus (2016, p. 368) claims:
Market participants can anticipate effects of cash building on prices and bid a negative price premium into the market rate of interest. Therefore, there is no necessary time lag. In the case of cash building through an increase in saving, the market rate of interest rate can fall immediately if the increase in purchasing power is correctly anticipated.
But to my understanding, this is nothing else than presuming perfect foresight on behalf of the entrepreneurs and, paraphrasing Keynes, “assuming our problems away.”3 It is in this spirit that I claimed that hoarding “necessarily” involves a time lag (2).
Regarding the last comment raised by Bagus, respectively that hoarding does not necessarily stem from saving (3), it would probably be best to start by pointing towards two premises that I employed in the original scenarios, but which I probably failed to stress enough. My original analysis refers to a society in which there is a smooth operating credit system (banks, stock exchange) during normal business activities. A smooth operating credit system is the prerequisite of a developed economy, as Strigl (1934, p. 111) colorfully explains:
Clearly, the introduction of credit makes a significant increase in economic returns possible, because the interpersonal transfer of capital will make it easier to direct capital into those usages in which its return—and consequently also the return from the other cooperating factors of production—will be greater. It is clear that only a smoothly operating credit market, or one operating with the least possible friction, will provide the prerequisite for “correctly” taking advantage of the supply of capital in the economy. Finally, it is also clear that a fully developed credit market is the prerequisite for the formation of a uniform interest rate, and that only a uniform interest rate makes the reliable calculation for the use of capital possible. Although we have said that credit is not a necessary prerequisite for an exchange economy using capital, we must qualify this here by adding that the institution of credit is certainly an adequate prerequisite for a relatively developed economy using roundabout methods of production.
Of course, I fully concede Bagus that if entrepreneurs would directly invest their savings, the MRI would be irrelevant. Credit would actually be irrelevant in that case. But such a society does not resemble our society at all. All I tried to show was that during normal business activity, in a society which uses an advanced credit market, the MRI could be a more efficient tool for entrepreneurs than waiting for the movements in relative prices to run their full course, due to an increase in the value of money.
I say ordinary business activity (and this relates to claim [3]), because the only examples that Bagus (2016, p. 363) can find in which hoarding implies disinvestment—i.e., it stems from investments—are bank runs, looming wars, internal riots and natural disasters.
Finally, there is only one more argument which I preferred to address last because, surprisingly, it does not have an economic nature but rather an ethical one. Bagus claims: “But who is to say what is optimal and what is not? From whose perspective is an action optimal?” I assume that I triggered this kind of reaction because if hoarding would be considered suboptimal, it would automatically result that the recommended policy program would be some sort of tax on cash holdings. Perhaps I did not stress enough that this was not my policy suggestion in the original article. I do not think that it would be useful or recommended to coerce people to put their money in the banks. I just consider that it would be advantageous for them to know that if they did (of course, considering that the banking system is healthy), they would indirectly contribute to faster economic growth.4 Of course, if people desire economic growth, i.e. an increase in material prosperity, hoarding would not be optimal. If the “uncertainty avoidance,”5 as Bagus puts it, caused when keeping cash around is greater than the desire for potentially faster growth, hoarding becomes the optimal solution. But considering that individuals usually want to increase the quantity of consumer goods that they own, investing through the credit system would probably bring these goods faster to their doors.
A REJOINDER REGARDING THE DIFFERENCES BETWEEN HOARDING AND INVESTMENTIn the previous section, I included additional qualifications to my thesis in the attempt to clear away most of the problems raised by the systematic critique made by Bagus (2016). In this second part I am left with the relatively easy part of summarizing the differences between hoarding and investment, an area in which Bagus actually brought more detailed contributions than myself.
First, hoarding implies a (monetary) tendency of prices to fall and implicitly generates Cantillon effects, as Bagus (2016, p. 370) points out. The positive feedback loop which he mentions, i.e. the fact that deflation encourages hoarding and that hoarding generates deflation, is a compelling argument. If this were the case, negative effects such as the redistribution of wealth associated with changes in purchasing power would be unavoidable.
Second, there is an additional selection process regarding which entrepreneurs will benefit from the credit pool. I am indebted to Bagus (2016) for pointing out this effect. Specialized intermediaries such as banks do tend to spend time and effort in choosing good entrepreneurs, as opposed to the case of hoarding in which the increase in purchasing power indiscriminately benefits all entrepreneurs, good and bad.6
Third on the list is what I referred to as the “wholesaler” argument, i.e. the fact that the pooling of resources can direct huge amounts of credit to specific large scale investments which could not be available by direct investment. This is, to my mind, an argument distinct from the one above.
The fact that investment can foster a more stable structure of production than hoarding is a fourth difference. I was not aware of this argument, based on the theory of maturity mismatching (Bagus and Howden, 2010), in my original article. The idea is, if I understand correctly, that savers committed to long term projects give entrepreneurs an increased assurance for undertaking longer production processes. The longer the maturity of the deposit, the safer it is for businessmen to invest, because it is less likely that the saver will withdraw his money. Cash holdings, on the other hand, have zero maturity and the owner can instantly change his mind and consume the saved resources.
Finally, keeping in mind the additional qualifications I added to the original thesis, I still hold to the idea that investment would generate faster economic growth as compared to building up cash holdings. If the market is an evolutionary (and implicitly time-consuming) process through which entrepreneurs learn by trial and error which investment projects best serve consumer preferences, a swift adjustment of the market interest rate should help them in their endeavors, given that they do not possess full knowledge. In fact, all the above arguments produced by Bagus, i.e. the tamping down of the Cantillon effects, the additional selection process and the fact that we get a more stable structure of production, all add to the idea of optimality.7
[Full Issue of the Quarterly Journal of Austrian Economics 20, no. 4 (2017)]
ABSTRACT: Roger Garrison (2001) employs the concept of “secular growth” in which a one-shot (but permanent) fall in time preferences can yield a long string of doses of net investment, so long as gross saving exceeds depreciation. However, Salerno (2001) argues that secular growth is incompatible with orthodox Austrian capital theory, and suggests ways that Garrison’s appeal to neoclassical readers can be maintained while respecting the framework bequeathed by Rothbard. Commenting on the dispute, Young (2009) argues—perhaps ironically—that the mainstream growth literature, steeped in the famous Solow model, comes down on the side of Salerno. The present paper clarifies some ambiguities in Young’s discussion, and then argues that Garrison’s usage of “secular growth” is more likely to resonate with a neoclassical reader than Salerno’s approach. To be sure, Rothbardians may ultimately reject Garrison’s standard exposition (because of Salerno’s objections), but Time and Money still represents a smooth gateway to introduce neoclassical readers to capital-based macroeconomics
KEYWORDS: Solow growth model, secular growth, capital theoryJEL CLASSIFICATION: B25, E21, E22, O11, O12, O16, O43I. INTRODUCTIONRoger Garrison’s (2001) Time and Money, and its accompanying PowerPoint presentations,Garrison’s series of PowerPoint presentations are available at https://www.auburn.edu/~garriro/tam.htm. provide a creative graphical exposition of Austrian macroeconomics in the form of three interlocking diagrams. Specifically, Garrison relates the Hayekian triangle to the “Production Possibilities Frontier” (PPF) so familiar in mainstream textbooks, which in turn he links to a standard loanable funds diagram familiar to Austrians and neoclassicals alike. Besides making for an entertaining seminar presentation, Garrison’s framework thus tells the Mises-Hayek business cycle story in a way that neoclassical economists can understand.To be sure, not all Austrians are happy with Garrison’s approach. For example, Barnett and Block (2006) reject the Hayekian triangle outright, while Hülsmann (2001) argues that Garrison’s approach to money “is irreconcilable with the standpoint developed in the writings of Menger, Mises, Rothbard, and others,” and indeed that “Garrison’s macroeconomics is…macroeconomics without money” (p. 34).
Although he appreciates Garrison’s return to the fundamentals of Austrian capital, interest, and business cycle theory—what Garrison himself dubs “capital-based macroeconomics”—Joseph Salerno (2001) worries that Garrison has unwittingly employed an analytical concept that conflicts with the verbal-logical foundations of Austrian macroeconomics. Specifically, Garrison adopts a baseline of “secular growth” as more realistic than a stationary (no growth) economy. As Garrison defines the term:
Secular growth occurs without having been provoked by policy or by technological advance or by a change in intertemporal preferences. Rather, the ongoing gross investment is sufficient for both capital maintenance and capital accumulation. (Garrison, 2001, p. 54)
Salerno (2001) argues that this concept of secular growth is dubious from an Austrian perspective. For one thing, Garrison’s discussion suggests that during periods of secular growth the economy is on “autopilot” (my term), whereas the Mengerian tradition roots Austrian analysis as causal from the foundations of the School.Salerno (2010) establishes Menger as the founder of a “causal-realist” tradition which was then elaborated by Mises and Rothbard.
More specifically, Salerno reminds us that in Rothbard’s treatment (which he viewed as merely elaborating capital theory in the tradition of Böhm-Bawerk, Mises, and Hayek), a change in time preferences corresponds to a new resting state. There may be a transition period as the production structure evolves, but in the Austrian framework
[t]he increase in real income resulting from a given dose of net investment does not buy, as it were, an automatic and continuous flow of extra capital goods that can be utilized for further extensions of the structure of production; all capital goods created by an act of net saving are fully absorbed in maintaining the enhanced flow of real income characterizing the new stationary economy. (Salerno, 2001, p. 45)
Salerno then illustrates his position with a numerical Robinson Crusoe example, in which each period Crusoe engages in discrete acts of net saving, jumping from one stationary economy to the next, in a succession of growing output. Although superficially this may seem like Garrison’s “secular growth,” Salerno argues that it is quite distinct, because each jump involves a further drop in time preference and a conscious decision to accumulate additional capital goods.
I agree with Salerno that Garrison’s notion of “secular growth” is at odds with Rothbard’s treatment in Man, Economy, and State (2004 [1962]). There, a one-shot (and permanent) fall in the community’s time preferences results in a new stationary state for the economy, with a lower interest rate, deeper capital structure, and higher gross investment to maintain it.For a numerical illustration of Rothbard’s approach to modeling the economy’s growth in response to a one-shot drop in time preferences, see Murphy (2006) pp. 96–98. But in Rothbard’s approach, once the economy adjusts to the new parameters, the process stops; we are back in a long-term equilibrium unless something disturbs it. In particular, there is no reason for the capital stock to continue growing, or for the flow of consumer goods to continue rising.
However, in the present paper we are not asking whether Garrison or Salerno has the approach to capital accumulation that is more compatible with Rothbard. Rather, here we focus attention on the narrow question of, “What approach is more likely to resonate with the way neoclassical economists think about capital accumulation?” At first blush, it would seem that Garrison comes out the clear winner, largely because of the way mainstream economists define their terms. In Section II of this paper, we will spell out this affinity between mainstream economics and Garrison’s terminology.
Yet even though I believe it will be easy to demonstrate that mainstream economists would quickly identify with Garrison’s treatment of secular growth, ironically Young (2009) reaches the opposite conclusion. Specifically, Young (2009) argues that neoclassical readers, familiar with the growth literature based on the famous Solow model, would agree with Salerno’s take on the concept of secular growth. In Section III of this paper, I will show that although superficially plausible, Young’s argument falls apart when we consider the time involved in moving to a new “steady state” in the Solow model. Notwithstanding the well-known results of the Solow model concerning savings rates and economic growth, it is still the case that mainstream economists would side with Garrison’s definition of “secular growth” over Salerno’s approach.
II. THE TERMINOLOGY OF MAINSTREAM GROWTH ACCOUNTINGIn abstract mathematical models of the economy—such as the canonical Solow growth model—it is customary to treat savings and investment the way that Garrison does in his book. In particular, if we start at a steady-state of no growth, where gross savings each period just balances physical depreciation, and then we suddenly increase the savings rate, there will be a succession of periods of what mainstream economists would label “net investment,” defined as that portion of gross investment that exceeds depreciation.A standard graduate level text is Romer (1996), and its introduction and discussion of the basic Solow model is covered in Chapter 1. (We will go over specific numerical examples of this phenomenon in Section III.)
The mainstream approach lines up perfectly with Garrison’s notion of secular growth in which “the ongoing gross investment is sufficient for both capital maintenance and capital accumulation” (Garrison, 2001, p. 54). In other words, during a period of secular growth, gross investment is high enough that it contains a component covering both depreciation (“capital maintenance”) and a remainder for net investment (“capital accumulation”).
To reiterate, this is how mainstream economists use these terms. To be sure, this labeling would not be due to deep philosophical considerations, but would instead be a matter of definition, carried over from a straightforward accounting treatment in the business world. For example, consider this discussion drawn from Investopedia.com’s entry on “Net Investment”:
If gross investment is consistently higher than depreciation, net investment will be positive, indicating that productive capacity is increasing. Conversely, if gross investment is consistently lower than depreciation, net investment will be negative, indicating that productive capacity is decreasing, which can be a potential problem down the road.Quotation taken from: http://www.investopedia.com/terms/n/netinvestment.asp, accessed January 11, 2017.
Thus we see that as a simple matter of definitions, mainstream economists would immediately understand what Garrison means when he describes secular growth occurring when gross investment exceeds depreciation, leading to net investment. In particular, if intertemporal preferences should suddenly change and disrupt an original “steady state” equilibrium, mainstream economists would endorse Garrison’s framework in which there would be many succeeding periods of positive net investment, while the growing capital stock (and hence growing depreciation each period) had not yet caught up with the sudden jump in gross saving/gross investment.
In contrast, I do not think the standard mainstream economist—used to thinking about capital as an aggregate quantity “K”—would be able to make much sense of Salerno’s discussion. Salerno’s point is that an Austrian theorist must view capital as a collection of specific capital goods with specific ends to serve, and in that framework, there are difficulties with Garrison’s approach. Yet these types of worries are not ones that would bother a mainstream economist. He or she would immediately adopt Garrison’s approach to savings rates, gross vs. net investment, and hence secular growth.
III. ANDREW YOUNG PITS SOLOW AGAINST GARRISONIn the previous section, I argued that simply by a matter of definition—and because they think of capital in aggregates like “K” rather than as concrete capital goods embedded in a subjective plan—mainstream economists would more easily embrace Garrison’s approach to “secular growth” than Salerno’s framework. However, there is one glaring complication to my argument: it is well-known in the growth literature that a higher savings rate cannot explain permanent differences in growth rates between countries, at least if we use standard models such as the Solow model.
Aware of this fact, Young (2009) weighs in on the Garrison/Salerno dispute over secular growth, and explains why he thinks neoclassical economists would declare Salerno the victor:
Salerno argues that, in the absence of technological or institutional change, time preferences must be falling over time for capital accumulation to be sustainable. Furthermore, Salerno’s argument echoes one of the primary conclusions of neoclassical growth theory [references omitted]…. As Robert Lucas (2002, p. 29) summarizes: the theory “emphasizes a distinction between ‘growth effects’…and ‘level effects.’…[C]hanges in savings rates are level effects….” In the absence of technological change, only a continually rising savings rate (and falling rate of time preference) can result in secular growth.
[…]
Either Salerno’s argument or that of neoclassical growth theory poses a challenge to Garrison’s theory of secular growth. Furthermore, despite their differences, there is little, if anything, contradictory between the two arguments. Most Austrians are not uncomfortable with diminishing returns, and neoclassical growth theorists would not likely deny that more capitalistic methods of production are also more time-consuming. (Young 2009, pp. 36–37, italics in Young’s original, bold added.)
Although Young’s general summary of the neoclassical growth literature is correct, there are some slight nuances in his handling of the matter that—in this case—actually defeat the purpose of his argument. To demonstrate this, I will first present two numerical counterexamples, and then I will explain in broad terms why Young is wrong to pit the Solow model against Garrison.
Counterexample #1 to Young: Perpetual Growth Despite Diminishing Returns and Constant Savings Rate
The standard Solow growth model—which we will exposit in discrete time—relates output to the input of homogenous capital and homogenous labor:
Yt = F(Kt, Lt)
Every period, output is divided between consumption and investment. Furthermore, capital grows with investment but every period depreciates at some rate δ, where 0 ≤ δ < 1. These considerations give the equations:
Yt = Ct + It
Kt+1 = Kt + It – δKt
One of the defining features of the Solow model (which is relaxed in later models in the neoclassical growth literature) is that the savings rate s, where 0 < s < 1, is exogenous and constant (at least for purposes of determining the “steady state” equilibrium). This gives us:
It = sYt
Kt+1 = Kt + sYt – δKt
Kt+1 = Kt + sF(Kt, Lt) – δKt
In standard expositions of the Solow model, there are more assumptions on the growth of the population, and of a technology parameter that “augments” the labor stock. For our purposes, we can dispense with these complexities, and hold technology and population constant. For simplicity, we will set the labor supply to 1 for all periods.
In this first counterexample, we will set δ=0, meaning that there is no physical depreciation in the capital stock. Further, we set Yt = F(Kt, Lt) = (Kt)1/2(Lt)1/2 = (Kt)1/2. That is, output every period is equal to the square root of the size of the capital stock that period.Because we have chosen Lt=1 for all t, labor’s contribution to output falls out of the equation. Notice that our production function is an example of the Cobb-Douglas class, with the shares of capital and labor each set to ½.
With this setup, in Table 1 we simulate the evolution of an economy where the initial capital stock is 100.
Table 1: Counterexample #1: An economy with diminishing returns and constant savings rate, yet perpetual growth
In Table 1, we see that the simulated economy enjoys perpetual (and constant) growth, as measured in absolute terms. Specifically, total real output grows by 0.05 units every period. Every period, the additional volume of output is split 10/90 between investment and consumption: Specifically (and as shown in the last column), net investment itself grows by 0.005 units each period, whereas consumption grows by 0.045 units (though space constraints prevent us from showing this in the table). Be careful not to become confused with rates of change: investment (like consumption) is a flow variable that, in this numerical example, itself increases linearly over time. However, the total amount of capital in each period is a stock variable that, in this example, grows exponentially over time.
Note that in this specific numerical example, there is no steady-state to which the economy moves; real output is 0.05 units higher every period, forever. Each period, the community enjoys 0.045 units of more (real) consumption, forever. Furthermore, this perpetual growth occurs despite the fact that we assumed a constant savings rate, and furthermore chose a production function (of the standard Cobb-Douglas class) that exhibits diminishing returns. That is to say, it is still true in this example that a given increase in K leads to ever smaller increases in Y (and hence investment and consumption) as K grows larger. (Thus, if this hypothetical economy experienced a perpetual stream of net investment of the same absolute size every period, then in the long run, the increase in real output each period would tend towards zero.) Nonetheless, there is no tendency in this economy for the growth in real output to asymptotically approach zero, even though there is a constant savings rate and a typical production function. On the contrary, real output grows without limit. Rereading Young’s block quotation above, and contrasting his description with our specific example, it is clear that something is amiss.
The “trick” we’ve used in Counterexample #1—and which is driving the results that probably strike most readers as initially counterintuitive—is that even though the derivativeOf course the derivative is only defined if we recast the model in continuous, not discrete, terms. of the production function with respect to K is diminishing as K increases, that feature does not imply that output is diminishing with respect to t. As the “Net Investment” column indicates, the periodic increments in K themselves constantly increase over time. Therefore, even though a given dose of additional capital will yield ever diminishing increments in output, perpetually increasing doses of additional capital can yield a constant increment in output over time.We can switch our Solow model to continuous time to verify analytically that our claims do indeed hold, and are not just a fluke of Excel rounding and (perhaps) an inadequate length of time in the simulation. Specifically, with Y(t) = K(t)1/2, and with dK/dt = (0.1)*Y(t), we can use calculus and substitution to determine that the second derivative of K(t) with respect to t is always +0.005, and that the derivative of Y(t) with respect to t is always +0.05. Thus, the relevant columns in Table 1 are not misleading; they accurately depict the operation of the Solow model with our chosen parameters. Additionally, we can determine that K(t) = [(0.05)t + K(0)1/2]2, which grows without limit as t tends to infinity. Indeed, that is exactly what we have illustrated in Table 1.
To be sure, the model depicted in Counterexample #1 is not very realistic. (In the next section we address this concern.) Yet it served the purpose of isolating the role that different assumptions play in yielding the standard results of the Solow model. In particular, Counterexample #1 showed that a constant savings rate plus “diminishing returns in the production function” do not rule out perpetual growth in real output, even though one might have thought otherwise from reading Young’s discussion of the neoclassical growth literature. It should go without saying that Young is aware of the importance of depreciation in these models, but nonetheless the results in Table 1 may be counterintuitive for many readers, and it is important to show that “diminishing returns” by itself does not prevent perpetual growth.
Counterexample #2 to Young: Long-Term (Secular?) Growth Even with Depreciation
An obvious objection to our first counterexample is that it did not include physical depreciation of the capital stock, and thus may have been an unfair test of Young’s position.In his comment on Young, Engelhardt (2009) also emphasizes the importance of depreciation in the analysis. Specifically, Engelhardt argues that it is not positive externalities, but rather the assumption of no depreciation, that drives Young’s own model of secular growth. I have two responses to such an objection.
First, even if it were true that employing a positive depreciation rate “fixed” everything and made secular growth once again appear untenable, my first counterexample would still underscore that Young’s emphasis on diminishing returns was not the full story. Young did not mention depreciation in his attempt to unite Salerno with the neoclassicals, and thus Counterexample #1 would be useful if only to clarify the terms of the marriage.
Second and more important, even when we add a positive depreciation rate to the Solow model, it still can take many periods—what we might interpret as “a long time”—for the periodic increases in real output to peter out. We illustrate this possibility in Table 2 where we have made the depreciation rate 5 percent of the existing capital stock, and where we have changed the initial capital stock to 1.000 to make the first few calculations intuitive.
Table 2: Counterexample #2: An economy with diminishing returns, constant savings rate, and depreciation, yet long-lasting growth
With our chosen parameter values, the typical neoclassical economist would characterize the “steady state” equilibrium by noting that when Kt = 4, investment exactly counterbalances depreciation.In this case, total output is SQRT(4) = 2. A savings rate of 10 percent thus implies gross investment of 0.2. But the 5 percent physical depreciation rate on the 4 units of capital implies total depreciation of 0.2, which totally absorbs the gross investment leaving 0 net investment. The capital stock will thus be 4 next period, and the period after, forever. If the capital stock were ever to exceed the level of 4, then depreciation would exceed gross investment and the capital stock would decline. Thus, once we add in physical depreciation, a constant savings rate—coupled with diminishing returns to capital in the production function—means that real output will indeed approach a plateau. In this case, real output will settle down in the steady state at a level of SQRT(4) = 2.
However, does this mean that Young is right after all, and that a typical neoclassical growth model leaves no room for secular growth in the Garrisonian sense? I would argue no. As Table 2 shows, even though real output is bounded above, it can grow by significant amounts for extended periods.
For example, we can imagine that Table 2 shows the evolution of an economy that starts with an initial savings rate of 5 percent, and then suddenly doubles the savings rate to 10 percent. Note that the time 0 values would constitute an original steady state at the lower savings rate (or higher time preference rate). Specifically, at time 0, if the savings rate is 5 percent, and the capital stock is 1, then investment just balances depreciation.
Now the rest of the table shows what happens if, for some reason, we disrupt that initial steady state by having time preferences suddenly fall, such that the constant savings rate jumps up to 10 percent. In Garrisonian terms, in the immediate aftermath of this preference change, gross investment is more than sufficient to cover depreciation, so that there is net investment—the capital stock grows. Garrison would label this as a period of secular growth.
Now Salerno (and Young) would presumably argue that no, this is not genuine secular growth, because it merely represents a transition period to the new steady state. In particular, once capital has quadrupled to 4, and real output has doubled to 2, gross investment will once again be adequate only to just offset depreciation. Net investment will have fallen to zero.
That is certainly true, but consider the length of this transition period. For one thing, the economy will never quite attain the new steady state, but will only asymptotically approach it. (Such an asymptotic approach is clearly not how Salerno is thinking about the issues, when he has in mind a transition to a new production structure consisting of particular capital goods.) Yet more significant than this mathematical trivia, is the proportion of the ultimate increase that has yet to be reaped after a significant passage of time. For example, note that by period 55, real output is 1.75 units, which is only seven-eighths of its steady state value. If we interpret time periods to be years, then the “transition period” (to which Salerno and Young wish to deny the label “secular growth”) spans at least two generations.
The Speed of Adjustment in the Neoclassical Growth Literature
Our conclusion from Counterexample #2—namely, that the speed of convergence to a new steady state can take a long time—corresponds with the neoclassical growth literature’s attempts to calibrate their models to real economies. For example, using standard parameter values for population growth, depreciation, capital’s share of income, and so forth, Romer (1996) writes in his graduate macro textbook, in his discussion of the Solow model:
Thus in our example of a 10% increase in the saving rate, output is 0.04(5%) = 0.2% above its previous path after 1 year; is 0.5(5%) = 2.5% above after 18 years; and asymptotically approaches 5% above the previous path. Thus not only is the overall impact of a substantial change in the saving rate modest, but it does not occur very quickly. (Romer, 1996, pp. 22–23)
To paraphrase Romer’s analysis, he is saying that when we plug plausible parameters into the Solow growth model, an increase in the savings rate from, say, 20 percent to 22 percent would eventually boost output by 5 percent relative to the original level. However—and this is crucial for our discussion—after the first 18 years of the sudden jump in savings, output would only have closed half of the gap to its new steady-state level.
For another example showing how neoclassical economists view time in growth models, consider the following commentary on a transition from a capital stock below the “golden rule” (GR) level—which, by definition, maximizes steady-state consumption—up to the GR level:
Note that in the transition to the GR [Golden Rule] point, there will be “initial” effects and “long-run” effects. Say we’re below the GR. As we increase savings, there will be a temporary decrease in consumption, and then a long run increase. Why? Because an increase in savings means less consumption right away…. However, as capital accumulates, output increases, and thus so does consumption. This situation gives us a look into why it’s called the Golden Rule…because we sacrifice consumption now for higher consumption for the people of the future. As Mankiw puts it, the welfare of all generations is given equal weight, so sacrifice by this generation is outweighed by the gains of future generations. (Sanders, 2008, p. 4, emphasis added)
As this commentary (which is taken from study notes on the Solow model) indicates, when neoclassical economists say that a higher savings rate cannot explain economic growth, they may be thinking in terms of generations. The time frame is much much longer than, say, Salerno’s thought experiment of Crusoe building a house over the course of 3,000 hours.
Discussion
To be sure, I am not endorsing the way that typical neoclassical economists deploy the Solow model when interpreting economic statistics. In particular, I have argued elsewhere that Romer (who is merely echoing the rest of the profession) is plunging headlong into the fallacy of the naïve productivity theory of interest that Böhm-Bawerk brilliantly refuted so long ago. (Murphy, 2005)
Instead, my modest point is that when economists such as Robert Lucas (whom Young quoted) say that a constant savings rate can only explain level effects, not growth effects, this observation does not pose a problem for Garrison and his notion of secular growth. As we have seen, the standard Solow model—calibrated with plausible parameter values—predicts that a one-time increase in the savings rate would lead to a permanently higher (but constant) level of output, but that this transition process could take decades before the bulk of the increase had been reaped. During those decades, gross investment would be higher than depreciation, such that the capital stock would grow with each successive burst of “positive net investment” (defined in the standard way that accountants and business owners would use the terms). Is this not entirely compatible with the Garrisonian framework?
Young is certainly correct when he points out that the typical neoclassical growth literature—at least with models that exclude the type of positive externalities from investment that Young believes will solve Garrison’s problem—has no room for growth in the steady state as a result of mere capital accumulation.
However, what the neoclassical economist means by “growth in the steady state” is not exactly the same concept as “secular growth” in Garrison’s framework. Now perhaps Garrison did intend to suggest that an economy could experience rightward shifts in its Production Possibilities Frontier (PPF) indefinitely, as the result of a one-shot increase in the savings rate. That would indeed be inconsistent with the neoclassical literature, and indeed would be hard to reconcile with diminishing returns and (physical) depreciation. However, in his diagrams in Time and Money as well as his PowerPoint presentations, Garrison only shows a few periods of secular growth in response to a fall in time preference, all of which is perfectly consistent with the neoclassical treatment.Even if he did not intend it, Garrison’s descriptions could understandably mislead some readers into thinking that a one-shot change in the savings rate could fuel perpetual growth, even with physical depreciation. For example, in his 2003 PowerPoint presentation on “Sustainable and Unsustainable Growth”—available at https://www.auburn.edu/~garriro/ppsus.ppt—at one point in the demonstration the slide reads: “With gross investment greater than capital depreciation, the economy experiences secular growth. This rate of growth is sustainable.” Strictly speaking, Garrison no doubt means that investments that occur because of a (one-shot) fall in time preferences, wherein gross investment exceeds depreciation, will not lead to a boom-bust cycle. However, his statement is definitely liable to lead some readers to conclude that the economy will continue this (“sustainable”) growth indefinitely, and that indeed this is the baseline of real-world economic growth upon which we add technological innovations. If that is what Garrison was trying to convey, then Young is certainly correct: neoclassical economists would argue that such an analysis ignores the straightforward implications of the standard Solow model. Specifically, if we assume diminishing returns to physical capital, and that depreciation is proportional to the stock of capital, then for fixed technology and a constant savings rate, the economy will eventually reach a “steady state” where gross investment just covers physical depreciation.
IV. CONCLUSIONGarrison’s definition of “net investment” accords with the way accountants, business people, and neoclassical economists use the term. As such, his related notion of “secular growth” will also resonate with mainstream economists. Salerno is right that Garrisonian secular growth is hard to reconcile with Rothbardian capital theory. However, perhaps the primary virtue of Time and Money is its exposition of capital-based macroeconomics in terminology and graphs that non-Austrian economists can understand. On this criterion, Garrison’s “secular growth” passes with flying colors.
There is an admitted complication that Andrew Young has brought up: a well-known result in the growth literature is that a sudden increase in the savings rate does not lead to permanently higher growth in the Solow model. However, all this means is that Garrison should be clear that his concept of secular growth is not permanent, but rather can last “only” 50 years (with plausible parameter values). This presents no problem for his book’s graphs or his PowerPoint presentations, since they only show a few years of “secular growth” where the PPF shifts outward in response to a one-shot increase in savings. There is nothing in Garrison’s exposition that depends on secular growth lasting literally forever, as opposed to (say) only 50 years.
In other words, Garrison’s treatment is entirely compatible with the neoclassical growth literature so long as he clarifies that his “secular growth” is a long-run but not an infinitely long phenomenon.
[The author thanks Joe Salerno for providing unpublished material, and William Barnett, Walter Block, Adam Martin, and an anonymous referee for feedback on earlier drafts. Alan Murphy helped derive results for the continuous-time version of the Solow model.]
Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017)ABSTRACT: The article responds to the main points raised by Howden (2016) in his comment on Machaj (2015). Most of them appear not to argue against the model developed in my paper, but argue in favor of most likely scenarios to happen in empirical reality and therefore most probable events to be depicted in the model.
KEYWORDS: capital theory, interest, production structure, labor intensityJEL CLASSIFICATION: B13, B53, D24, E43
The results of the UK elections are unquestionably negative for the economy, bad for investment, bad for the pound, and for a swift Brexit resolution.
The UK economy has performed exceptionally well in the past years, even after the Brexit referendum. So well, that international agencies such as the IMF or the OECD had to completely reverse their negative expectations for the economy of a “Yes” vote.
The problem is that we have focused on the positive — the fact that doomsayers were wrong — without analysing the negatives — the impact on potential growth and increase in investments. The Bank of England had to increase its growth estimates for 2017 to 1.7% and 1.3% for 2018. However, the uncertainty of a hung parliament, a weak government unable to negotiate Brexit from a position of strength, and the ongoing weakness of the pound may continue to erode growth potential, gross capital formation, and economic agents’ investment and hiring decisions.
It is extremely unlikely that Brexit will be reversed. It is, however, very likely, that negotiations will be more difficult and longer.
The UK is a very dynamic economy, and its companies have enormous strengths, with a thriving export sector and global multinationals. These will continue to benefit from a weak currency, but internal demand and the large surplus of service exports may suffer from the uncertain process of an even more complex Brexit.
As such, it is likely that we will not see a major impact in the growth prospects of the economy due to the benefits of a global and strong external sector, which benefits more from solid high-margin products and competitive technology than from weak currencies, but internal demand challenges will likely have an impact on consumption, hiring and wages.
It is no surprise, then, that the FTSE will continue to rise. It is fundamentally composed of diversified international companies. The impact of uncertainty may weigh on banks, consumer stocks and those with a large proportion of sales in the UK. However, the FTSE is more impacted by estimates of the global economy and energy-commodity prices. It is an index with almost 30% of sales in foreign currency.
The pound weakness may continue, also because the BoE is unlikely to take any measures to defend the currency.
As for bonds, extended QE means that sovereign bond yields will remain depressed, while solid corporate earnings and good balance sheets will support a more than adequate demand for corporate bonds. A clear indicator in the wake of the UK election this month has been that yields are still contained in all the different indices.
Clearly, investors will have to pay attention to guidance and cash flow generation of companies, but I would imagine that the forthcoming uncertainty will likely have an impact on a potential growth that should be well above EU or US figures, but will not.
Being complacent about average growth and acceptable macro figures cannot disguise the fact that the UK could and should grow well above its comparable economies and that the Bank of England is keeping an uncomfortably aggressive quantitative easing program that will leave it without tools in case of a change of economic cycle that is now more likely than before.
Reprinted with permission of the author. Daniel Lacalle has a PhD in Economics and is author of Escape from the Central Bank Trap, Life In The Financial Markets, and The Energy World Is Flat (Wiley).
Capital, Interest, and Rent: Essays in the Theory of Distributionby Frank A. FetterIntroduction by Murray N. RothbardSheed Andrews and McMeel, Kansas City, 1977, 400 pp.
Reviewed by Israel M. Kirzner
Reprinted from Austrian Economics Newsletter 2, no. 3 (1980)
This book is a most valuable collection of “all the essays in which Fetter developed and presented his theory of distribution;” it is prefaced by a substantial and characteristically scholarly Introduction by Professor Rothbard, to whose editorial vision and initiative our gratitude is due for this volume. Frank A. Fetter (1863–1949) was, of course, a leading American economic theorist of the early years of this century, teaching at Cornell from 1901 to 1911, at Princeton from 1911 to 1931, and serving as President of the American Economic Association in 1912. During the course of a prolific and distinguished career of scholarly writing, commencing from about 1894 and continuing until the year of his death, Fetter made a particularly brilliant series of contributions to the theory of distribution, most of them during the years from 1900 to 1904. In these papers Fetter carried forward the radical reformulation of economic theory which had begun with the marginal utility revolution of the 1870’s, but which, at the turn of the century, was still far from being complete. Along with the new insights learned from the marginal utility theorists there remained pervasive and incongruous traces of earlier misunderstandings. These were particularly troublesome in the area of distribution theory, in the treatment of rent theory, interest theory, the concept of capital. Fetter attacked these problems with keenness of insight, with profound clarity of understanding, and with a delightfully lucid literary style. In the course of his essays he challenged some of the leading theorists of his time, including particularly Böhm-Bawerk, Marshall, J.B. Clark, and Irving Fisher. From his work there emerged a unified theory of distribution which fits illuminatingly into the broader framework of modern, subjectivist economic theory. (In this respect Fetter offers a striking similarity to Phillip Wicksteed — whose work is nowhere quoted in this volume, and in whose own work Fetter is himself not mentioned either.) Professor Rothbard is to be warmly congratulated for his excellent idea of collecting these papers and offering them to the present day student. Not only can the modern reader learn a great deal of the history of modern economics from this volume; these papers also demonstrate how economic theorizing can be engaged in by a master. It is a rare pleasure, these days, to encounter economic reasoning so elegantly presented, so powerfully yet lucidly argued.
The Introduction is a gem in its own right, giving us Murray N. Rothbard, the economist, at his very best. Careful and wide scholarship, perceptive interpretation and keen criticism of Fetter’s contributions, characterize this brilliant introductory essay. Probably the most provocative statement in the Introduction is Professor Rothbard’s opening sentence describing Fetter as “the leader in the United States of the early Austrian school of economics.” This may come as a distinct surprise to the reader of this volume, who encounters Fetter’s numerous, trenchant, no-punches-pulled attacks on Böhm-Bawerk, and Fetter’s dismissal of the Austrian school as having “stopped short of any lasting contribution to better concepts of capital and income” (p. 159). The reader may also recall Schumpeter’s asserting it to be “not quite correct” to classify Fetter as an “Austrian” (History of Economic Analysis, p. 874). Yet Rothbard’s claim can be defended. While it is difficult to discover any “early Austrian school” in U.S. twentieth-century economics, to which present-day U.S. Austrians might look back with filial pride, it cannot be denied that Fetter’s own work is thoroughly imbued with insights from the earlier Austrians whom he describes (p. 75) as holding the center of the stage in the post-1885 theoretical developments. That Fetter, while paying his respects to his Austrian forebears, is prepared to push forward the frontiers of knowledge by his own efforts (one thinks particularly, in this regard, of his splendidly consistent pure time preference theory of interest), can provide a useful model for today’s Austrians.
To seek, in this review, to examine Fetter’s contributions in detail would, in view of Rothbard’s own comprehensive Introduction, surely be a mistake. Rather than attempting to duplicate Rothbard’s treatment, the reviewer begs permission to dwell critically on one small part of that treatment. It may be confidently hoped that many economists will be stimulated by this outstanding volume to an appreciation of the roots of modern Austrian economics, and to making their own contributions to its further wholesome development.
Professor Rothbard credits Fetter with a “brilliant criticism” of Böhm-Bawerk’s famous “third ground” (in which Böhm-Bawerk claimed to explain that present goods are worth more than future goods as a result of the greater productivity of the former). Rothbard cites Fetter as showing this argument to be “totally invalid” by pointing out that “capital goods are really future goods.” When a firm hires workers or buys capital goods, Rothbard argues, it “is really buying future goods in exchange for a present good, money.” The “capitalist-entrepreneur hires or invests in factors now and pays out money (a present good) in exchange for productive services that are future goods” (pp. 11–12).
This reviewer wishes, with respect, to question the use of a terminology that may foster unnecessary confusion. When a firm hires, let us say, a truck, the truck is certainly, in one obvious sense at least, a present good: it does exist now. Similarly when it hires the services of laborers, these services are provided in the present. What Professor Rothbard (quite correctly) means, of course, is that the final consumption output, to which the truck and the labor services make their contribution, will become available only in the future. However, this perfectly correct and useful insight does not require us to say that when a firm buys a truck it is merely buying future consumption goods. It is entirely in order (and perhaps more simple) to say that the firm (a) buys present capital goods and services; and then (b) puts these present productive goods and services to work in timeconsuming production processes — in the course of which production processes these present intermediate goods ripen and mature into the final consumption goods to be available in the future. The capitalist producer in so doing is of course sacrificing present goods for the sake of the consumption goods to be available only in the future. But this does not require us to say that the truck is nothing but a future good.
Strictly for illustrative purposes let us imagine Knight’s Crusonia plant (an edible plant that grows at a fixed rate). Say that one pound of the plant today will grow into two pounds of the plant next year. An entrepreneur buys a pound of Crusonia today. Has he bought a present good or a future good? Clearly the pound of Crusonia he has bought is in one sense a present good, it can be consumed today. Nonetheless, since the purpose in buying it is, let us imagine, in order to obtain the two pounds that will be available (if present consumption is abstained from) next year, it is quite correct to say that the present one pound of plant is the key to two pounds of future plant — and it may hence seem harmless to describe the one pound of present plant as not being a present good at all, but as simply being “two pounds of future plant.” However (quite apart from the Hayekian criticisms of this Knightian view of present capital goods as guaranteeing a flow of future outputs — as if such output will be automatically forthcoming, without need for entrepreneurial decisions at all), such a formulation unhelpfully conceals the distinction between means and ends. One pound of present plant may be seen as the end goal of earlier growth processes. It may also be seen as present means for the achievement of future ends. It does not seem helpful to describe present means as being nothing but future ends. Rather we focus attention on the doubly Austrian insight that, while means tend to assume the value of the ends which they are expected to produce, nonetheless, where the ends are available only in the future, the present value of the presently available means equals the value of their future output only after discounting for time preference.
Fetter does (on p. 184) as Rothbard cites, write that it “would be far more consistent use of language to call intermediate, or productive, agents ‘future goods’ than present goods,” — but this does not appear to be the basis for an attempted refutation by Fetter of Böhm-Bawerk's third ground. After all, if Böhm-Bawerk were to argue that one pound of Crusonia plant today is more valuable today than the prospect of one pound of Crusonia plant next year, (because of the greater productivity of the former), this cannot immediately be shown to be nonsense merely by asserting that the present pound of plant is two pounds of future plant. Rather, in emphasizing the future output of which present capital goods represent the inchoate form, Fetter appears simply to be challenging the parallelism claimed by Böhm-Bawerk to exist between the third ground and the other two grounds. In the other grounds it is argued that present enjoyments are valued today more highly than future enjoyments are valued today. In the third ground, on the other hand, it is argued that present intermediate goods (i.e., present means) expected to ripen into valuable future enjoyments, are valued today on the basis of these valuable future enjoyments. In this third ground, therefore, there is no comparison between the present valuation of present enjoyments and that of future enjoyments — only the insight that the value of present means depends on the value of future ends. This represents a criticism of Böhm-Bawerk’s understanding of the relation between the third ground and the other grounds; it does not seem intended as a refutation of it. For this Fetter had, of course, devastating and thoroughly Austrian arguments — forged, ironically enough, by none other than Böhm-Bawerk himself.
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
ABSTRACT: When individuals save more and invest directly in projects there results capital accumulation and growth. When individuals save more in order to add to their cash holdings, consumer goods are liberated that can be used for capital accumulation causing also economic growth. At first sight, the processes seem similar. But are there differences? And if so, what are they? In this article and responding to Pătruți (2016), we will first emphasize that cash building does not necessarily stem from saving. Second, we will argue that cash building by saving does not necessarily imply a longer time period for capital accumulation to materialize. Third, we will criticize the argument that hoarding would be suboptimal vis-à-vis direct investment. Finally, we will analyze the differences between cash building by saving and saving through investing.
KEYWORDS: Austrian school, capital theory, structure of production, investment, interest, hoardingJEL CLASSIFICATION: B13, B53, E14, E22, E31, E41, E43, O40
REFERENCESBöhm-Bawerk, Eugen von. 1889. Capital and Interest, Vol. II: Positive Theory of Capital. George D. Huncke, trans. South Holland, Ill: Libertarian Press, 1959.
Braun, Eduard. 2014. Finance Behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market. Liberty.me.
Fillieule, Renaud. 2007. “A Formal Model in Hayekian Macroeconomics: The Proportional Goods-in-Process Structure of Production,” Quarterly Journal of Austrian Economics 10, no. 3: 193–208.
Garrison, Roger W. 2001. Time and Money: Macroeconomics of Capital Structure. London: Routledge.
Hayek, Friedrich A. 1935. “Prices and Production,” reprinted in Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, pp. 189-329. Auburn, Ala.: Ludwig von Mises Institute, 2008.
——. 1936. “The Mythology of Capital.” In Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, pp. 489–520. Auburn, Ala.: Ludwig von Mises Institute, 2008.
——. 1941. The Pure Theory of Capital. Chicago: University of Chicago Press.
Howden, David. 2015. Money in a World of Finance. Journal of Prices & Markets 4(1), Papers & Proceedings of the 3rd Annual International Conference of Prices & Markets, Toronto, Canada, Nov. 6-7, 2014: 13-20.
——. 2016a. “A Refinement to the Typology of ‘Goods’” Journal of Prices & Markets 4, no. 2: 4–11.
——. 2016b. “Fifteen Elucidations of Roundaboutness.” Working paper.
——. 2016c. “’Lengthening’ the Structure of Production.” Working paper.
——. forthcoming. A Consumption-Based Theory of the Term Structure of Interest. Journal of Prices & Markets, Papers and Proceedings of the 5th Annual Conference of Prices & Markets, Nov. 4–5, 2016, Toronto, Canada.
Howden, David, and Yang Zhou. 2016. “The Structure of Labor.” Working paper.
——. forthcoming. The Structure of Labor and Capital Ordering. Journal of Prices & Markets, Papers and Proceedings of the 5th Annual Conference of Prices & Markets, Nov. 4–5, 2016, Toronto, Canada.
Huerta de Soto, Jesus. 2006. Money, Bank Credit, and Economic Cycles. Melinda A. Stroup, trans. Auburn, Ala: Ludwig von Mises Institute.
Hülsmann, Jörg Guido. 2010. “The Structure of Production Reconsidered.” Working paper.
Machaj, Mateusz. 2015. "The Interest Rate and the Length of Production: An Attempt at Reformulation,” Quarterly Journal of Austrian Economics 18, no. 3: 272–293.
Menger, Carl. 1871. Principles of Economics. James Dingwall and Bert F. Hoselitz, trans. Auburn, Ala.: Ludwig von Mises Institute, 2007.
Mises, Ludwig von. 1912. The Theory of Money and Credit. H. E. Batson, trans. Irvington-on-Hudson, New York: Foundation for Economic Education, 1971.
——. 1949. Human Action, the Scholar’s Edition. Auburn, Ala.: Ludwig von Mises Institute, 1998.
Reisman, George. 1990. Capitalism: A Treatise on Economics. Laguna Hills, Calif.: TJS Books, 1998.
Rothbard, Murray N. 1962. Man, Economy, and State: A Treatise on Economic Principles, with Power and Market: Government and the Economy. Auburn, Ala.: Ludwig von Mises Institute, 2007.
——. 1963. America’s Great Depression, 5th ed. Auburn, Ala.: Ludwig von Mises Institute, 2000.
Strigl Richard von. 1934. Capital and Production. Margaret Rudelich Hoppe and Hans-Hermann Hoppe, trans. Auburn, Ala.: Ludwig von Mises Institute, 2000.
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
ABSTRACT: Machaj (2015) does a great service in pointing out a key assumption, heretofore unaddressed, in Filleule (2007) and Hülsmann (2010). Machaj errs, however, in stating that who saves will have an ambiguous effect on the interest rate and that where savings are directed can have ambiguous effects on the length of production. In this brief comment I will first show that who saves will have no effect on the interest rate. I then turn my attention to what it means to “lengthen” the structure of production. Although extended production time or additional “stages” of production make convenient placeholders for increased roundaboutness, they fail to grasp the core concept as it pertains to capital theory: what is it about production processes that makes more or better consumer goods?
KEYWORDS: capital theory, interest, production structure, roundaboutness, labor intensityJEL CLASSIFICATION: B13, B53, D24, E43
The Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
The Interest Rate and the Length of Production: A Commentby David Howden
David Howden (dhowden@slu.edu) is professor of economics at Saint Louis University – Madrid Campus. In addition to Jeffrey Herbener and Shawn Ritenour, I would also like to thank, without implicating, an especially insightful referee.
ABSTRACT: Machaj (2015) does a great service in pointing out a key assumption, heretofore unaddressed, in Filleule (2007) and Hülsmann (2010). Machaj errs, however, in stating that who saves will have an ambiguous effect on the interest rate and that where savings are directed can have ambiguous effects on the length of production. In this brief comment I will first show that who saves will have no effect on the interest rate. I then turn my attention to what it means to “lengthen” the structure of production. Although extended production time or additional “stages” of production make convenient placeholders for increased roundaboutness, they fail to grasp the core concept as it pertains to capital theory: what is it about production processes that makes more or better consumer goods?
KEYWORDS: capital theory, interest, production structure, roundaboutness, labor intensityJEL CLASSIFICATION: B13, B53, D24, E43
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 4 | 345–358Winter 2016
The Interest Rate and the Length of Production: A CommentDavid Howden
David Howden (dhowden@slu.edu) is professor of economics at Saint Louis University – Madrid Campus. In addition to Jeffrey Herbener and Shawn Ritenour, I would also like to thank, without implicating, an especially insightful referee.
ABSTRACT: Machaj (2015) does a great service in pointing out a key assumption, heretofore unaddressed, in Filleule (2007) and Hülsmann (2010). Machaj errs, however, in stating that who saves will have an ambiguous effect on the interest rate and that where savings are directed can have ambiguous effects on the length of production. In this brief comment I will first show that who saves will have no effect on the interest rate. I then turn my attention to what it means to “lengthen” the structure of production. Although extended production time or additional “stages” of production make convenient placeholders for increased roundaboutness, they fail to grasp the core concept as it pertains to capital theory: what is it about production processes that makes more or better consumer goods?
KEYWORDS: capital theory, interest, production structure, roundaboutness, labor intensityJEL CLASSIFICATION: B13, B53, D24, E43What is the relationship between the rate of interest and the length of the structure of production? Austrian School economists often claim an unambiguous negative relationship between these two variables. Indeed, the assertion that artificial reductions to the interest rate cause an unsustainable lengthening in the structure of production is the central tenet of the Austrian theory of the business cycle.
Recently, Fillieule (2007) and Hülsmann (2010) have challenged this claim by deriving the logical outcome of a drop in the interest rate given a fixed stream of aggregate expenditure. As the rate of interest falls, current consumption is discounted at a lower rate. The result is a shorter production structure, with production activities moved closer to final consumption, or to what Menger (1871, ch. 1) referred to as goods of the first order. While such an outcome is opposed to traditional analysis, it is the logical consequence of a reduced interest rate on a constant expenditure stream.
While such reasoning is correct, bypassing an important causal relationship creates an outcome more apparent than real. Within a fixed expenditure stream, the interest rate can only decrease if consumption falls or savings increase. Both of these outcomes represent different sides of the same coin, as the market rate of interest is the intertemporal price differential between present and future goods, i.e., between consumption and investment expenditures.Technically the pure rate of interest is the intertemporal price differential between equivalent satisfactions, as provided for by the use values embodied in goods. To the extent that financial assets, such as money, circulate according to their exchange and not use value (Howden 2015: 17; 2016a), the intertemporal price differential of the physical goods will be the same as that of their satisfactions. Machaj (2015, p. 279) is quite correct in challenging Fillieule’s and Hülsmann’s novel conclusion that a lower interest rate will shorten the structure of production since they give no cause as to why the interest rate would fall. Realizing that a decrease in the level of consumption is a necessary precondition for a falling interest rate goes far in illustrating the traditional negative relationship between the interest rate and the length of production.
Machaj overreaches with this conclusion, however, in then positing that who increases his savings will have an ambiguous effect on the interest rate. He does so by describing scenarios where the interest rate decreases without decreases in total consumption. This outcome gives the seeming result of “total savings increasing without total consumption going down” (Machaj, 2015, p. 279).
Imagine a simple scenario of capitalists decreasing their consumption by X units (total savings increase). Imagine that this additionally saved money is being spent only on higher wages. Under the framework—for the purpose of simplicity—workers are being treated as pure consumers, so that wages are fully spent on consumption. Hence a decrease in capitalists’ consumption by X units is fully (under such scenario) counterbalanced by an increase in X units of laborers’ consumption. At the same time, total savings are increased (because capitalists are saving more), and the interest rate can fall with total consumption unaltered. (Machaj, 2015, pp. 279–280)
The belief that the relationship between consumption and the rate of interest depends on who saves, lower time preference capitalists or higher time preference workers, is attractive but misplaced. What matters is the aggregate level of savings and not its composition amongst individuals.Indeed, the stock of savings has only a value dimension and does not acquire a temporal aspect until it is invested (Braun, 2014, p. 55).
Assume a closed economy in a no-profit equilibrium. Aggregate income Y accrues to factor owners in the following manner (Rothbard, 1962, p. 334): workers in the form of wages w, capitalists in the form of a return r on their investment, and landowners by payments l for the use of land. Workers consume CW, capitalists consume CK, and landowners consume CL, with total consumption C being the sum of worker, capitalist and landowner consumption. There is no income hoarded in the form of money.
Workers’ savings SW are given as:
SW = w – CW
Capitalist savings SK are given as:
SK = r – CK
And landowners’ savings SL are given as:
SL = l – CL
Since savings in the closed economy can only come from workers, capitalists and landowners, total savings S simplifies to the standard expression:
S = Y – C
Since the interest rate is negatively related to the savings-consumption ratio, and since aggregate savings and aggregate consumption are two sides of the same coin, we find the standard result that increases in consumption must drive savings lower and thus increase the rate of interest.
In this scenario, all income flows to the factor owners in the form of wages, a return on capital and rental payments for land use, and these groups then decide whether to save or consume this income according to their own preferences. Taken together, it is clear that aggregate savings cannot increase except by either 1) an increase in income, or 2) a decrease in aggregate consumption expenditures. The composition of the originators of the savings, however, has no bearing on the rate of interest.
Machaj’s example aims to show that savings can decrease even if total consumption is unchanged. Since he assumes explicitly that the expenditure stream Y is constant, the inconsistency between a falling interest rate with unchanged consumption must be explained through other means. Machaj assumes the worker is a pure consumer with no savings (CW = w). He then proceeds to shift the income distribution so that r increases by the same amount as w decreases. It is here that he states that savings must rise since workers save less than capitalists. However, the total sum of consumption expenditures will also have decreased by the same amount and not remain constant as Machaj states.
To summarize, the redistribution of income will decrease consumption by the same amount as savings have increased, resulting in a lower interest rate. Consequently, Machaj has not demonstrated that a decline in saving need not be offset by a commensurate increase in consumption expenditures.Before moving on I must point out one more quibble with Machaj’s presentation of the relationship between the length of the structure of production and changes of the consumption-savings ratio. He (2015, p. 279) points out correctly that what is relevant is the interest-rate elasticity to the consumption-savings ratio, though he comments that a sufficiently high elasticity would shorten the structure of production. Actually, the sign on the elasticity is the only relevant determinant of whether the structure of production shortens, lengthens or is neutral with respect to changes in the consumption-savings ratio. As we will see, the answer to this question hinges critically on what one means by changes to the “length” of the structure of production.
Still, the second part of Machaj’s paper focusing on intertemporal labor intensity (ILI) has great merit, though not because it pertains to the consumption-savings relationship. Instead, it helps to answer the question of “where does the saved money go?” (Machaj, 2015, p. 280). This question has heretofore been answered in peculiar ways, e.g., Fillieule (2007) sees any change in savings as being distributed evenly across the stages of production, and Hülsmann (2010) assumes all savings are directed to the first stage of production. Machaj’s contribution is in relaxing these assumptions.
Machaj gives a series of three examples where a lowering of the equilibrium rate of interest induces either no change, a lengthening or a shortening of the number of stages of production. All three examples share a common interest rate and the only differentiating factor is the ILI. The ILI is the degree to which labor is employed in production and, more importantly, where within the production process this takes place. Machaj’s examples illustrate that labor employed at the later stages of production will have the intuitive (and standard) effect of lengthening the structure of production. If, however, capitalists employ laborers at the earlier stages of production, the result will be a reduction in the number of stages of production.
Machaj uses this insight to question Hülsmann’s central conclusion that a shortening of the production structure will result from a lower interest rate. Effectively, Machaj demonstrates that this result has nothing to do with the rate of interest but rather depends on where labor expenditures are directed.
Machaj sheds light on what Howden and Yang (2016; forthcoming) refer to as the “structure of labor” by which they mean the temporal and qualitative ordering of labor that complements capital along the structure of production. Superficially, one could believe that Machaj’s example relies on an adequate answer to whether human capital is indeed capital in the same sense that physical capital is. I claim only a “superficial” relevance to that question since the labor/capital ratio of 85/200 is constant in all of his examples and thus the relationship between the length of the production structure must be contingent on some factor other than the relationship between any definition of human capital and physical capital. Freed from commenting on controversies concerning the quality of labor, I will point out two deficiencies with the problem as it is structured.
The first is that, as in Fillieule (2007) and Hülsmann (2010), Machaj has no causal explanation for why the interest rate falls. The interest rate decreases from an equilibrium level of 1/9 to 1/19 in all three of Machaj’s examples, though this is not caused by a change in the consumption-savings ratio, which remains constant at 1/2. Nor does a change to the money supply or its velocity affect the interest rate, as the expenditure stream (MV) is fixed at 300 in all examples. Given no causal reason to explain why the interest rate was more than halved, it is difficult to treat Machaj’s conclusion as anything more than a theoretical example of passing curiosity, but which has no bearing on the real world.
More seriously, attempts to show paradoxical changes in the production structure due to changes in the interest rate without giving a reason why the rate changed are analogous to reasoning from a price change. Although they represent seemingly plausible and logically consistent examples, they lead to vacuous results. To give an analogy, the physicist could, e.g., wonder what the effect would be on a 120-mile journey that takes two hours at 60 miles per hour if we increased the speed to 90 miles an hour. If our travel time remained constant it would be obvious that the distance magically lengthened to 180 miles. Of course, the correct answer would lie in identifying that travel time is the result of speed and distance, notwithstanding that the three variables are all defined tautologically in terms of each other. The journey cannot take on multiple lengths, and the time must change to equate the new speed with the existing distance.
Likewise, attempts to derive changes to the length of production when the interest rate changes and the consumption-savings ratio and aggregate level of expenditure remain constant suffer the same deficiency. The rate of interest is not sui generis. It is determined first and foremost by the savings-consumption ratio. Thus the interest rate is the dependent variable that changes in response to the savings-consumption ratio and cannot be treated as the independent variable affecting savings or consumption.
Still, we can let this objection pass and question whether there is something else of interest in his result. Implicit in the statement that the structure of production changes length according to changes in the interest rate, or dependent on the degree of ILI for that matter, is that we share a common understanding of what units the production structure is measured in. Machaj uses two units interchangeably. On the one hand, the production structure is reckoned in “stages” and to lengthen the structure means to add a new stage. On the other hand, each stage is defined as having a duration of one year. To lengthen the structure thus implies a greater amount of temporal units necessary to produce a given amount of output.
Such beliefs about how best to measure the structure of production are common. Fillieule (2007, p. 201) makes the same assumption, as does Hülsmann (2010). The use of “stages” is deficient, however, in that adding more stages is analogous to a lengthened production structure but gives no reference to whether the stage is added closer or further from consumption. In other words, the temporal ordering of stages does not affect the length of the production structure, provided that somewhere in the structure there is productive activity.One could quibble that defining each stages as a fixed temporal length, e.g., one year, is ad hoc though as an assumption there is nothing unmeritorious about doing so.
If stages or time are deficient units, when the Austrian-school economist refers to the “length” of the structure of production, in what units must he measure this dimension? Although increased production time is the conventional usage of the term “lengthening,” there are good reasons to doubt its applicability.
The most obvious doubt should come from the apparent, if contrived, examples that show an ambiguous relationship between the rate of interest and the temporal length of the capital structure. One of Machaj’s great contributions is in demonstrating that where savings (signaled as they are by a lower interest rate) are invested is more complicated a question than was once thought. Of course we know that savings will be directed more profitably at a temporal stage further from final consumption as the interest rate falls due to the discount effect. At the same time if, as is the case in an Austrian business cycle, consumers increase their demand for consumption goods, entrepreneurs will be enticed to invest resources closer to final output to take advantage of the derived demand at these lower stages. Garrison (2001, p. 72) refers to the “tug-of-war” that occurs at both ends of the structure of production, but doesn’t have a clear way to answer whether the strain at the higher and lower stages is “lengthening” the production structure.
Results that show an ambiguous relationship between the length of the production structure and the interest rate do so by defining the length in terms of “stages,” or what is analogous, time. There is great ambiguity in the Austrian literature as to what a “lengthening” of the structure actually means. Examples abound of the lengthening being the addition of more stages (e.g., Garrison, 2001, p. 82; Rothbard, 1962, pp. 519, 996; Huerta de Soto, 2006, p. 280; Hayek, 1935, p. 156).Of these authors, only Hayek (1941, p. 73) has paid attention to defining what a “stage” of production actually means: separate operations performed by distinct firms. I doubt this definition is readily shared by others using the concept. Other authors stress the lengthening of the time element of production (Böhm-Bawerk, 1889, p. 82; Strigl, 1934, pp. 3–4; Rothbard, 1962, p. 423; Reisman, 1990, p. 460; Mises, 1912, p. 360; 1949, p. 556; Hayek, 1935, p. 150).
Both views on lengthening are consistent with the approach used by Machaj, which he uses to illustrate his counter-intuitive result. One could also point to more nuanced views that could be consistent with Machaj’s examples of a lengthened structure of production. Rothbard (1962, p. 1006 n113; 1963, p. 10), Huerta de Soto (2006, pp. 337, 365, 369), and Hayek (1935, p. 310) all allude to the weighting of investment according to what stage it is directed to. Under this chain of thought, it is possible to conceptualize an investment made in a higher stage as lengthening the structure of production more than an equivalent investment in a lower stage since the investment is further from final consumption.
Equating additional stages with a lengthened period of production is not without its drawbacks. Böhm-Bawerk (1889, p. 82) first noted that there was no strict proportionality between the number of stages and the length of production time, and Hayek developed this chain of reasoning more fully (Hayek, 1941, pp. 73–74). In a section devoted to “Capital Accumulation and the Length of the Structure of Production,” Rothbard gives an example where there is an ambiguous relationship between Robinson Crusoe’s investments, total consumable output produced and the temporal period of production of this output (1962 p. 543). Hayek gives the most comprehensive examination of this point:
It is frequently supposed that all increases in the quantity of capital per head (at least when they do not involve changes in the quantities of durable goods) must mean that some commodities will now be produced by longer processes than before. But so long as the processes used in different industries are of different lengths, this is by no means a necessary consequence of a change in the investment periods of particular units of input. If input is transferred from industries using shorter processes to industries using longer processes, there will be no change in the length of the period of production in any industry, nor any change in the methods of production of any particular commodity, but merely an increase in the periods for which particular units of input are invested. The significance of these changes in the investment periods of particular units of input will, however, be exactly the same as it would be if they were the consequence of a change in the length of particular processes of production. (Hayek, 1941, pp. 77–78)
Machaj relies on labor reallocations to show scenarios in which the structure of production is temporally lengthened or shortened given the same interest rate, but Hayek was critical of any approach to understanding the lengthening of the structure of production by means of looking at shifts in labor instead of capital (1936, p. 496, n16). This stemmed from his belief that focusing narrowly on labor shifts would not explain why an increase in that specific factor was being pursued, something which he believed could take place only after a capital investment had increased the marginal productivity of labor. Thus the term “period of production” (including capital and labor) was an unfortunate term to describe the intended phenomenon, i.e., more roundabout production processes. (One alternative offered by Hayek was to measure roundaboutness by way of the “period of investment” [Hayek, 1936, p. 496].)
By providing multiple production structures differing only by the stages at which payments to an originary factor are made and in what magnitude, Machaj gives no explanation for why the rearrangement of the structure of production should occur. Capitalists will not rearrange deliberately the input factors along the structure of production unless the consequence is greater productivity or decreased costs. In Machaj’s examples, the total amount of expenditure directed to labor relative to aggregate expenditures (actually to the originary factors in general, but he focuses on labor) increases from 70/300 to 85/300. This bidding for labor, either in terms of higher wages or more workers, only occurs if labor productivity is enhanced. The only way for labor productivity to increase is by increasing the capital stock per worker. Note that this final point is a not just an empirical tendency, but rather a praxeological law. Contriving examples to illustrate where labor will be reallocated to within the production structure without making reference to the reasons why labor will command a higher wage or be demanded in greater quantities are technical questions that do not fall within the scope of economic theory. Any consequent discussion of changes to the length of the structure of production that starts by assuming away the reasons why the length would change provide answers to questions that do not concern the economic theorist.I thank an astute referee for this point.
If lengthening the structure of production has any relevance for capital theory, it is only as a placeholder for roundaboutness. After all, it was the more roundabout methods of production that Böhm-Bawerk stressed as the cause of economic growth (1889, pp. 10–15). (Economic growth is here understood to mean more or better consumer goods.) A greater amount or more highly valued output could be produced for a given amount of inputs only if the inputs were arranged in such a way that coincided with more capital intensive means of production.I ignore here technological advances. In this way roundabout production processes are those that are more capital intensive. Consequently, when the Austrian-school economist discusses lengthening the structure of production, he must not entertain notions that it is a temporal extension (although it could be). Nor must he consider the addition of more stages or operations in the productive process (although this too will likely occur). Instead he must reckon lengthening in physical terms—an increase in the capital intensity of the production process.
That conclusion only pushes the problem one step further back: what is the best measure of capital intensity? There are only two ways that the production structure could be said to become more capital intensive (Howden, 2016b, c). The first is through the production of a greater amount of durable capital goods. Thus if the output mix between capital goods and consumption goods shifted in favor of the former, the result would be a greater intensity of the capital stock.This is subject to a minimum threshold. Capital suffers depreciation and a portion of the newly produced capital goods in any given period will be necessary to replace the lost productivity of the existing stock. Thus, the structure of production can only be said to become more capital intensive if a sufficient amount of capital goods are produced to replenish the depreciation of the existing stock. This increase in capital intensity of the overall production process can be achieved by 1) substituting more capital-intensive production processes for shorter labor-intensive processes, 2) shifting production to existing goods that entail a more capital-intensive production process, 3) producing new goods in a capital-intensive way without changing the production plans of existing goods, or 4) increasing production of existing goods in less capital-intensive industries (e.g., oranges) while not retrenching production of goods in more capital-intensive industries (e.g., heavy machinery). All of these examples increase the capital intensity of the structure of production, and in a roundabout way they will also result in temporally lengthened production processes since the capital goods themselves embody not just the originary factors of production, but also “time stored up” (Mises, 1949, p. 492). Furthermore, method 4 would result in an increase in the ratio of temporally shorter to longer production processes but would still require additional capital, which is consistent with the goal of increasing the roundaboutness of a production process.
The depreciable nature of durable capital goods leads us to the second method to increase the capital intensity of the production structure. Production of more durable capital implies that less future output will be needed to keep the existing stock intact. Thus, capital intensity can be increased if the durability of the newly produced capital goods is greater than previously was the case.
While these two definitions of increased roundaboutness concern the production of capital exclusively there is also a third, less explored, way. Roundaboutness is undertaken to produce more or better consumer goods. If the average duration of serviceableness, i.e., durability, of such goods were increased with no change in the aggregate production methods, one could still say an increase in roundaboutness had occurred. Böhm-Bawerk (1888, pp. 89–94) discusses this outcome though is hesitant to include changes to the durability of consumer goods as a type of roundaboutness in production, but rather as a “parallel” process that augments the phenomenon.I have noted elsewhere the relationship between the durability of consumer goods and the term structure of interest (Howden, forthcoming), but Böhm-Bawerk focuses here on the relationship between the durability of consumer goods and the demand for future goods, which then affects the pure rate of interest.
Machaj abstracts from the output mix in his examples, and thus we cannot be sure whether any of them represent a lengthened structure of production, notwithstanding the appearance that this has happened by focusing on the temporal aspect of production. In conclusion, changes to savings preferences alter the “length” of the structure of production, which is reflected in the interest rate. In the unhampered economy, the interest rate does not change the structure of production but rather it is through preference shifts between present and future goods on the structure of production in conjunction with the credit market that the interest rate obtains. Of course, the role of the production structure in determining the rate of interest on the loan market has been discussed already and at length in Rothbard (1962, ch. 6 and esp. p. 378).
We come now to the most dramatic episode in the history of the wages fund doctrine, — the attacks on it by Longe and Thornton, and Mill's surrender to the latter. Immediately after, came Cairnes's endeavor to reshape and rehabilitate the doctrine; the first attempt, since Adam Smith's day, at a deliberate and careful statement of its meaning. All this stir was due, as is usually the case with such a burst of active discussion, to the pressure of practical problems. The trade union question had entered on a new phase: the great commission of 1867 was both a result and a further cause of the concentration of public opinion on disputes about wages. Naturally the theory of wages in general received a larger share of attention.
Francis D. Longe, a London barrister, not known before or much noted after as a writer on economic subjects, published in 1866 an eighty-page pamphlet under the title, A Refutation of the Wages Fund Theory of Modern Political Economy, as enunciated by Mr. Mill and Mr. Fawcett. As the title indicates, Longe made no pretence of examining the history of the theory, or its presentation by any long series of writers. He took the two books then most in vogue, and examined the current doctrine as there expounded. To that doctrine, he found three objections to make: (1) that there is no definite fund, distinct from the general possessions of the community, devoted to the payment of wages; (2) that the laborers do not constitute a body among whom the aggregate fund could be divided by competition; (3) that the wages fund doctrine "involves an erroneous notion of the demand and supply principle." Of these objections, we may consider for the present the first only. The second, as to the distribution of the wages fund among different classes of laborers, does not deal with the essence of the old doctrine, whose expositors had always referred, more or less clearly, to the multiform causes that might influence the particular share of the general fund which might go to one set of laborers or another. In any case, this part of the controversy was not handled by Longe in a manner to attract, or indeed to deserve, much attention. The third objection, as to the general law of supply and demand in relation to wages, was put more effectively, and had a wider hearing; but its consideration may be postponed until we reach, in a later part of the present chapter, the same line of reasoning in the pages of Thornton and Mill. It is the denial of a definite wages fund which marks most signally the new phase on which the discussion now entered. This first objection is the beginning of a long series of similar attacks on the old doctrine; and at the same time it hinges directly on what Mill and other of Longe's immediate predecessors had said.
Longe denies that there is "a definite fund, distinct from the general wealth, destined for the purchase of labour." He has a brief word of criticism on Mill's two funds, of "capital" for productive laborers, and "unproductive" funds for servants and the like; but like Mill, gives attention chiefly to the analysis and definition of capital. He denies that it is intention which determines whether a given portion of wealth shall be capital and shall be used in paying wages. He quotes passages from Mill, and from Fawcett, Mill's alter ego, in which the intention of the owner is described as the decisive factor; and, following the more obvious meaning of these passages, conceives this intention to be applied directly to the money and potential money proceeds at the disposal of capitalists. To treat such a cause as decisive, he urges, "excludes the very cause which in real life governs both the quantity of wealth which is from time to time used as capital, and the particular mode of production in which it is used." That cause is "the existence or prospective existence of a purchaser." "The wealth or capital available for the maintenance of labour" is not the fund which limits wages; "the wealth available for the purchase of their work" is the real fund.Longe, pp. 37–47.
This reasoning presents itself in two ways: negatively, as to Mill's discussion of the nature and limitation of the funds available for the immediate employer of labor; and positively, as to the real sources from which these funds are regularly replenished. The replenishment, according to Longe, comes from the purchases or the demand of the consumers who buy the articles made. Something has already been said as to this phase of the controversy; something more will be said of it when we take up, in a later chapter, the treatment of the wages fund at the hands of German economists.See Part I, Chapter V, pp. 106–109; and Chapter XIII, below. The welfare of any particular set of laborers depends so obviously on the demand for the commodities which they make, that the same force is easily inferred to apply to laborers and to wages at large; and Longe could find a sufficiency of respectable company in this part of his reasoning. And the same may be said of the negative part, — of that which is concerned with the constitution of the wages fund, the relation of capital to wealth, and the significance of the capital of the immediate employers. Here Longe was on much-trodden ground; and what he said on these topics connects itself most directly with the turn which the controversy next took.
All the funds which serve to employ laborers are constantly treated by Longe in terms of money and of money value. This was a natural, an almost inevitable, result of those passages in Mill's Political Economy which were noticed in the last chapter. Mill's volumes contained the economic gospel of the day, alike for the faithful and the heretic. Longe had read and re-read the chapters which bore directly on his subject, and, not being versed in all the phases of economic discussion that bore on it more remotely, took Mill's words in their simplest and most obvious meaning. For him, the wages fund never appeared in any other light than that of funds or means in the hands of employers, available for paying immediate money wages. Hence he was easily led to deny that there was any fixity, or predetermination, in the fund; or any importance to it whatever. The farmer is limited as to his payments for wages "only by the amount of money for which his crops or stock will sell." Employers, we are told, really pay laborers after these have done their work; and laborers are maintained from what they have been paid on every preceding Saturday, "or from what they have inherited from ancestors." Coal is often bought when it is at the bottom of the pit, and the money is paid as soon as the coal reaches the pit bank: a case in which laborers, it is supposed, clearly need not get their wages from capital. So, many journeymen are paid by the fortnight or month, while the employers get the money some days before they pay their men.Longe, pp. 48, 49, 53. The reader conversant with more recent discussions of capital and wages will find here some familiar suggestions. To repeat, the presentation by Mill, the authority of the day, of the mode in which funds of capital were turned over to laborers, invited the sort of attack which Longe made.
Substantially the same view as that of Longe was adopted by another writer, whose position may be briefly referred to as another indication of the turn which the controversy was taking. Henry D. MacLeod published in 1873 his Principles of Economical Philosophy.This book was mainly a new edition of the Elements of Political Economy, published in 1858. Like his other writings, this book had weight and value for the elucidation of the phenomena of credit and banking; but on the general principles of economics, Macleod had not much to say that gained or deserved a great deal of attention. As to the wages fund, he quoted with approval Longe's proposition that purchasers' demand determined the amount that would be paid in wages; but, for himself, laid most stress on the effect of credit in enlarging the sums that can be paid out to laborers. Here the conception of the source of wages as simply money funds appears in the most unequivocal form. "Thus we see that the true ‘wages fund' is not the actual amount of specie in the manufacturer's pocket, but the price which the consumers pay for the complete product. And how is this to be obtained before it is actually received? By means of Banking Credits. This is the precise use and function of Banks which issue notes. It is to issue notes to form this 'wages fund' in anticipation of the price paid by the consumers. And thus we see the gigantic importance of a Solid banking system to the labouring classes. It multiplies the' wages fund' a hundredfold. ..."MacLeod’s Principles of Economical Philosophy, vol. ii, ch. xiii, pp. 126, 127. As to the direction in which such arguments as these of MacLeod’s are pertinent, compare what was said above, Part I, Chapters III and IV, pp. 63–65, 83–85.
Precisely the same point of attack as Longe's was also chosen by William Thomas Thornton, a writer who was of the inner circle among the reigning economists, a close friend of Mill's, well known by earlier publications, and in every way able to command an attentive hearing. Thornton published in 1869The preface to the first edition is dated Dec. 31, 1868. his book On Labour: Its Wrongful Claims and Rightful Dues, Its Actual Present and Possible Future. His predecessor Longe is not referred to in the book, and very likely was not known to Thornton; yet both on the law of supply and demand as affecting wages, and on the determinateness of the wages fund, he might have got hints from Longe. The supply and demand discussion, which was much the more prominent in Thornton, we may still postpone for a moment, in order to follow without a break that as to the nature and limit of the wages fund.
Thornton never thought of denying that wages were paid from capital. Nor, for that matter, had Longe done so explicitly; though some of his objections, carried to their logical outcome, must have involved such a denial. But Thornton, quite as explicitly as Longe, conceived this fund of capital to be money means wholly in the possession of the immediate managers and employers of the laborers. Naturally he concluded at once that, as such, it was not a fixed or inelastic fund. He was brief on this part of the subject, but none the less clear:
"Determinateness or indeterminateness is the one point of difference between those who affirm and those who deny the wages fund. ... If there really were a national fund the whole of which must necessarily be applied to the payment of wages, that fund could be no other than an aggregate of smaller similar funds possessed by the several individuals who compose the employing class of the nation. Does, then, any individual possess such a fund? … Of course, every employer possesses a certain amount of money, whether his own or borrowed, out of which all his expenses must be met, if met at all. …"On Labour, pp. 84, 95.
and Thornton goes on to ask whether the employer may not spend more or less for a dozen different purposes, on his family, on buildings, on repairs. The whole inquiry rests on the assumption that the money funds of the employers constitute the real and important capital applied to the payment of wages; and on such an assumption, he remarks, truly enough, that '' it sounds like mockery or childishness to ask these questions."
To this attack, Mill surrendered. He reviewed Thornton's book in the Fortnightly Review for May, 1869, accepted Thornton's version of the question in dispute, and admitted that his objections were unanswerable. "The capitalist," says Mill, "starts at the commencement with the whole of his accumulated means, all of which is potentially capital." Doubtless Mill had in mind here the common definition of capital, as set forth in his own volumes: it depended on the intention of the owner. Thence he might have reasoned, looking merely at the money means of immediate employers, that there could be no wages fund distinct from any of the other possessions of the capitalist. Yet some thought of real capital, and of the irrevocable commitment of at least some part of it to other things than wages fund, seems to have remained in his mind; for the flexible element, which makes him concede that the. wages fund is an indeterminate thing, is found by considering, not all the possessions of the employer, but certain available funds or uncommitted assets. How much be shall advance to laborers, how much expend for himself and his family, is undetermined and free. "There is no law of nature making it inherently impossible for wages to rise to the point of absorbing not only the funds he intended to devote to carrying on his business, but the whole of what he allows for his private expenses, beyond the necessaries of life." Here again it is difficult to make out exactly what Mill was thinking of. It may be some version of the old doctrine of capital as fixed by intention; or an echo of the Ricardian doctrine that all capital was resolvable into advances of wages; or simply the naked case of the individual capitalist and his possible expenditure of money. At all events, it was the last mentioned that was uppermost. In the Political Economy, as we have seen, Mill had sometimes considered food, clothes, shelter, as constituting the wages part of circulating capital; sometimes had spoken of "funds" or "income" or cash. Here the latter view is taken unequivocally. The surrender of the rigid wages fund then becomes inevitable. The result is not satisfactory to one who would follow Mill's own advice of disregarding the outward mechanism of paying and spending, and attending to the realities of the phenomena.See above, p. 232. Longe and Thornton had gone astray, in a direction which Mill himself, consciously or unconsciously, had pointed to in the Political Economy. Now he followed them into hopeless confusion between real capital and real wages on the one hand, and the money mechanism of nominal wages on the other.
The explanation of Mill's loose thought and hasty surrender is not far to seek. Personal regard for Thornton probably counted for something: he was disposed to make every possible concession to his old friend. But the main cause was a change in his interests and sympathies, which led him to get quit of the wages fund discussion as promptly as possible. In his later years, social problems, in their bearing on the wider questions of philosophy and ethics, engrossed his attention more and more. By far the larger part of the review of Thornton is given to the ethical aspects of trade-unionism, the other topics being passed over with a comparatively light touch. He cared much more for the right and wrong of trade-unionism, as tested by some final standard, than for the mechanism of market wages and the elasticity of the wages fund.
No doubt, too, another circumstance helps to account for his ready acceptance of Thornton's version and refutation of his older doctrine. He had himself never stopped to consider that doctrine with much care. We have seen how briefly he had stated it in the Political Economy, and how ambiguously he had applied it. When he was confronted by Thornton's objections, he had no well-defined views of old standing to fall back on; and he was too much interested in the larger social questions, perhaps was too old, to overhaul the whole theory of wages and capital from its foundations. On other topics -thus on the law, or equation, of supply and demand, which we shall presently consider-he had reached clearer thought in his younger days, and, not being taken unawares, was able to weigh Thornton's objections more critically. On the wages fund doctrine, he had no accumulation of critical thought to draw on.
The law or equation of supply and demand, just referred to, occupied much space in this discussion. As we have noted, Longe and Thornton had found it necessary to say something on the bearing of supply and demand on wages and the wages fund. Mill did the same; though he yielded less to Thornton here than on the nature and elasticity of the fund. The controversy branched off into fields somewhat beyond the scope of the present inquiry; but some review of this phase of it may be advantageous.
Longe had begun by questioning whether the general law of supply and demand had anything to do with wages and the wages fund. He had no difficulty in showing that the writers then in vogue, and more especially Mill and Fawcett, supposed that law to be in point: they conceived of the immediate determination of wages as being a simple application of supply and demand. Ricardo long ago had set the example of distinguishing between market and natural wages: market wages being determined by the ratio of capital to population, and natural wages by their "cost," — i. e., by the price of food, or the quantity of labor given to the production of a given quantity of food. His successors had worked out a neat and harmonious formula, applicable alike to labor and to commodities: supply and demand determined marked or temporary rates, while cost determined natural or permanent rates. Mill had given precision to the phrases about supply and demand by putting the law in the form of an equation: quantity demanded varies with prices, and price must be such that quantity demanded equals quantity supplied.See the familiar passage in the Political Economy, Book III, ch. ii § 4. Longe questioned the real working of the principle even in this version; but he maintained that in any case the wages fund theory alleged a relation between supply and demand very different from that set forth in Mill's equation. Under the wages fund doctrine, demand in relation to labor means quantity of capital offered, not quantity of labor demanded. The ratio or equation is the simple one of comparing a given quantity of offered capital with a given quantity of labor in the market, and not the more complex one of ascertaining at what price the quantity demanded of labor will be equal to the quantity that happens to be supplied.
Thornton, like Longe, found it necessary to analyze the phrases about supply and demand which formed the whole of the philosophy of wages for Cobden and the public at large, and were used by the economists in a way not much less superficial. Unlike Longe, who had taken up this topic very much by the way, Thornton took it up deliberately and systematically, and tried his hand at a complete restatement of the law of supply and demand. We need not follow the intricacies of his reasoning about supposed cases of horses at one price and another, of corn and gloves, Dutch auctions and so on. With the application of the principle of marginal utility, this whole phase of economic theory has become much simplified. Mill's equation of demand and supply is stated in better terms, and with fuller considation of all the elements involved, in the now familiar proposition that price depends on marginal utility. Mill himself, in admitting the justice of some of Thornton's criticisms, pointed out that one important condition had not been mentioned in the Political Economy, which yet must be present if the equation of demand and supply is to fix price at a definite point. Quantity demanded must vary with price continuously. The same condition, it 1s clear, must be present if the modern version of the law of demand and supply is to bring a determinate answer. If marginal utility is to fix price without a range of possible variation, each added increment of the article offered must have a less utility than the portion preceding it. These are now commonplaces; they make Thornton's discussion antiquated, and leave Mill's significant only as showing that, on topics which he had st9pped to think over with care, he reasoned with severe accuracy.
For the subject of the present volume, this general discussion is pertinent because it shows both Mill and Thornton. following in the path which Longe had declared to be the wrong one: approaching wages and wages fund as a narrower problem within the larger one of demand and supply in general. And here Longe was right. Mill's equation of supply and demand assumes a demand, or quantity offered, which varies with the price of the thing on sale. Supply is supposed to be given; demand, in the sense of quantity offered, is uncertain. The problem then is, at what price the whole supply will be carried off. But in the version of the wages fund doctrine which was then current, both supply and demand were fixed. Supply was the number of laborers; demand was the quantity of capital, or of circulating capital. Bring the two together, and the average or general rate of wages must be the result.
This difference between the strict wages fund doctrine and the general law of supply and demand may be made more clear by considering another case of a similar sort, where also the usual formula of demand and supply was applied, and yet was inapplicable. The proposition that the value of money varies inversely with its quantity was traditionally presented by the classic writers as an ordinary case of the working of demand and supply. The permanent or natural value of money (i.e., of specie) was supposed to be determined by its cost of production; its market or temporary value, by demand and supply. Supply was the total quantity of money, due account being taken of "its rapidity of circulation," or the quantity in use for purchases at any moment. Demand for money consisted of all the commodities on sale. Clearly, demand here was a thing fixed from the start, not a thing varying as the rate at which the money was offered might be high or low. The value of money was determined in the simplest way possible: divide the total of money by the total of commodities. That the operation of demand and supply as to money was peculiarly simple, had been pointed out often enough, most clearly by Mill himself. He had none the less presented demand and supply, or the play of forces that fixed the "market". value of money, as analogous to the play of forces that determined the value of individual commodities at any moment: whereas the two cases differ in essentials. Needless to say, we are not concerned here with the truth or untruth of the quantity theory of money. Its treatment by Mill and his contemporaries, whether right or wrong, shows that even on a subject which, like the theory of money, had received their deliberate attention, they made an indiscriminating use of the formula of supply and demand as the universal determinant of "market" values. Naturally, they did the same with regard to the wages fund, which had rarely received deliberate attention. In strictness, the theory of their wages fund was like that of general prices. Demand and supply, that is, capital and population, were both at any given time fixed: there was no play for a varying demand and no possibility of more than one point of equilibrium.
Mill, as we have seen, was brought to admit the indeterminateness and the elasticity of the wages fund, in the sense of money funds available for the direct employers. Hence he accepted, in some degree, the criticisms which Longe and Thornton made, in different ways, on his former off-hand application of demand and supply to the problem of market wages. He agreed with Thornton so far as to admit that here was a case where more than one point of equilibrium in the equation of demand and supply was possible, and where therefore no certainty existed that one rate or another should emerge from the forces directly in operation. It followed that workmen might get better terms, — higher wages, — by means of combinations and strikes, than they could get otherwise: and thus Mill was led to the question which he had most at heart, the right and wrong of trades-unionism. The theoretical and more strictly economic questions as to demand and supply, like those as to the nature and limitation of the wages fund, received but a scant and unsatisfactory examination at his hands.
In truth, it may be questioned whether, under any form, an analogy can be usefully drawn between the immediate forces determining the general rate of wages, and the immediate causes determining the price of this or that commodity. Needless to say, a connection does exist between the causes that determine the wages of any one class of laborers and those that determine the prices of the commodities they make. Making allowance-often it must be a large allowance-for the friction caused by the position of employers as middlemen between laborers and consumers, we may say that the play of demand and supply in determining prices also determines proximately the share in general wages which shall go to one set of laborers or another. But this belongs to the problem of particular wages, not to that of general wages. As to general wages, Mill had come to the conclusion that the money funds which constitute the proximate demand for labor were indeterminate. We may go further, and admit that there is elasticity not only as to the money funds which go to hired laborers, but as to the consumable commodities which go to the laborers. Yet the variations which take place in the money wages or the real wages which may be turned over to laborers at large, present but a loose analogy to the changes in prices of commodities under the play of the motives analyzed in the doctrine of marginal utility. There is no sign of that continuous diminution of utility with each increment offered the purchasers, which is of the essence of the law of demand and supply as to commodities. In the concrete world, the expectations and calculations of the employing class, the manœuvres and combinations of laborers, a confused medley of causes acting in multiform ways, may bring about in any one season a greater or less of total wages, always within those limits of predetermination which have been elsewhere set forth.Compare what was said in Part I, Chapter IV, pp. 82–94. Here we have phenomena of a sort that do not readily reduce themselves to any rule, or fit into any general law of value.Possibly, in an analysis of the succession of advances made to laborers over a long series of years, a general formula of demand and supply, or of final utility, may be applicable. Over a whole lengthened cycle of production, and in view of the total advances made during the cycle, it may be helpful to conceive of successive increments of capital as turned over to laborers, each with less and less utility for the capitalists as there are repetitions of the process. This mode of approaching the problem of the return to capital was suggested by Jevons, and has been followed with various modifications, by other writers since his time. But obviously it is applicable only to the problem of the final division of the proceeds of a complete productive cycle, not to the narrower question of "market" wages which is the essence of the wages fund problem. At best, I suspect that this mode of approaching the general problem of capital and interest, and so of wages, needs to be both amplified and qualified before it can yield a sufficient explanation of the realities of industrial life. Like the older formulae of the classic writers, it brings a temptation to be content with large general principles, and a danger that their concrete application shall suffer neglect.
Fairly weighed, Mill's review of Thornton thus marks no real advance in the discussion. The curious acceptance of reasoning by which the wages fund is supposed to be made up by the money means of the immediate employers, rendered it unfruitful as to the really difficult question at issue. The discussion of demand and supply added little to what Mill had said in the Political Economy, and certainly made no helpful application of old views or new ones on the topic in hand. Even on that question of the right and wrong of trade-unionism, which now chiefly appealed to him, Mill simply applied the familiar formula of his utilitarianism. Had it not been for the brief and summary recantation of a form of the wages fund doctrine which he had never really maintained, this paper would have had no prominent place in his economic or philosophic writings.
The next important step in the controversy was taken by John Eliot Cairnes. A year or two after Thornton and Mill had threshed the matter over, and almost immediately after Mill's death, Cairnes published his volume on Some Leading Principles of Political Economy, Newly Expounded.London, 1874. The preface is dated March, 1874. Mill had died in 1873. As the title indicates, it is an attempt at a restatement and modification of more than one part of the economic theory. The rate of wages is the subject of the second book; the passages pertinent to the present inquiry being partly in the opening chapter, which considers the theory of wages directly, and partly in the later chapters on Trade-Unionism, which apply and illustrate the theoretic conclusions.
As to the nature and constitution of the wages fund, Cairnes goes at the matter virtually in the same way as Longe and Thornton and Mill. The case of the individual employer and the means at his command are analyzed.
"Why does A. B. employ his wealth in productive operations? and why does he employ so much and no more in productive operations? … This point having been settled, he has yet to consider in what proportions the amount shall be divided between Fixed Capital, Raw Material, and Wages. What is to prescribe the respective quotas? Manifestly, in the first place, the nature of the industry in which he proposes to embark his capital. … Now the considerations which weigh with the individual capitalist are those which weigh with a community of capitalists; and we are therefore justified in concluding that the main circumstance governing the proportion which the wages fund shall bear to the general capital of a nation is the nature of the national industries."Leading Principles, Book II, ch. i, § 8. The first two of the extracts here quoted are separated by a page or two in Cairnes's text; but they are parts of a continuous thread of reasoning.
This clearly rests on the assumption that the fund for paying wages is held by the capitalists who directly employ labor, and that, in Thornton's language, it can be "no other than an aggregate of smaller similar funds possessed by the several individuals who compose the employing class of the nation."See the passage as quoted above, p. 246. Cairnes later quotes the same passage from Thornton.
The same assumption is made more specifically when Cairnes goes on to examine further in what manner capital is divided into its three constituent parts of Fixed Capital, Raw Material, and Wages. A capitalist starts with £10,000; with £5,000 he can buy fixed capital and raw material, with the other £5,000 he can employ 100 workmen at £50 a year. This example might indeed be supposed, if it stood alone, to be merely illustrative, and not meant to give a literal account of the where and what of the wages fund. But Cairnes uses it as perfectly significant of the details and realities of things; for he proceeds at once to draw from the supposition as to employers' means in hand, a general conclusion of importance. Some simple arithmetic applied to the £10,000 shows that if laborers are plenty, a less proportion of the cash can go to wages, and a larger proportion will be needed to furnish the plant and materials required to keep the many laborers busy. The details of this odd bit of reasoning, and its validity, are not of great significance; what is important for the present subject is the use of the money illustration as a means of drawing large conclusions. Cairnes generalizes from it to the effect that the larger the supply of labor, the smaller the proportion of wages fund to other sorts of capital. The outcome of his reasoning is finally stated thus: "Our analysis accordingly issues in the following conditions as the determining causes of the Wages Fund, viz.: the total capital of the country; the nature of the national industries; and the supply of labor," — a conclusion which rests simply on an analysis of the mode in which an individual employer would be likely to use his money means.
Cairnes, as was just noted, divided capital into three parts, — fixed capital, raw materials, and wages fund. He thus got rid of the phrase "circulating capital," which Ricardo and his followers had often used to denote that part of capital which was "destined to the maintenance of labor." But the change was one of language rather than of substance. Like his predecessors, Cairnes failed to keep clearly in mind the distinction between the real wages fund of commodities, and the money funds of the immediate employers; or rather, he neglected the former almost entirely. The threefold division was indeed made, in terms, with reference to the capital of the community at large; but when Cairnes proceded to any detailed reasoning as to the wages fund part, he gave attention solely to employers and to the money means they dispose of.
Reasoning so, how could Cairnes maintain that the wages fund was in any way fixed? that the employer could not borrow, or retrench on his personal expenditure? Within a few pages of the passages just quoted, in which the wages fund is described in terms of cash, he turned to Thornton's questions as to the determinateness of the fund, and might fairly have been expected to answer them directly. He did not do so. He then changed the point of view; found it needful to enter on an explanation of a larger and wider question, — the nature of economic laws; and at last came back to answer Thornton by setting forth, not whether the wages fund was determinate, but in what sense there was an economic law which made it indeterminate within limits.See § II of the chapter just cited.
As to the nature of economic law, and the kind of determination which it may be expected to bring about, Cairnes wrote justly and truly. "What an economic law asserts is, not that men must do so and so, whether they like it or not, but that in given circumstances they will like to do so and so; that their self-interest or other feelings will lead them to this result." The application of economic law in this sense to the wages fund was that the habits and desires of capitalists would lead them to maintain accumulation and investment at a certain rate. Individual capitalists might cut down wages and swell their private expenditure; but, "the character of the wealthy classes remaining on the whole what it is, increased accumulations in other quarters would neutralize exceptional extravagance in some." The disposition to accumulate being thus fixed, a certain proportion of the sums invested must (Cairnes italicizes the word) go to wages. At the root of the argument we find the theory of what Mill called the effective desire of accumulation, — that, with a given return to capital, accumulation will be maintained; and so a determination and even predetermination of a certain amount of capital to wages.
This is familiar doctrine: that high profits increase accumulation, low profits check it. But it does not apply to wages hic et nunc. Without stopping to inquire just how accurately and promptly accumulation in fact responds to a rise or fall in the return to capital, we may be sure that the process takes some years at least to work itself out. Clearly the old version was that this factor had nothing to do with "market" wages. At any given time, according to Ricardo and all the array of the English writer-s down to Cairnes's time, it was the ratio of capital ,o population that determined wages. If high profits were the result, more capital would be accumulated, and after a space wages would rise: but only after a space. Economic laws acting through the desire of capitalists to reap high returns, — “covetousness held in check by covetousness," as Cairnes himself elsewhere expressed it, — perhaps determined wages in a cycle of years. But here was no answer to Thornton's question: was the wages fund at any given time or at any given season determinate or indeterminate?
Thornton put his question by asking how the funds of capitalists Smith and Jones were determined. Cairnes also, when he tried to restate the doctrine, asked how the funds of A. B. would be distributed and used. But when he came to answer Thornton's question, he set up a different kind of "determination ": one that was settled not once for all this season, but after a while through slowworking causes. Thornton would have admitted freely — indeed did admit, — what Cairnes said about capital and accumulation and profits. He, too, maintained that in the end high profits stimulate accumulation and increase wages; and, conversely, that low profits check accumulation and in the end lower wages. But Thornton asked whether there was not flexibility in the funds immediately available for paying wages, and whether trade-unions could not squeeze from the employer something he would not otherwise give; and here Cairnes, with his rehabilitated wages fund, did not squarely meet the question.
Cairnes himself had in mind the trade-unions, and the application of his theory to their doings. Here the point of view just described is even more distinctly taken: the real limits to the action of trade-unions being found, not in any rigid wages fund, but in the fact, or supposed fact, that profits are at the minimum necessary to induce accumulation. At the very outset, to be sure, Cairnes notes incidentally that there are certain quasi-physical limits to the wages fund. "In order to maintain the stock of commodities of all sorts which in any civilized community goes to support the laboring population, a certain large proportion of the general wealth must exist in the form of fixed capital and raw material. The wealth available, therefore, for the remuneration of labor can not at the utmost be more than the balance which remains after those indispensable requirements have been provided for, under pain of complete failure of the fund."Cairnes, Book II, ch. iii, § I. This is not so far from a statement of the true question as to the wages fund proper: whether the tangible commodities that can go or will go to laborers are at any moment limited. By proceeding on this line Cairnes might have been able to give a direct answer one way or the other to Thornton's questions as to determinateness. But he passes at once to the other problem, — as to "the limits arising from the action of human interests operating under the actual circumstances of man's environment in the world." These "economic" limits are simply that "profits are already at or within a handbreath of the minimum": here is the effective obstacle to the endeavor of trade-unions to raise general wages.
When he got to this point, Cairnes said explicitly that the reasoning applied only to "the average rate of wages, as a permanent state of things" (the italics are his own). For a while, trade-unions may secure a general rise in wages, even though profits be at the minimum: but after a lapse of time, and in consequence of a shrinkage of capital, they will find they have killed the goose that laid the golden eggs. Under favorable conditions, when the progress of industry makes a gain possible in one direction or another, they may secure a rise in wages at once, instead of waiting until a rise in profits brings greater accumulation of capital, and thus, eventually, higher wages. Either of these admissions assumes a wages fund that for the moment is not determinate.A capitalist, for example, who has committed himself to an industrial enterprise by making large purchases of building and plant must find labourers to work for him or suffer heavy loss. … Under these circumstances, supposing the workmen on whom he relies to strike for higher wages, and that he has reason to believe they possess the resolution and are in command of funds sufficient to enable them to maintain a prolonged strike, it may be wisdom to concede to their demands. … It is evident, therefore, that workmen have, by means of combination and by accumulating sufficient funds, very considerable power of acting upon the rate of wages." —Cairnes, Leading Principles, Book II, ch. iii, § 3. This was all that Thornton maintained. Compare the passage cited above, at p. 257, about the employer with the £10,000, which he is supposed to assign in certain fixed proportions to plant, material, and wages. In the extract just given, Cairnes admits that the sum available for wages may be stretched without affecting the other parts of capital: and, as the context shows, extends the admission to wages at large. By implication, Thornton's questions are answered just as he would have answered them; and the wages fund is rehabilitated by restating a doctrine as to the relation of wages and profits, and the effects of profits on accumulation, which had been preached by almost every English writer of the century.
It may, indeed, be maintained that there never was more than this to the wages fund doctrine: namely, Ricardo's teaching that profits were the leavings of wages, and his further teaching that accumulation was increased by high profits and diminished by low. Historically, there may be ground for this contention. We have seen that the whole doctrine of wages as determined by the ratio of capital to population was crystallized by Ricardo's handling of capital as resolvable into a succession of advances to laborers. We have seen, too, that the rigidity or determinateness of the capital from which wages came was not often prominent in the minds of the writers who maintained its importance. But none the less, the wages fund doctrine is a different and distinct one from that of. the determination of wages by product, via capital. It applies to wages in any one season; and presents primarily the question whether at any given time there is an amount of capital available for paying wages which can or can not be increased. That wages in the long run are determined by product, with enough deduction for interest to induce the accumulation of capital, is stoutly maintained by plenty of writers who sweep the wages fund out of the way with scorn. It is virtually Cairnes's doctrine; and, while he insists on an advance from capital as an intermediate step in the settlement of wages by product, he adds nothing to what his predecessors had said as to the manner and degree of the determination of the advance of capital, or as to the position of employers and hired laborers in the social use of capital and in the social distribution of finished goods.
Before leaving this last stage in the old-fashioned way of reasoning on the subject, it may be pointed out how, notwithstanding his professed maintenance of the older doctrines, Cairnes had diverged far from them in his final conclusions. He marks the last stage in a change of emphasis, so great as to be a change of opinion, which had been going on gradually and almost imperceptibly among the English writers since Ricardo's day. Ricardo had laid it down first, that market wages depend on the ratio between capital and population; second, that if the result of the momentary ratio were wages higher or lower than was "necessary" or "natural," population would increase or decrease until wages were again at the normal point; third, that if the result of this process again were high profits, accumulation of capital would be stimulated, until at last a stage of equilibrium might be reached. In Cairnes, we find that the second and third propositions have changed places. The first step in the analysis remains practically the same, though the phrases are changed a bit: wages depend on the ratio between the number of laborers and that part of capital which constitutes wages fund. The second step now is that if the process results in higher or lower profits than are needful to induce accumulation, capital will grow more or less rapidly, and its return will be brought back to the normal level. Capital gets a certain minimum return: wages get the rest. The third step is that which Ricardo had put second: the Malthusian theory of population, regulating the supply of labor, and eventually bringing wages to the point fixed by the standard of living. The two writers, at either end of the line, agree in giving scant attention to the step which they put third in order. Ricardo said little of the accumulation of capital and the likelihood of its responding to a high or low rate of profits: he conceived that wages adjusted themselves to their natural rate more quickly than profits to their point of equilibrium.Ricardo generally dismissed the question as to profits in a footnote, as in the Essay on the Influence of a High Price of Corn, Works, p. 377; or briefly referred in his text to the fact that of course accumulation would be checked long before profits got to zero. Works, p. 67. The chapter in the Political Economy entitled "The Effects of Accumulation on Profits" (chapter xxi) is chiefly given to other subjects than its title indicates: to some criticisms of' Adam Smith, and to the relation between gross profits and interest. Cairnes, on the other hand, makes but brief and off-hand mention of the supply of labor as determined by the principle of population; while the increase or decrease of capital, in correspondence with the rise or fall of profits above the normal point, is presented and emphasized at length. In Ricardo, profits appear as the residuary legatee; in Cairnes, wages.
This change in emphasis appeared gradually. Torrens and M'Culloch had approached the later point of view when they confronted laborers' combinations with the same objection as Cairnes's: an enforced rise in wages would check accumulation. Mill stood half-way, on this subject as on others. He gave much space to the effective desire of accumulation, and the rate of return on capital as a measure of that desire; and he presented the tendency of profits to a minimum in a manner to imply that accumulation responded rapidly and easily to changes in the rate. Elsewhere, and more commonly, he remains on the Ricardian ground: wages are the element that is stationary, and profits vary. In Cairnes, the assumed fixity of wages at last becomes only a remoter possibility, not dwelt on at all in the treatment of concrete questions. This final abandonment of a doctrine fundamental in Ricardo's reasoning on distribution brought with it a complete change of front, and new vistas on every aspect of the social questions: a change of which all the consequences in economic theory have not yet been fully worked out.
The wages fund doctrine proper has now been done with, and, strictly, the end of our task has been reached. But there are some aspects of distribution at large so closely connected with the pros and cons of the wages fund controversy that they come within the scope even of an inquiry directed, as this is, to a very limited part of the general subject. There are some questions, also, as to the practical bearings of the discussion and its outcome, which call for careful consideration. These somewhat disconnected topics will serve also to make clear the significance and limitations of the conclusions reached, and the kind of aid which a discussion of the wages fund question can yield to economic theory in general.
It will be convenient to begin with the questions as to the practical bearing of the conclusions which have been reached in the preceding chapters. The general reader, and even the economist most intent on the larger generalizations of his subject, will not fail to ask himself, what light do these discussions throw on living subjects? What help do they give in reaching answers as to the right and wrong, the chances of success or failure, of strikes and lockouts? What basis do they give for settling disputes by arbitration or conciliation?
It may be said at once that the answer must be a disappointing one. The conclusions of the economist as to the theoretical relations of wages and capital have little or no bearing on the disputes between laborers and capitalists as they usually appear in the specific case. Though students of economic principles may see, without further discussion, the meaning and justification of this apparently paradoxical answer, a more detailed explanation may not be unwelcome to one or another set of readers.
Something was said, in the last chapter, as to the elasticity of the sources whence wages come, and as to the possibility of an immediate general rise at any given moment. The conclusion, whether as to money wages or real wages, was against any rigid predetermination of the funds whence the total wages of a given period are derived. But, as was then noted, this result is of value rather as illustrating the significance and the limitations of our general reasoning, than as answering any questions likely to arise in specific form. The attempt at a simultaneous advance in wages all along the line never is made. An all-inclusive combination of hired laborers (and to their case, for obvious reasons, the discussion can be confined) is not indeed inconceivable or impossible, but it is in the highest degree improbable. What takes place in fact in the dealings of workmen with their employers is a succession of isolated bargains and struggles. First one set of laborers, then another, strives for an advance; the practical question is as to the limits and obstacles which may be encountered by such separate endeavors.
It did indeed occur, in the older literature of our subject, that this sort of case was considered with reference to the relations of wages and capital in general. It was sometimes said that, while the laborers of a particular trade might very possibly get an advance of wages in consequence of a union and a strike, the advance would take so much more out of the general wages fund, and would thus be secured at the expense of the rest of the laborers. Such reasoning proceeded on the basis of a fixed fund, unalterable at the moment, whence alone laborers could be paid; it followed that if some got more, others must get less. It was not often made clear whether a money wages fund or a real wages fund was had in mind; nor was it explained how long the offsetting loss would continue, or what forces might tend to make it endure or disappear.An unequivocal example of this sort of reasoning is in Mill's Political Economy; see the discussion of the passage in fra at pp. 233–235.
Some degree of theoretic truth there may be in this reasoning. The reader will remember that while the source of wages, whether of money wages or of real wages, is elastic, it is elastic within limits. It is then true that a very great rise in the reward of a considerable set of laborers would take place, at least for a while, to the detriment of other laborers. As to money wages, the funds which the body of employers can turn to the hire of laborers are not indeed rigidly predetermined. They can be stretched to a certain extent, and can meet some new demands without curtailment in other directions; but any very great increase in the funds turned over to one group of laborers, carried far enough, must diminish those which go to the rest. The case with real wages, while presenting some variations, is in essentials the same. The flow of consumable goods whence all real income, whether wages or any other form of return, must come, is similarly elastic within limits. A rise in the money wages of a given group (taking place very possibly without a diminution in the money wages of others) would bring an increase in the total purchases of commodities by consumers. True, the new demand, if not very great, could be met by some hastening and stretching of the existing supplies of goods nearly finished or half finished. On the other hand, if any large group of laborers suddenly had the means of buying much more than before, — so much more that no stretching of the commodities available would suffice to meet their added demands, — less would be left for the others. Only, in this case, the losers would not necessarily be other laborers; they might be any receivers of money income. Who would lose, would thus depend on the kind and amount of commodities which are bought with their new money means by the fortunate laborers, and on the response of prices and supplies to their new demand.
These conclusions are of the hopelessly inexact sort which exasperate the practical man, desirous of answers so precise as to admit of immediate concrete application. No one can say whether an advance of five, or ten, or twenty per cent in the wages of all the employees in textile industries, would cause a diminution either of money wages or of real wages for the rest of the laborers. To draw an exact line, — to say that so many millions of dollars and so many tons of goods, so much and no more, can be got without passing beyond the elastic limits of the general sources, — this is impossible. But it is safe to say that in concrete life it happens very rarely, probably never, that a specific rise in wages, secured by strike or trades-union pressure or simple agreement, can be shown to bring any offsetting loss in the wages of those not directly concerned. The sums involved in any particular case, though they may be absolutely large, are small in comparison with the total which must be considered if the general effects are to be examined. A rise of ten per cent in the wages of coal miners or of iron workers may mean a matter of mil1ions, and yet is only a small fraction of total wages payments and of total purchases of real income by consumers at large. The chances are that such an advance would bring real gain to the laborers involved, without loss to any of their fellows. Doubtless, if all the consequences of the change could be infallibly traced, some justification for the misgivings of the writers of the older school might be found. It might appear that the immediate employers were crippled by the added expenses, and had less to spend in hiring other sorts of workmen; or that the banks, which advanced them the funds for this expense among others, had less to lend to other employers. These are possibilities of the sort which the ultra-conservative would be disposed to make much of. But it is out of the question in any concrete case to follow all the might-have-beens, or trace the have-beens in their rapid interlacing with other forces and events. The chances, to repeat, are against any traceable loss which would offset the visible gain. Certainly an unbiased and judicious adviser, having the interest of all laborers at heart, would hesitate long before counselling any particular set of laborers against an endeavor to get better terms from their employers, on the ground that as an ulterior result of success, some of their fellows might suffer. If no other objection than this presented itself, he could safely assert that economic science had nothing to say against their endeavors, and much in favor of them.
The substantial obstacles which may prevent a rise in wages are to be found in another direction. The man of affairs would say that the success of a move for higher wages depended on the state of trade and prices. The economist would say the same thing in different language, by laying it down that consumers' demand, or demand for commodities, mainly determined the share of income which could be got by any one group of laborers. Let us follow in brief review the chain of forces which would come into play in such a case.
Proximately, the success or failure of an attempt to get higher wages will depend much on the accidents of the particular situation. The extent to which the employers happen at the moment to be tied by contracts; the temper or pugnacity of one party or the other; the organization, the discipline, the available funds on either side, — such surface causes may decide the outcome in any given case. Forces of this sort are too often forgotten by the economists, intent as they are on the deeper currents of the industrial stream.
Even the forces next in order, likely to be referred to by the thoughtful man of affairs and the well-informed financial writer, are often neglected by the economists. The cautious everyday observer would describe these less accidental causes by saying that the success of the laborers' effort depended on the state of the market: whether sales and profits were such as to make the employer prefer the additional expense of a higher wages bill to the loss of a satisfactory season's trade. This, again, must depend largely on the expectations and previsions of the larger body of active capitalists of whom the direct employers are but one part. If the merchants, speculators, bankers, lenders, are all hopeful and eager, then trade will be good and the workmen may get a substantial slice of the profits of good times. Their share would probably be substantial, because not likely to go beyond the limits to which the real wages fund of available commodities could be stretched, and because they are likely to spend at once and so convert their money gains into immediate real enjoyment; whereas their employers, who habitually postpone the fruition of a large part of their income, may be overtaken by a financial revulsion before realizing and pocketing their profits.
Beyond such a stage as this in the play of social forces, the calculations and prophecies of those immediately concerned, whether workmen or employers, do not usually go. Only the most shrewd and thoughtful among them will go a step further, and point out that in the end the success of any particular group of workmen in permanently retaining a substantial advance in wages must depend on whether the consumers of the goods they make can and will pay more for them. The economist will say the same thing, though probably with a more distinct conception of who are consumers and what constitutes consumers' demand. The man of affairs thinks of almost any buyers as consumers: the woollen manufacturer is a consumer of wool, and the shivering individual who buys a coat is a consumer of woollens. The careful economist thinks of the latter alone, — of the person who has immediate wants to satisfy, who weighs one want against another, and is in truth the only real consumer. His purchases are made at the counter of the retail shopkeeper. Evidently he is separated by a long and complicated series of middlemen from the various workmen whose successive efforts have combined in producing the final enjoyable commodity. Whether his demand is such as to make possible a rise in the wages of some or all of the workmen who have so combined, is to be ascertained not by the ups and downs of a season or two, but by a stretch of experience which to the man of business seems of secular length. The economists who have insisted on consumers' demand as a determining cause or source of wages have not always set forth with sufficient emphasis the distance between the consumer and the chain of producers who combine to work for him. They have spoken of consumers' demand as a cause closely affecting wages, — misled perhaps by an unconscious confusion between proximate purchasers and ultimate consumers. But it remains true that, in the end, the wages which any particular group of workmen can get depend on what the consumers are able and willing to pay for the commodities produced, and that a real, steady, and permanent rise in wages can be got by such a group only if the permanent conditions of the market — that is, of ultimate demand — are favorable to them.
Something more will be said of consumers' demand in another place. This factor in the situation has played a curious and interesting part in the development of economic thought, elsewhere to be considered in detail.See Part II, Chapter XIII. Here it will suffice to point out what follows clearly enough from the reasoning of the preceding chapters, that it bears only on the wages obtainable by a particular set of laborers. The older economists had a fashion of expounding with elaborate emphasis the theorem that demand for commodities was not demand for labor, but only determined the direction of the demand for labor. They were right, even though they put their theorem in terms and with applications that made the result seem paradoxical to the practical man. Consumers' demand, or demand for commodities, is the important force to be considered when we inquire whether and how a given set of workmen can get better wages, — whether more money wages, or their probable concomitant of more real wages. This is the last force involved in the specific struggles of the industrial world; for in practise we do not meet the attempt at a general advance in all wages. Yet the general advance alone would involve those wider questions as to the source of wages at large, and the relation of all wages to capital, which form the subject of the wages fund controversy. The form in which the concrete social question appears is in the efforts of this or that set of particular workmen, whose success will depend on the factors of closer or remoter operation which have just been described: on the accidents of the moment, on the state of trade, on consumers' demand.
This analysis would need to be pushed still further if all the problems involved were to get their due share of attention. Back of consumers' demand there are other forces, or other phases, of the same forces. Consumers' demand, or the play of supply and demand as to enjoyable commodities, can be translated into terms of final utility, and can lead to that psychological analysis which has played so large a part in recent economic discussion. On the other hand, the extent to which laborers or their children can transfer their exertions from one industrial group to another; the nature and permanence of the obstacles in the way of such transfer; the chances of an eventual equalizing tendency, if the conditions of consumers' demand have raised or lowered the returns of any one group, — here are other important aspects of the case. According as we do or do not conclude that an equalizing process exists, we get a different result as to the ultimate determining causes of the exchange values of commodities.If there is effective movement from group to group among laborers, value is determined in the end primarily by the sacrifice involved in labor, that is, by real cost of production; while relative wages depend on the intrinsic attractiveness of different sorts of work. If there is not effective movement from group to group, value and relative wages are both determined in the end by the final utility of the consumable commodities produced. In the recent discussions of the fundamental laws of value, the important bearing of the presence or absence of free choice of occupation by laborers has been strangely neglected. But, to repeat what is said in the text, questions of this sort, — perhaps the most difficult which the economist has to deal with, — carry us far from the immediate relation of capital and wages. Every phase of the most intricate problems of value, as well as of production and distribution, would thus present itself before the final answer could be given to the questions raised by those successive isolated contests between laborers and employers which are carried on in the actual world.
All this, however, would carry us further and further from the subject in hand, and the object of the digression into the field of particular wages and of value has perhaps been sufficiently attained. As the causes that affect the share of income and enjoyment accruing to particular classes of society are different from those that affect the income of society as a whole, so the causes that determine the share which a particular set of laborers shall have are different from those that determine the total that goes to laborers as a whole. It is only with the total that the wages fund or the discussion of wages and capital has to do. In the nature of the case, the practical questions and the concrete social problems which press for immediate attention are more likely to be of the particular sort. They are questions as to the wages of one trade, one group, one district; struggles between the employers and workmen of a given time and place, affected by the accidents of temper, and the turns of trade often no less accidental, as well as by the remoter operation of consumers' demand and final utility. On such topics the economist is not helpless; he may be able to give judicious advice, or at all events to bring a calm and farseeing mind to the consideration of the particular case. But the wages fund, and the theoretical relations of wages and capital, will not help him at all.
We may pass now to the other group of topics mentioned at the beginning of this chapter; namely, as to the connection between the wages fund controversy and some wider questions as to distribution. The relation of capital to wages has been much discussed, in recent years, in close association with another important subject, — the precise manner in which the machinery of distribution works, and more particularly the sense in which one or another share is to be regarded as residual. Here also the inquiry will lead to subjects far removed from that of the present essay: serving again to illustrate the limitations rather than the applications of its main conclusions.
A brief historical sketch will most conveniently introduce this part of the discussion. In the Ricardian analysis of distribution, profits were the residual element. Rent was fixed, very simply, by the differences between the natural sites in use. Wages, determined in the first instance by the ratio of capital to population, were fixed over any period but the shortest, by the standard of living or by what was "necessary" to maintain the laborers. Profits got the rest, and thus were the residual element in distribution; profits meaning what was got by capitalists actively engaged in the conduct of industry. In the long run profits would doubtless be affected by the rate of accumulation, and by the disposition of capitalists to accept a larger or smaller reward; but this only by a slow-working process. Virtually, profits got what did not go to wages or to rent.
As time went on, as less abstract modes of investigation made their way, as the march of concrete events brought with it an unmistakable rise in general wages, a different mode of describing the working of distribution was gradually adopted. The return to capital was described as depending on the effective desire of accumulation, and was associated more closely with the inactive investor whose revenue comes solely and simply as a recompense for saving or waiting. Profits, in this sense, being fixed by the strength of the disposition to save, wages became more variable, and got the benefit of any general increase in the output of industry. This shift in the point of view was introduced insensibly, and at first without any change in the old doctrine as to the payment of wages from capital; the change being simply in the assumption that the amount of capital turned over to laborers accommodated itself quickly and easily to variations in what the laborers produced.Compare what is said below. Part II, Chapter XII, toward the end.
Next, when the wages fund doctrine had been effectively attacked and undermined, it was a natural step to describe the laborers, already given are residual position in essentials, as the direct and immediate receivers of so much of the product of industry as did not go elsewhere. The other sharers got parts sliced off in accord with principles supposed to be settled. The receivers of wages were then the residual holders in the distribution of total income, with or without a further carving-out of employers' profits from the general mass. Thus we have the residual theory of wages, which during the last ten years has been so much in vogue.
But if the description of the machinery of distribution given in the preceding pages is accurate, this new version of the industrial situation is not tenable; not tenable, that is, as a description of the facts of modern industry. More especially, it is not in accordance with the facts of that case which is chiefly had in mind by every one who discusses the economics of modern times, — the régime of employing capitalists and hired workmen.
We have seen that, directly, the hired laborers, and the inactive investors as well, get stipulated money shares. They take no chances; they have been promised so much, and so much they receive, — barring bankruptcy on the part of the managing employer. Under the conditions which prevail so preponderantly in the modern industrial world, the true residual sharer, certainly in the first instance, is the active capitalist, the business man. He has made his bargains for stipulated payments to investors and to laborers. Usually he has interlacing obligations with other business men which affect his operations, past and future, so intricately that he can know where he stands only by elaborate and sometimes deceptive bookkeeping. Indeed, he rarely knows where he really stands: for how much he is finally to secure, depends on the outcome of operations still in progress. But what proves to be left is his own. He wins or loses, according as the industrial venture turns out well or ill. Doubtless what he finally gets, or, in the phrase of the business world, what he makes, is not a simple income such as the economist of the present day would label with a single word. Ricardo would have called it profits, simply. A writer of the present generation would describe it, with a view to final classification and explanation, as consisting partly of interest on his own capital invested, partly of wages for work done; these wages, again, being susceptible of elaborate analysis, according to distinctions sometimes substantial and sometimes fanciful. But, however classified, and however susceptible or unsusceptible of accurate measurement at any given time, the income of the season appears as a net sum, the residual outcome of the operations of the season. The hired laborer gets his fixed wages, the investor his stipulated income: the managing business man takes the rest.
No doubt, as to independent laborers, the description of their situation as residual is accurate; but it fits the case, not because they are laborers, but because they are independent producers. They are owners of part of the gross output of society. They sell what they turn out, and so become holders in the first instance of part of the money income of society. They may have wages to pay, or interest or rent to meet: what is left is then their own. In their case, as in that of their fellow business managers on a larger scale, the gains received may be resolvable, when analyzed with regard to permanent causes, into wages and interest and rent. It may be a question, too, how far the returns for labor, which are received by the petty independent workmen, are in essentials similar to the wages of the hired laborers, and how far they are to be classed with the net returns' for work which the great employers earn. But their place in the direct process of distribution is the same as that of the business man with whom business earnings or business profits are usually associated.
If, then, setting aside the case of the independent workman carrying on operations in such small ways as to deprive him of the dignity of the capitalist's place, we attend to that part of the community's industry which is conducted on a large scale by business managers, we have a result bearing some surface resemblance to Ricardo's. The net gains of this class, which he called profits, are the direct residual element. The resemblance to Ricardo's version of the case, however, is obviously more apparent than real. He reached his conclusions by reasoning which assumed wages to be fixed and unvarying: and the residual position of profits held good, if not as the definitive outcome of distribution, at least for very considerable periods. In the reasoning just set forth that residual position is assigned to the business manager simply in the first stage of distribution: in the division of that money income which is the first step toward the concrete assignment to one hand or to another of the real income of the community.
So much is direct and unquestionable fact. If it be maintained that the independent producer, — that is, under typical modern conditions, the managing capitalist, — is not the residual sharer of the social income, regard must be had to some other than the first steps in distribution, — to some later and more obscure steps. But in analyzing such further steps, it is indispensable to keep close to the facts of the living world, and to follow the concrete manner in which income reaches the hands of those who are to enjoy it. The first actual step in the process by which the distribution of income takes place in the modern world is the payment of money sums by the business man to laborers and investors, and the retention in his own hands of the residual share.
Consider now the case as to real income. This reaches the member of an advanced society only by the expenditure of money income. Is there any ground for treating the real income of the community and of its various members in a different manner from their money income?
In the stage that immediately follows the distribution of money income, it would seem that no ground for a different statement of the case can be found. The finished and enjoyable commodities which are coming to market in a continuous stream constitute the real income which brings substantial satisfaction. The total volume of the stream is settled by the efficiency of a succession of productive efforts made in the past. The quality and quantity of the individual constituents have been adapted to satisfy the expected tastes and means of consumers. The money income which reaches various hands goes to the purchase of the inflowing commodities. Produced though these must have been with regard to the probable demand of purchasers, no precise determination of shares to one or another kind of income can appear; least of all can any part be said to be residual. None of the real income is settled in advance to be wages, or interest, or rent, or employers' profits. There is no residual share at all: there is a miscellaneous assortment of commodities which go to one person or another, according to the money means and the money expenditure of each one. In fact, the conception of a residual share would seem to be applicable only to the case of money income. There is nothing corresponding to it in the machinery by which real enjoyable income is secured.
There is still another sense in which a residual share may be spoken of. It might be maintained that one or another set of persons secure the main benefit of advances in the arts; not by any direct or quick-working process, b as the permanent outcome of the forces which eventually shape distribution. They would thus be in a position to receive what is left after other classes have received their settled shares. It may be contended that the laborers have the residual place in this sense; the incomes going to capitalists and rent-receivers being so determined by permanent forces that the progress of industry inures mainly to the laborers' benefit. Or it may be asserted, with the socialists, that the condition of the laborers tends to remain unimproved as the arts advance, and that the well to-do classes, — investors, business men, and rent-receivers taken together, — monopolize the material gains of advancing civilization.
We are concerned here chiefly with the relation which these divergent views as to the permanent outcome of the march of progress bear to the wages fund discussion; and the answer is simply that the relation is nil. The residual position of laborers or of others, in this sense, has nothing to do with that direct and immediate relation of wages to capital which gave rise to the wages fund doctrine. Wages may be paid from capital or from product, may come from a rigid or an elastic fund of capital: whatever the answer, it will throw light only on the machinery by which their remuneration is secured, not on the nature and relative strength of the forces which move the machinery. If we would know whether the tendency in an advancing society is for the receivers of wages or interest or rent to become the chief beneficiaries of improvement, we must inquire as to the causes which in the long run determine the one or other sort of income. As to interest, for example, the inquiry must be mainly as to the promptness with which accumulation responds to a higher or lower rate of return. If capital is saved and invested rapidly when a certain rate of return is exceeded, and if its accumulation is promptly checked when that rate is not yielded, we may say that interest is fixed by a constant force at one point, and that the share of income going to the owners of capital is determined by a simple multiplication of the principal by the rate. Again, as to the earnings of managing business men (if these are to be regarded as a distinct class, as doubtless for many purposes they must be), we should need to consider, first, how great a degree of regularity and conformity to law exists in this special form of income; next, how far the qualities which mainly enable it to be earned are the result of education and training, how far of the traditions and the environment of the well-to-do classes, how far of varying degrees of inborn and unchangeable ability. On such lines we might reach a conclusion as to the extent to which this sort of return is likely to be kept at a fixed point. The examples need not be pushed further. What has been said suffices to indicate how the permanent causes which determine the distribution of income must be followed if we would know whether one class or another gets greater or less gain from the general progress of society. The cool and unbiased observer would probably find it equally difficult to accept either the optimistic view which makes the laborer, if only he be intelligent and alert, the chief beneficiary of the advance, or the pessimistic view which represents him as hopelessly excluded, under the régime of private property, from any real improvement in his lot. However this might be, he would find no ground for one conclusion or the other from the analysis of capital and wages, or from the position of hired laborers and other laborers with relation to past product and inchoate wealth. The wages fund discussion, stripped of non-essentials, throws light simply on the process by which, in any advanced organization of the productive arts, the yield of an intricate succession of efforts finally reaches the consumer and becomes real income. What in the end determines real income and its apportionment to one class in society or another, is a very different question, or, rather, a mass of different questions, much less easy to answer, and at all events involving other and wider premises.
Nevertheless, by way of illustrating still further the relation between the permanent forces of distribution and the channels through which they work out their effects, we may follow in rapid review, on the lines of the reasoning presented in the last chapter, the mode in which a change in the permanent forces may bring about, proximately or remotely, a rise in general wages.
Money income, which, as the key to real income, must be followed in any such review, goes directly and in the first instance to the independent producers, and among these, in more or less complete preponderance in different communities, to the capitalist employers. Through their hands it passes to the others, hired workmen and investors, whose incomes have been classed as dependent. The most effective way in which any considerable and permanent change to the advantage of laborers can come about is by causes which increase this proximate source of their income; either through directly larger receipts accruing in the hands of active capitalists, or through the less direct process of larger money sums being turned over to the capitalists by investors. It may be admitted that, even in the absence of conditions swelling these sums, a general rise in wages is not impossible. The money means which employers can advance to laborers are not fixed or predetermined; the residual share which they are to retain is probably not at the absolute minimum, and certainly is not fixed by any rigid law; and well-directed pressure on them may squeeze out something which the laborers would not otherwise get. But it is still true that the money funds which the active employers can turn over to laborers are at any given time subject to a limit which, even though it be elastic, is not distant; and that a considerable and permanent gain in general money wages can come only when larger money means flow into the hands of the employing class.
This holds good, whatever the causes of the larger money means: even though it be only a greater plentifulness of money or of its substitutes. A general advance in prices, due to monetary causes, inures first to those who have products to sell. It reaches those who are in receipt of dependent incomes only by a secondary process, which usually works out its results after a longer or shorter interval. No phenomenon is more familiar in monetary history than the slow advance of money wages, as compared with the prices of goods, when a sudden increase of inconvertible money causes a depreciation of the circulating medium. This is not a necessity of the case; put it is a result which, obviously, is very likely to ensue from the position of the active manager of industry at the primary source of money income. When a general advance in total money income takes place by some more gradual process, it goes again first to the managing producers, and through their hands is again transferred, more or less slowly, to those whose incomes are derivatory.
An increase in the total money revenue of the community may bring also a substantial gain in its real revenue of consumable goods. Thus a more ample production of goods may sell for a larger total, even though prices are declining; the increase in quantity more than offsetting the decline in prices. Such has been the course of events during the last generation in almost all civilized countries. The larger gross money incomes of the active managers of industry, brought about in this way, have been the source of that unmistakable rise in money wages, as well as in other sorts of income, which has taken place concurrently with the fall in prices. Whether the position of the active capitalists at the starting point of the gain has enabled them to reap advantages similar to those which they almost invariably get from a sudden rise in prices, is not easily to be ascertained. The probabilities are that some substantial pickings have not failed, for a time at least, to remain in their hands. The optimist may assert, not without a good show of reason, that such gains are the justified reward of the initiative taken by the business man in those multiform improvements of the arts whose accumulated effect has been the general increase of well-being; while the philosophic observer may accept them as the outcome, inevitable even though not always agreeable, of the régime of private property, taking their place among the mixed results whose balance on the whole serves to justify the existing order of things. However this may be, the fact of the case is that the increase of the money receipts of the active managers of industry has been the proximate source and the main cause of the gain in secondary money incomes. The general and continued advance in money wages could not have taken place if the money inflow to the capitalist employers had not also enlarged.
No doubt, side by side with the general progress of the arts which has increased the total income of the community, other causes may have been at work to divert a larger part of that income to the laborers: causes which might have led to a result similar in kind, though less marked in degree, even if there bad been no general progress. The interest which from time to time has been paid to investors may have been such as to move these latter to save more, and put more money means into the hands of the active business class. The residual income which has been retained by that class, again, may have been so great and so tempting as to induce them directly or indirectly to enlarge their ventures. From either source would come larger money means for industrial operations, and so the proximate causes of a rise in money wages: always supposing the number of hired laborers remains 'the same, or does not increase as much as the funds directed to their hire. How far the advance in money wages has in fact been due simply to the general advance in production and in the community's total income; how far an increasing disposition to accumulate and invest among capitalists, active and idle, has had its share; how far trades unions have been efficacious in securing for laborers a quicker and greater advance than unorganized workmen could have got, — these must be matters largely of conjecture. The facts of the situation, so far as they can be made out, would seem to warrant no large generalizations as to the absorption of the whole gain by one class in society or another, and so confirm neither an optimistic nor a pessimistic view as to any residual shares. All hands have gained, and the proximate cause of the gain for all has been in the general and continued increase of the gross revenues which flow first into the hands of capitalist employers.
Continuing such an investigation as to the mode in which the condition of hired laborers may advance and has advanced, we should have to consider real wages: the flow of consumable goods to whose purchase money income is devoted. That flow, so far as the production of one or another sort of commodity is concerned, folio the apportionment of money income; not indeed with mechanical exactness, but, given time, with sufficiently accurate response. The traders buy, and the more distant producers turn out, such finished goods as are demanded by the purchasing consumers. For any one season the quantity and quality of consumable goods that may go to real wages are largely predetermined; but with the lapse of time, with the continual consumption of commodities now on hand, and the continual production of new commodities, we find the flow of real income responding to the apportionment of money income. The volume of real wages will then depend partly on the proportion of the productive efforts of the community which the laborer's share in money income will direct to the satisfaction of their wants, and partly on the efficiency of the productive efforts so directed. If one half of the revenue of society gets into the hands of laborers, probably one half of the work of society will be directed to making commodities for laborers' use.Probably, but not necessarily. This would depend on the rate of pay earned by those who produced the commodities consumed by the laborers, as compared with the pay of those who produced the real income of other classes. Assuming all workers to be equally paid, or the different strata to be called on in the same proportion in the making of every sort of real in-come, the probability mentioned in the text becomes a certainty. How much of such commodities they will get will then depend further on the extent to which the arts make this part of society's work effective. If inventions and improvements happen to be applied with great effect to the commodities bought and consumed by laborers, their substantial real wages will be so much greater. The further possible developments of the situation, in case of a rise in money wages which brings also a rise of real wages, will readily suggest themselves. Population may or may not increase in such mode as eventually to neutralize the advance. The real happiness finally yielded to the laborers may or may not grow: the ethical philosopher and the psychologist, as well as the speculative economist, would have something to say at this point. No subject among the humanities involves a wider or more difficult set of questions: none needs to be approached with greater diffidence and caution.
The complication of causes and conditions which need to be considered for a full understanding of all that bears on the welfare of laborers, or indeed of any class in society, is thus almost infinite. To follow these causes and conditions would be to write a book not only on distribution, but on social philosophy at large. The present volume has a much more modest task, and this digression into the larger field has been meant chiefly to show, by comparison, the limitations of the subject now in hand. The fundamental questions as to wages and distribution; as to what makes wages high or low; as to the ultimate effects of the march of progress in bringing special benefit to one or another class in the community, — these can not be settled by any inquiry as to the wages fund or as to the proximate source of wages. Some aid in answering them must indeed be got by following the course of concrete industry. It is indispensable to any inquiry which shall bring solid results that not only the fundamental forces at work shall be discovered, but that the precise mode in which they work out their effects shall be traced step by step. It is here, and here only, that the analysis of the relation of wages to capital, as set forth in the preceding pages, may help us: pointing out the mode in which production and distribution take place in modern societies, and the machinery through which the abiding moral and material forces work out their effects.
This, then, is the conclusion of our inquiry. The old doctrine of the wages fund had a solid basis in its conception, incomplete yet in essentials just, of the payment of present labor from past product. The new theories which disregard this fundamental fact, and seek to explain distribution by considering labor as paid directly from its own present product, begin with a false premise and distort the facts of the actual world. But the analysis of the mode in which labor yields enjoyable products, of the grounds for considering the capital of the "Community as the source of real wages, of the relation of the money funds of employers to the wages of hired laborers, — all this is to take only the first step toward an understanding of the situation. To use a phrase which has already been applied, it describes the machinery of production and distribution, not the forces which move the machinery and cause its parts to shift and change. The wages fund theory — if that name can be given to the form in which it has here been set forth — shows the steps by which wages get into the laborer's hands, and so points to the nearest and most obvious causes which affect them. It shows what is the process by which goods are produced in the great and complicated organism of modern society, and what are the channels by which the enjoyable commodities reach the hands of its various members. To understand that process, to follow those channels, is indispensable to truth and accuracy of knowledge. But it does not tell the whole story.
During the first half of the present century, when Adam Smith's prestige was greatest, it was the custom to treat all earlier contributions to economic thought as of little account, and to begin the history of the subject with the Wealth of Nations. In the reaction of the second half of the century there has been a disposition to credit too much to Adam Smith's predecessors, and to belittle his own contributions. Before proceeding to the details of his discussion of capital and wages, we may consider for a moment his general position in the growth of economic theory: thereby supplementing what has just been said of the stage of earlier speculation as to wages.
On some subjects, and notably on those which most attracted the attention of his contemporaries, Adam Smith gained much and directly from his predecessors. The mercantile ideas, in their cruder forms, had been refuted by a long series of writers, by North and Hume among the English, by Boisguillebert, Cantillon, and the whole line of the Physiocrats. The functions of money in domestic and in international trade had been fully and adequately discussed by these writers; and much had also been done toward clearing up the subject of money by writers who, like Locke and Steuart, were still befogged on international commerce and the balance of trade. On credit, paper money, and banking there had been active discussion since the close of the seventeenth century, when banks began to exercise their functions on a considerable scale, and paper-money experiments came to be tried in almost every form. Adam Smith was abundantly familiar with the literature of his subject, and accepted without hesitation what had been accomplished by his predecessors. The famous attack on the mercantile system bears, indeed, the unmistakable marks of his vigorous and independent mind, in the reasoning as to the limitation of industry by capital, and in the general discussion of foreign trade. But the ground had been prepared for it by a long line of writers; and the upper tier of the educated public was prepared to accept "his views at once.
The subjects of production and distribution show Adam Smith, not perhaps at his best, but at his freshest. Here he broke new ground. On the division of labor and its causes and effects, the functions of capital, the partition of income into wages, profits, and rent, the causes determining the amount of each form of remuneration, on all these topics he started economic thought on new lines, and on lines that have been substantially followed since his time. The very novelty of his investigation made it inevitable that his results here should be more crude than on the subjects which had been worked over by two or three generations of previous thinkers; a defect which, rightly considered, makes the debt of science to him so much the greater.
Even on these subjects, it would be a mistake to consider Adam Smith as an unaided pioneer. The division of labor, and its consequences in bringing exchange and necessitating a medium of exchange, had been noted by a long series of writers, from ancient times to modern. Further, some stimulus to his thought on capital doubtless came from the general reaction against the treatment of interest and money by the mercantile writers. The older and cruder notions as to the importance of an abundance of specie had been effectually exploded before he began. As these exaggerations in regard to the importance of plentiful specie crumbled away, it was inevitable that other ideas connected with them should be overhauled and reshaped. The function of money having become clear, interest could no longer be explained as affected simply by the abundance or scarcity of money. The better understanding of the medium of exchange, again, directed attention to the nature and qualities of the commodities whose barter was seen to be facilitated. All this paved the way to the consideration of real capital, and the real machinery of production. In such indirect ways Adam Smith probably got a stimulus to his speculations on capital and interest, and so, by a natural progression, on capital and wages.
The Physiocrats, moreover, had attacked the real problems of production and distribution. The place of land in production had been emphasized by them. The derivation of all net income from land, and the reasoning which led to the denial of net income in other directions, began the treatment of distribution on the lines of modern theory. The very emphasis on these deeper subjects, as compared with the almost exclusive attention of their predecessors to the more superficial phenomena of money, was an important advance. Turgot, as we have seen, had described the importance and functions of capital with great insight and ability. Adam Smith was familiar with the writings of his French contemporaries; he used them freely, and certainly drew much from them.
But, when all is said, the essential novelty of Adam Smith's contributions remains unmistakable. The importance and consequences of the division of labor he followed into regions where his predecessors had left a blank. Any one who compares his discussion of the income from land with that of the Physiocratic writers must see that, both m the main lines and in the details with which they are illustrated, an essentially new turn had been given to the discussion. On capital and its functions, his treatment, in some respects no more profound than Turgot's, is yet fresher, more direct, and closer to the real phenomena which it is the object of the economist to explain. Distribution was practically created by him. The simple division under the three heads of wages, profits, and rent, in itself marks an epoch. Something of the sort may indeed be said to underlie the Physiocratic separation of the three classes, — the productive, the barren, the disposable; but the most cursory comparison shows how much closer to the actual phenomena was Adam Smith's classification of income and income-receivers. Under each head, again, he advanced far in the direction which subsequent thought has followed to our own time. This is especially the case with his treatment of the main subject of the present inquiry: wages and capital, and the relations of workmen and employers.
The point of departure in Adam Smith's reasoning on production and distribution is the division of labor. The first and second books of the Wealth of Nations, which contain chapters of most interest and importance to later generations, open with this topic. The emphasis was intentional, and is one of the marks of Adam Smith's insight. He rightly thought that the characteristic phenomena of advanced societies rest on the division of labor, developed under the conditions of free industry. And this he held to be true of distribution as well as of production. The account of the increase in the productiveness of labor from its division is one of the best-known, as it is one of the most interesting passages in the book.
Observe the accommodation of the most common artificer or day labourer in a civilized and thriving country, and you will perceive that the number of people of whose industry a part, though but a small part, has been employed in procuring him this accommodation, exceeds all computation. The woollen coat, for example, which covers the day labourer, as coarse and rough as it may appear, is the produce of the joint labour of a great multitude of workmen. The shepherd, the sorter of the wool, the wool-comber or carder, the dyer, the scribbler, the spinner, the weaver, the fuller, the dresser, with many others, must all join their different arts in order to complete even this homely production. How many merchants and carriers, besides, must have been employed in transporting the materials from some of those workmen to others who often live in a very distant part of the country! How much commerce and navigation in particular, how many shipbuilders, sailors, sailmakers, ropemakers, must have been employed in order to bring together the different drugs made use of by the dyer, which often come from the remotest parts of the world!I What a variety of labour, too, is necessary in order to produce the tools of the meanest of those workmen! To say nothing of such complicated machines as the ships of the sailor, the mill of the fuller, or even the loom of the weaver, let us consider only what a variety of labour is requisite in order to form that very simple machine, the shears with which the shepherd clips the wool. The miner, the builder of the furnace for smelting the ore, the feller of the timber, the burner of the charcoal to be made use of in the smelting house, the brickmaker, the bricklayer, the workmen who attend the furnace, the millwright, the forger, the smith, must all of them join their different arts in order to produce them.Wealth of Nations, Book I, chapter i, p. 6. The page numbers given here and elsewhere for the Wealth of Nations, refer to McCulloch's edition. I have quoted only a part of this closing paragraph in the chapter: enough to indicate its character.
From this initial description, Adam Smith is led to the discussion of the exchange of commodities, the first effect of the division of labor; then to that of money as the medium of exchange; then to price, and the component parts of price; and so to wages, profits, and rent, as the component parts of the price of commodities. His first Book, whose main subject is announced in the introduction to be "the causes of the improvement in the productive powers of labor," is thus occupied largely with the subject of distribution.
This is one of the many incongruities in the marshalling of the matter of the Wealth of Nations, — incongruities ascribable to the difficulty of presenting in systematic fashion so great a mass of new reasoning, new facts, new conclusions. Another of the consequences of the division of labor might have been advantageously taken up before entering on the discussion of distribution; but it does not appear until the first Book, with all its details and digressions, is done with, and the second Book, on capital, is introduced. The division of labor brings not only the cooperation of many thousands of laborers and the exchange of their products, but the succession, step by step, of different stages in the processes of production, and so the spreading of labor over a considerable time. With the element of time, capital appears. The best way of introducing the uninitiated reader to the fundamental truths of economics would be to bring close together at the outset the three topics between which Adam Smith has interposed his long account of distribution, — the division of labor, the use of money, and the nature and functions of capital. One consequence of their separation in the Wealth of Nations is that passages under each head, not professedly connected with each other, need to be put together in order to get a full understanding of the author's conclusions; while another consequence probably is that Adam Smith himself missed conclusions that would have suggested themselves from a more compact exposition of these related subjects.
When Adam Smith, after long digressions, gets to the third of the topics just mentioned, — the functions of capital, — he recurs to the first and fundamental thought. The second Book, whose subject is described as "the Nature, Accumulation, and Employment of Stock," begins thus, in the Introduction:
In that rude state of society in which there is no division of labour, in which exchanges are seldom made, and in which every man provides everything for himself, it is not necessary that any stock should be accumulated or stored up beforehand, in order to carry on the business of society. Every man endeavours to supply by his own industry his own occasional wants as they occur. When he is hungry, he goes to the forest to hunt; when his coat is worn out, he clothes himself with the skin of the first large animal he kills; and when his hut begins to go to ruin, he repairs it, as well as he can, with the trees and the turf that are nearest it.
But when the division of labour has once been thoroughly introduced, the produce of a man's own labour can supply but a very small part of his occasional wants. The far greater part of them are supplied by the produce of other men's labour, which he purchases with the produce of, or what is the same thing with the price of the produce of his own. But this purchase can not he made till such time as the produce of his own labour has not only been completed, but sold. A stock of goods of different kinds, therefore, must be stored up somewhere sufficient to maintain him, and to supply him with the materials and tools of his work, till such time, at least, as both these events can be brought about. A weaver can not apply himself entirely to his peculiar business, unless there is beforehand stored up somewhere, either in his own possession or in that of some other person, a stock sufficient to maintain him, and to supply him with the materials and tools of his work, till he has not only completed, but sold his web. This accumulation must, evidently, be previous to his applying his industry for so long a time to such a peculiar business.Wealth of Nations, Book II, Introduction, pp. 118, 119. Thirty years later, a writer conversant with the writings of Adam Smith and his immediate followers, expounded this matter as follows: "The accumulation of capital is necessary to that division of labour by which its productive powers are increased, and its total amount diminished. ... The accumulation of stock enables one class of men to work in any line cheaper for the rest of the community, than if each class worked in every line for itself. The immediate saving of labour is here occasioned by its subdivision. It is a consequence of the same accumulation of stock, that one class of men collects the articles necessary for the others all at once, and thus saves each the necessity of collecting for itself, which would be a repetition of the same toil for every transaction. This saving, too, is occasioned by the division of labour; and all writers have agreed in giving the same account of the connection between the division of labour and the accumulation of stock.” Edinburgh Review, vol. iv, p. 370; the article being a severe review of Lord Lauderdale’s Inquiry into the Nature and Origin of Public Wealth.
Here the essential function of capital is clearly explained. It enables labor to be spread over a long period, and so makes possible the division of labor and that development of the arts under the division of labor, which are the main causes of the efficiency of civilized industry. The analysis, it is true, is not complete. The process of production is regarded from the point of view of the individual producer. When the weaver has completed and sold his web, capital is supposed to be no longer needed. It has been shown, in the first part of the present volume, that capital performs its functions not by enabling the individual to carry on his operations until he gets a salable commodity, but by enabling society as a whole to carry on complicated operations involving a long interval between the beginning of production and the final enjoyable commodity. Though Adam Smith had himself given warning, often enough, against confounding the needs of the community with those of the individual, it is not surprising that he should himself have failed to observe the distinction in this, the most intricate part of the whole subject. As will appear more fully in the coming chapters, most writers after him, to our own time, have stopped short at the same point in analyzing the function of capital.
It suffices for the present subject to consider very briefly the further analysis by Adam Smith of the functions of capital. Not only is it essential to the division of labor, but it increases the productive powers of labor; it employs "productive" labor, and stimulates industry. Its effects in getting raw produce from the land, in manufactures, in wholesale trade, in retail trade, are examined and classified. Certain fundamental propositions, which have made their influence felt in all the literature of economics, first appear in developed form in the Wealth of Nations, — that capital is the result of saving; that it is perpetually consumed and reproduced; that industry is limited by capital. On some of these topics the reasoning is carried only half way; thus on the mode in which capital limits industry, and, as has just been stated, on the connection between capital and the division of labor. On others, while the fundamental propositions laid down by Adam Smith can not be shaken, he gave an undue emphasis to some corollaries; as in the excessive eulogy on parsimony which he attached to the solid truth that capital had its origin in saving. In all this the order is again confusing, and appears to be largely a matter of accident: a defect which is due, — to repeat what was said a moment ago, — to the fact that his analysis of the whole subject was practically a new birth.Mr. Edwin Cannan, in his History of the Theories of Production and Distribution in English Political Economy from 1776 to 1848, has given an excellent critical account of Adam Smith's doctrines on production and distribution: an account which comes short of justice, however, in that Mr. Cannan could not warm himself to some cordial recognition of the credit to which the great Scotchman is entitled.
We may turn now to that part of the discussion of capital which bears more directly on the question of wages. The eighth chapter of the first Book of the Wealth of Nations treats of the Wages of Labour: the first deliberate and extended treatment of that subject in the literature of economics. In Adam Smith's arrangement of his matter, it comes before the discussion of capital in the second Book; but the doctrines set forth in the later passages were clearly in his mind when writing the earlier. The oft-quoted opening paragraphs of the chapter on wages are, in their essential parts, as follows:
In that original state of things which preceded both the appropriation of land and the accumulation of stock, the whole produce of labour belongs to the labourer. ... But this original state of things ... could not last beyond the first introduction of the appropriation of land and the accumulation of stock. It was at an end, therefore, long before the most considerable improvements were made in the productive powers of labour. ...
It seldom happens that the person who tills the ground has wherewithal to maintain himself till he reaps the harvest. His maintenance is generally advanced to him from the stock of a master, the farmer who employs him. … In all arts and manufactures the greater part of the workmen stand in need of a master to advance them the materials of their work, and their wages and maintenance till it be completed. ...
It sometimes happens, indeed, that a single independent workman has stock sufficient both to purchase the materials of his work, and to maintain himself till it be completed. He is both master and workman, and enjoys the whole produce of his own labour, or the whole value which it adds to the materials on which it is bestowed. ... Such cases, however, are not very frequent, and in every part of Europe, twenty workmen serve under a master for one that is independent: and the wages of labour are everywhere understood to be, what they usually are, when the labourer is one person, and the owner of the stock which employs him another.Wealth of Nations, Book I, ch. viii, p. 29. In these excerpts, I have retained only passages referring directly to wages, omitting those which describe rent and profits as “deductions from the produce of labor.”
Here we have two fundamental propositions. First, that in civilized industry maintenance must be provided for some considerable time, until the product is completed. The division of labor is not referred to, in terms, as the essence of the "improvements in the productive powers of labor" which cause the need of such maintenance; but that Adam Smith had this in mind, is clear from the other passages, already quoted, in earlier and later parts of his treatise. As in the later account of capital, the time during which maintenance must be provided is not described with regard to the final attainment of enjoyable goods; it is that which elapses until the particular product in hand is ready for market. When the harvest is reaped, when the specific work in hand is "completed," the need of maintenance is supposed to cease. Secondly, we have the proposition that the needed supplies of food and materials are rarely owned by the workmen, and that hired laborers get their wages through a bargain with employers. How it happens that workmen hardly ever own "stock “sufficient for their materials and maintenance, Adam Smith does not stop to inquire; nor, for that matter, did any of the economists who came after him, until, in our own day, the assaults of the socialists compelled attention to the origin and justification of the unequal division of wealth. But Adam Smith was at least aware that the historical fact of unequal distribution was an essential premise to his reasoning on wages, and in that regard saw the situation more clearly than many of his immediate successors.
Wages, then, "depend everywhere upon the contract usually made between these two parties," the workmen and the masters. The conditions under which the bargain is made, and the extent and limit of the demand for labor by the masters, presently come up for consideration.
The demand for those who live by wages, it is evident, cannot increase but in proportion to the increase of the funds which are destined for the payment of wages. These funds are of two kinds: first, the revenue which is over and above what is necessary for the maintenance; and secondly, the stock which is over and above what is necessary for the employment of the masters.
When the landlord, annuitant, or moneyed man, has a greater revenue than what he judges sufficient to maintain his own family, he employs either the whole or a part of the surplus in maintaining one or more servants. Increase this surplus, and he will naturally increase the number of those servants.
When an independent workman, such as a weaver or shoemaker, has got more stock than what is sufficient to purchase the materials of his own work, and to maintain himself till he can dispose of it, he naturally employs one or more journeymen with the surplus, in order to make a profit by their work. Increase this surplus, and he will naturally increase the number of his journeymen.
The demand for those who live by wages, therefore, necessarily increases with the increase of the revenue and stock of every country, and cannot possibly increase without it. The increase of revenue and stock is the increase of national wealth. The demand for those who live by wages, therefore, naturally increases with the increase of national wealth, and cannot possibly increase without it.Book I, ch. viii, p. 31.
Here are mentioned two sources of demand for labor, "revenue" and "stock."
"Revenue" evidently means what is spent for servants and retainers, hired by the employer for the direct satisfaction of his own wants or whims. When Adam Smith gets to the elaborate treatment of stock and capital in his second Book, he has much more to say of laborers hired from revenue. They are unproductive" laborers; and what is spent on them is "prodigality," and entails pure loss to the community.Book II, ch. iii, p. 147. Some of the passages may be quoted in which Adam Smith mentions cases of "prodigality" such as he had in mind when describing the effects of this form of the demand for labor. "In those towns which are principally supported by the constant or occasional residence of a court, and in which the inferior ranks of people are chiefly maintained by the spending of revenue, they are in general idle, dissolute, and poor; as at Rome, Versailles, Compiègne, and Fontainebleau." (P. 148.) And again: "In a country which has neither foreign commerce, nor any of the finer manufactures, a great proprietor, having nothing for which he can exchange the greater part of the produce of his lands which is over and above the maintenance of the cultivators, consumes the whole in rustic hospitality at home. If this surplus produce is sufficient to maintain a hundred or a thousand men, he can make use of it in no other way than by maintaining a hundred or a thousand men. …The great Earl of Warwick is said to have entertained every day at his different manors, thirty thousand people; and though the number may have been exaggerated, it must have been very great to admit of such exaggeration." Book III, ch. iv, p. 182.
Without going into any extended consideration of the outlying topics which these distinctions suggest, we may note how the discussion of this part of the demand for labor, scattered as it is through various passages of the Wealth of Nations, illustrates both the strength and the weakness of Adam Smith's treatment of the course of production and distribution. His historical knowledge and practical bent led him to give more attention to the demand for u unproductive" labor than was given to it by his successors. He was living at a time when luxury still took in large part the form of a great retinue of servants; though it was beginning to take more and more the modern form of the purchase of commodities from capitalist middlemen, who have hired the laborers ministering to the wants and caprices of the rich. He reasoned as if the difference were of vital consequence to the community: the one course was the result of "prodigality" and led to waste, while the other entailed "parsimony” and brought progress. There may be an important element of truth in the proposition that the workman hired by the capitalist is likely to be more sober and industrious than the retainer of the nobleman;On the probability of "the cultivation of the soil with the same kind of indolence and slackness as in the feudal times," under such a direction of luxurious expenditure, see an interesting passage, evidently reflecting Adam Smith's views, in Malthus's Political Economy, second edition, p. 235. and there are important social consequences from the rise of a class of capitalist entrepreneurs. But clearly the direction of production and consumption remains the same at bottom, whether the unequal distribution of wealth works itself out in one way or the other. All laborers employed out of "revenue" are supposed to be unproductive; a proposition which, in any larger consideration of wants and their satisfaction, is crude and untenable. The further conclusions to which Adam Smith was thus led, in his consideration of "unproductive" labor, while consistent in themselves, are unsatisfactory enough. They go with that undue emphasis which the classic economists, following his lead, put on the mere accumulation of capital as the one thing needful for public prosperity. But he was certainly right on one point: in maintaining that the demand for "unproductive” labor occurred under different conditions and with a different play of motives from those which appear in the case of "productive" labor. In so far, he showed his insight into the complexities of real life, and set an example of close attention to varied facts which might have been usefully followed by the long series of his admirers and expositors.
On the second and more important part of the demand for labor, — that which comes from "stock," — it is less easy to make the different parts of the Wealth of Nations hang together. Sometimes, indeed most commonly, this “stock" is conceived in terms of money, or as consisting of funds in the hands of the immediate employer. Sometimes the money payments are described as of no essential importance, as only steps toward the distribution of real wages. The uncertainty and confusion which thus showed itself in Adam Smith continued to appear in almost all the discussions of wages for fully a century after his time.
The phrases “funds destined for the maintenance of labour," and “funds destined for the payment of wages," occur again and again: they are the undoubted parent of the word "wages-fund" as it is used in later literature. Sometimes, "capital" and "stock" are used to denote the source of wages. In the chapter on profits we find all these phrases used interchangeably: "The dimmution of the capital stock of the society, or of the funds destined for the maintenance of labor, as it lowers the wages of labour, so it raises the profits of stock."Book I, ch. ix, p. 43. Whichever words were used, Adam Smith, when speaking directly of wages, seems to have conceived of their source simply as funds in the hands of the immediate employer. In the passage quoted a few moments ago.At p. 142. again from the chapter on wages, the "stock" of the master is apparently thought of in terms of money. It is the amount over "what is sufficient to purchase the materials of his own work, and to maintain himself till he can dispose of it." In the later discussion of fixed and circulating capital, in the second Book, we read that "that part of the capital of the farmer ... which is employed in the wages and maintenance of his labouring servants is a circulating capital."Book II, ch. i, p. 120. The funds controlled by the immediate employer would seem to be referred to in all these passages.
On the other hand, when the independent discussion of capital is undertaken, in the second Book, a different view appears. Here Adam Smith comes so much nearer the truth, — indeed, states the essential truth so clearly that it is surprising he did not turn back to his chapter on wages in the first Book, and remodel its matter and its phrases. The same remark might be made, to be sure, of many passages in the Wealth of Nations. On a great range of topics, — rent, profits, value, international trade, — there are flashes of insight, pregnant statements, which yet fail to be carried to their last consequences.
The "stock" of society is divided, in the second Book, into two parts: the" stock," in a narrower sense, of finished commodities which is" reserved" for immediate consumption; and the "capital," whether fixed or circulating, which is expected to afford a revenue. The distinction between fixed and circulating capital, (very different from that which became traditional with later writers) is largely fanciful; but the confusion here does not affect the part of the reasoning that bears on our present subject. It is under the head of circulating capital, that we should expect a consideration of those forms of capital which make the demand for what Adam Smith called "productive” labor. Either the money funds in the hands of the immediate employer, or the finished consumable commodities on which the laborers spend their money wages, might here be given the chief emphasis. Both of them, in fact, receive their share of attention, and both are discussed in curious harmony with distinctions and definitions that have come to the front again in very recent times; while yet, under either head, the reasoning is not carried to its logical conclusion as to the real and important source of wages.
Adam Smith rightly treats the commodities which in one sense are finished, but are not yet in consumers' hands, as capital. "The stock of provisions which are in the possession of the butcher, the grazier, the farmer, the corn merchant," and "the work which is made up and completed, but which is still in the hands of the merchant or manufacturer, and not yet disposed of or distributed to their proper consumers," — these are parts of circulating capital.Book II, ch. i, p. 122. Adam Smith did not indeed call them capital for the reason which would nowadays be given: that the butcher and merchant do a share of helpful work in production, and that goods in their hands are wealth not yet enjoyable. But the essence of the situation was grasped by him, even if all its connections and consequences were not perceived. Adam Smith had defined capital as that which yielded a revenue; whence it would have followed, that a dwelling house or a suit of clothes, if let for hire by the owner, became capital. Nevertheless he qualifies his general definition at this point: such revenue-yielding commodities belong not to the community's capital, but to its stock reserved for immediate consumption. "The stock of food, clothes, household furniture, etc., which have been purchased by their proper consumers, but which are not yet entirely consumed," are not capital: they are realized income. But “work which is made up and completed, but which is still in the hands of the manufacturer and merchant, and not yet disposed of or distributed to the proper consumers: such as the finished work which we frequently find ready-made in the shops of the smith, the cabinet-maker, the goldsmith, the jeweller, the china merchant," — all this is part of capital, being not yet in the hands of the "proper consumer."Book II, ch. i, pp. 121, 122. At this point Adam Smith might be expected to look for the capital which is the immediate real source of wages, as of all other income, — the consumable goods, in dealers' hands, ready for purchase by laborers. But he never did so. The illustration which he used for bringing out his meaning as to this form of circulating capital is "the finished work which we frequently find ready-made in the shops of the smith, the cabinet-maker, the goldsmith, the jeweller, the china-merchant, etc." The simpler goods which laborers will buy obviously belong in the same class; they are capital in the same sense and for the same reason. But Adam Smith's thought seems turned to these only in dealing with other subjects, and never in connection with the payment of wages out of capital. The hints which he gave, the acute distinctions which he suggested, if followed to their consequences, might easily have led to the development of a theory of wages that would have kept close to the concrete facts, and avoided the vague generalizations of the wages fund doctrine of later days. Adam Smith himself never followed them out; his successors did even less; and thus the passages which have here been cited make the impression of curious but unfruitful anticipations of the essential truths.
So far as money and money wages, and the place of money in capital, are concerned, Adam Smith's direct discussion is admirable; and the substantial ground for criticism can again be only that the truths here set forth were not brought to bear more fully on the question of real wages. While he classes money as part of circulating capital, he notes the peculiar place which it has in the capital of the community. It never wears out: hence "the fixed capital, and that part of circulating capital which consists in money, ... bear a great resemblance to one another."Book II, ch. ii, p. 125. Money has a place of its own; he describes it, in language used with frequent emphasis, as simply "the great wheel of circulation," and as "altogether different from the goods which are circulated by means of it." The real revenue of society, and of each individual in society, is in "the quantity of consumable goods which they can all of them purchase with this money."Book II, ch. ii, pp. 125, 126. This simple and oft-neglected truth he dwells on at length, having an eye on the familiar fallacies of the mercantile writers, to which he was giving the finishing stroke. And yet, as we have seen, when capital is regarded as the source of demand for labor, he seems to think of the money funds with which the employer pays the hired laborer. It is true that a case to which he often refers, by way of illustrating the need of advances to the laborer, is that of the farmer, maintaining his laborers at his own table, and so owning in natura the capital which remunerates them: a case which emerges again and again in later literature. But Adam Smith usually has in mind the very different conditions which in fact prevail in the modern world. He describes a society with a developed money régime, in which all income appears first in the form of money payments and money rights. He does not fail to point out, with emphasis, the simple distinction between money wages and real wages; but he never goes into any further detail as to the connection between the two, or as to the nature and determination of the flow of consumable commodities whence real wages must come. Here, as on the question of the place of such commodities in "stock" or "capital," he advanced without error to a certain point, and then stopped short.
No doubt the reason why Adam Smith failed to carry further his reasoning both as to the relation between money wages and real capital, and as to the place of dealers' stocks in social capital, is to be found in his mistaken view as to the extension of the productive cycle. He thought of production piece by piece. The employer needed funds with which to pay laborers simply until the product was salable: the need of advances ceased when the particular article in hand was completed. This simple every-day operation is easily confounded with the larger and more intricate process by which the labor of the whole community is spread over a lengthened period. Many writers after Adam Smith have been guilty here of much worse confusion: the great master's fault was one of inattention rather than of express error.
To sum up the theory of capital and wages, as it stood with the appearance of the Wealth of Nations. Adam Smith had shown that, in a society having a developed division of labor, the process of production was spread over some length of time, and that for the laborers in such a society subsistence must be provided until their present labor should result in finished goods in the future. How great this provision must be, was not indeed considered with a full appreciation of the position of the whole community; but the fundamental fact had been clearly pointed out. Further, he had shown that, under the unequal distribution of wealth in modern societies, the supplies from which laborers must for the moment get their subsistence, are in the hands of others: hence laborers get them by a bargain with those others. Exactly what the employers have to offer in that bargain, he did not consistently and fully set forth. Some of them have "revenue," more of them have "capital “and "funds," with which they remunerate labor. All laborers hired by those who employ them for gain from the sale of the product, are dependent on advances from the capital of the employers. But what that capital consists of, is not clearly stated. The remarkable analysis of capital in the second Book might easily have led the way to a more explicit statement: but Adam Smith did not advance farther on the path which he here opened.
I have divided the present volume into two parts: a first, of five chapters, containing a statement at large of my own views on the relation of capital to wages, and on the wages fund doctrine; and a second, of nine further chapters, in which the history of the wages fund discussion from its beginning to the present time is followed. At the close, a final chapter gives a brief summary of both parts. In this arrangement I have departed from the traditional plan, and perhaps from the strictly logical plan. It has been customary, in critical and historical inquiries as to one or another phase of economic theory, to begin with the history and criticism, and to close with the statement of the author's final conclusions. But criticism and comment proceed inevitably from the thinker's own point of view; and to weigh the conclusions of others, without having explained one's own, necessitates either an incidental and thus unsatisfactory statement of the grounds of an opinion, or a considerable anticipation of views whose full exposition is nevertheless postponed. I have accordingly adopted the reverse order, and trust I have been able thereby to make at once a briefer and a clearer presentation of my opinions.
I am sensible that in the first part, in which my own views are stated, there is some elaborateness of exposition and some liberal reaching-out to related topics. I have endeavored to make my meaning clear not only to those who have already given some attention to economic theory, but to those who are new to such discussions; and hence I may have been prolix, and may have explained at needless length matters that to many readers will seem very simple. The historical and critical discussions of the second part are addressed more particularly to special students of economic theory. While not essential for following the reasoning or for weighing the conclusions of the first part, they yet consider aspects of the wages fund controversy not to be neglected by those who would reach an opinion on the subject as a whole.
I have to express my warm thanks to Professor Maffeo Pantaleoni, who generously put his well-stocked library at my disposal in Rome during the winter of 1894–95; to Mr. James Bonar, of London, who read the manuscript of some of the earlier chapters, and greatly aided me by his criticism; and to my colleague Professor W. J. Ashley, who has read all the proofs of the volume, and offered many helpful suggestions.
Two chapters have already appeared in print. Almost the whole of Chapter III was published, under the title "The Employer's Place in Distribution," in the Quarterly Journal of Economics for October, 1895. Chapter XIII, on the wages fund at the hands of German economists, was published, in essentials, in the same journal for October, 1894.
F.W. TaussigHarvard University, November, 1895
The results of the prolonged inquiry may now be summed up: both the positive conclusions reached in the first part of the volume, and the outcome of the historical and critical chapters of the second part.
We began, in the first chapter, with the proposition that all laborers, and all the members, of any community m which the successive division of labor has been developed far, are supported chiefly by the product of past labor. When once attention is fastened on real wages, the enjoyable and consumable commodities which satisfy human wants; and when the mode in which production is carried on in any but the most primitive communities is considered, — it becomes clear that present labor does not produce present real income.
Whether labor is to be regarded as paid from capital or not, depends on what is meant by the term capital. The most consistent and significant meaning of that term is, wealth not yet in enjoyable shape. In this sense, labor clearly is not paid from capital: for by definition things yielding satisfaction or constituting real income are not capital. But real income is constantly emerging from capital. Labor is steadily putting the finishing touches to wealth not yet in enjoyable form, and so advancing it to the stage where it becomes a source of real wages as well as of real interest and real rent. Considering any but the shortest period in production, the resources from which the community must look for support and enjoyment exist at any one time mainly in the form of capital, not in the form of enjoyable wealth. Income now earned or now acquired has its real source in the continuous flow of consumable commodities which is steadily emerging from the capital of the community. Such was the result of the second chapter.
The third chapter considered the special case of hired laborers, and the relation between the capitalist employer and his workmen. If all laborers were independent, — if all were owners or tenants of land, or artisans carrying on production at their own risk and charge, — no ground would exist for saying that their share of enjoyable wealth and real income came from the available total by a process differing in essentials from the process by which others secured their income. But in fact, in most modern communities, a very large number, often the larger number, among those who, earn their living by manual labor are not in this independent situation. They are dependent, for their share of real income, on being hired by some one else. With the advantages or disadvantages of this situation our inquiry is not concerned. As the industrial situation stands, ownership of wealth is in fact unequally divided; the greater part of the capital and of the steadily accruing wealth of the community is owned by a comparatively small number of active capitalists; and the money rights derived from the sale of the endless variety of marketable commodities flow first into their hands. Hired laborers are dependent for their money income, and therefore for their share of real income, on a bargain with those owners of capital. The body with whom hired laborers deal directly, consists of their immediate employers only; but the body whose dealings are really decisive as to the extent to which laborers shall be hired, is much larger. It includes the middlemen, merchants, bankers, who form so influential a contingent in the ranks of the active managers of industry. In a larger sense, and in the long run, it may be said to include also the idle investor, who invests his money means, — his claim on the community's possessions, — by putting them in the hands of the managing class, and who gets from that class a stipulated income. At all events, hired laborers are dependent on a wages fund (if one chooses so to call it) which is in the hands of the capitalist class. Their money income is derived from what the capitalists find it profitable to turn over to them.
This is a wages fund doctrine, and a conclusion as to the relation of capital to wages, quite different from that reached in the first two chapters. It bears not on the permanent and unalterable relation of real capital to real wages, but on the relations of certain kinds of laborers to the capitalists of our modern communities. It would not be applicable to a society in which all workmen were independent producers, or in which the centralized administration of production was secured by cooperative methods; still less in a society organized on a collectivist or socialist basis. It explains some of the phenomena of modern advanced communities, and applies to them the more, in proportion as the régime of employing capitalists and hired laborers is the more fully developed.
The remaining chapters of the first part gave some further applications and illustrations of the main conclusions reached in the first three. On the one hand, the much-debated question as to the elasticity of the proximate source of wages was examined in its double aspect, — as to the source of the real wages of all laborers, and as to the sources of the money wages which hired laborers get from employers. In either case, there were found to be wages funds which were roughly predetermined, yet were so elastic, and elastic within such considerable limits, that the predetermination served chiefly to illustrate the nature of the. reasoning applicable to questions of general wages, and could not give guidance as to any concrete difficulties or practical problems.
In the concluding chapter of the first part, it was then pointed out that, in its relations to other economic questions, whether practical or theoretical, the whole wages fund controversy was of comparatively little significance. Practical questions, — on strikes, trade unions, combinations, — invariably arise as to particular wages, not as to wages at large; while it is only to the questions of wages at large that general reasoning as to wages and capital can apply. So far as the deeper problems of distribution are concerned, it appeared again that these have little to do with the general wages fund. More particularly, the residual theory of wages, which has been much associated with attacks on the old wages fund doctrine, has no real connection with the questions as to the sources either of real wages or of any other sort of real income. In fact, the wages fund doctrine, or what there is of truth in it, has to do rather with production than with distribution. It serves to describe the process by which the real income of the community emerges from a prolonged process of production; and it serves to describe in what manner the hired laborers of advanced industrial communities get their share of this accruing real income. It thus describes important parts of the machinery of production and of distribution. But it can tell us little as to the forces which move that machinery, — as to fundamental causes which make the real income of the community large or small, or which determine the share of that real income which in the long run shall go to wages or interest or rent. Its truth has been misconceived, its importance exaggerated.
In the critical and historical chapters of the second part, the long and often wearisome controversy has been followed from Adam Smith to the present time. For near a century, indeed, there was little in the way of controversy. Adam Smith pointed out that, with the division of labor, the relation between productive exertion and its enjoyable result becomes indirect and prolonged in time; and he laid it down that wages are therefore paid from capital. In this very first stage of the discussion the confusion appeared between money wages and real wages — between the payment of the hired laborer from the money resources of the employers, and the derivation of real income from social capital. Adam Smith explained at length that money was but "the wheel of circulation," and that the true source of all income was consumable goods; but he failed to examine what was the relation of consumable goods to capital.
His successors did not go farther. For one reason and another, they failed to do more than repeat the vague and general proposition that wages depended on capital. The main cause of this unsatisfactory treatment was the emphasis which, after Malthus and Ricardo had made their influence felt, was given to "natural" wages, to the standard of living, and to the principle of population. This caused questions as to "market" wages to be dismissed with brief mention, and so to receive no more careful examination than had been given this topic by Adam Smith. The formula that wages depended on the ratio between capital and population was handed on from writer to writer with no important variation and no real development, throughout the period of the ascendency of the English school.
The unsatisfactory and ambiguous character of the accepted formula is clearly shown by the mode in which it was applied at the hands of John Stuart Mill. By this authoritative writer the lengthened period of production is referred to in the briefest terms, and the dependence of labor on "capital" in the sense of real capital is rather implied than expressed. On the other hand, "capital" in relation to wages is usually described as funds, sums, money resources, and spoken of as if it were all in the hands of the direct employer. The latter meaning was fastened on by the critics who first began to question the soundness of the traditional view. Longe and Thornton began to ask whether the funds which employers could turn over to laborers were predetermined, and so were led to deny the rigidity of the wages fund. Cairnes tried to answer them; but, while continuing to speak chiefly of employers' resources and money funds, he never fully faced the question whether those funds were or were not predetermined. In the end, this almost exclusive attention to employers' funds and laborers' money wages, led to a denial not only of the rigidity of the wages fund, but of the payment of wages out of any fund of capital at all. It was maintained that wages were paid from current pro. duct, not from capital.
In the closing chapter we have compared this last turn in the wages fund controversy itself with the new mode of approaching economic theory which is associated with the Austrian school, and which has served, unexpectedly and undesignedly, to bring once more into the foreground the mode in which real income emerges from social capital. The examination of these two currents of thought has brought into bold relief the question which underlies the whole controversy. The two propositions, — the one, that labor gets its reward from a product that is its own, or at least is current product; the other, that present labor represents in the main a future result and gets its immediate reward from products of the past, — both have directed attention to that relation in time between exertion and result, which had been so lightly passed over in the older literature of the subject. It is not too much to hope that on this topic, at least, there may be substantial agreement among economists. It has been said that the controversy over the wages fund is a barren one; and so it is, as an effort to settle the causes which finally determine wages and shape distribution at large. But as a mode of describing the methods and sequence of production, the concrete structure of society in its economic aspects, the manner in which a prolonged and complicated series of exertions brings at last the flow of real income, the place which capitalists have in the distribution of income, — on these topics something can still be gained from the discussion. The inquiry here undertaken as to the true relation of wages to capital, and the summary of the historical development of the old doctrine, may put into truer light old views and modern criticisms, and may be helpful for that restatement of economic doctrines on which the present generation is so busily engaged.
Taussig's IntroductionThis book, written in 1892–1895 and published in 1896, has long been out of print. The London School of Economics (University of London) now honors me by undertaking a reprint in its series of scarce books and monographs.
The book should be read in the light of the stage at which economic theory stood when it was prepared. Large matters of principle were then in a ferment, which in England and the United States had led to revolt against the older doctrines and against the dominance of John Stuart Mill. On no point was that revolt more effective than on the subject of wages. The wages fund doctrine, so long the accepted basis, or at least starting point, of the treatment of wages, was strongly attacked and weakly defended. In England, Longe, Thornton, and Cliffe-Leslie, were among the more conspicuous of the dissenters; and Mill yielded to Thornton, giving up the doctrine. The only serious attempt at defense came from Cairnes, who vet endeavored not so much to maintain the old view as .to remodel and rehabilite it, — with no real success, and with no effect in stemming the contrary tide. In Germany, there had long been discontent with this doctrine, as with the general drift of the British school; not, to be sure, with such sharpness and consistency as to have any influence on the general economic formulations of the time, yet so wide-spread as to promote the reaction in theory.
It was in the United States that the attack was most vigorous. The most conspicuous assailant was Francis A. Walker. Of him one of the keenest critics and eclectics of his day, Henry Sidgwick, remarked that he had at last given the coup de grace to the doctrine. Henry George argued on lines very similar to those of Walker, with the fluent and effective style that brought this, with the rest of his teaching, to the notice of an enormously large circle of readers. These were joined shortly by J. B. Clark. By the time of that scholar's contributions, the old doctrine was so shattered that he could deal with it as almost negligible, and could proceed without further ado to the formulation of very different theories of his own. It became quite the fashion among Americans to show one's modernity by a contemptuous dismissal of the wages-fund doctrine and of all that went with it.
In these debates it seemed to me at the time, and seems to me still, that there was great confusion of thought. Both the older writers and the newer were partly right, partly wrong. In particular both failed to distinguish the process by which the money wages of hired laborers get into their hands from that by which the laborers get the real income of goods and services emerging from the complicated operations of production. The older writers had usually started on the right track, but soon got astray (following Adam Smith) by treating it all as a matter simply between the immediate employer and his men. Most of the dissidents did not even start right, and at all events went astray in the same way as their predecessors. It was a case of throwing out the good with the bad.
I have to confess that, feeling quite sure that there was this confusion, the spirit of counter-reaction was unduly strong in me. Some things which are in this volume could certainly be said in a better way. I have no doubt there are other things which, to say the least, call for modification. Especially as regards the continued use of the term "wages fund," I should change what I wrote forty years ago. The phrase is of more than doubtful expediency, having connotations which, even tho they be explicitly disclaimed, are not easily shaken off. However defined and explained, it implies the existence of a constituent in the social income which is set apart or determined in advance with some sharpness. But the reasoning with which the first chapter of this book starts, and which gives its keynote, is applicable only to the social income ("real income") as a whole, and to the "predetermination" of that. I hope and believe there has been no failure in the volume to perceive this distinction, or call attention to the qualifications needed when applying the notion of predetermination to any one form of income, such as contractual wages. Very likely the qualifications are even more important than is indicated in these pages. At all events the term "wages fund" should be discarded.
What now, irrespective of terminology, remains of the old formula and what saving remnant may there be in and for new formulations? The answer can be indicated, I think, by comparing the old wages doctrine with the doctrine on money and prices which was its contemporary. The two belong in the same class, and reflect on the attitude characteristic of economic thought at the time of their vogue. In both the statement is of independent variables which are confronted with each other. The terms of exchange establish themselves once for all. It is tacitly assumed in both that the amounts are not dependent variables. The number of laborers (the "population") depends on one set of causes; the wages-fund ("the capital") depends on quite another. Similarly, the quantity of money is supposed to be settled by causes which have nothing to do with those that bear on the volume of commodities.
Both formulas, however, try to find a simple statement and a simple solution for phenomena that are highly complicated. The one tries to find out what determines the general price level; the other what determines the general wages level. In neither case, it may he noted, was any doubt entertained by the older writers whether there was any such thing; no question, of the sort which has been raised in later days, whether there really exists such a phenomenon as "general wages" or "general prices." Particular wages and particular prices were indeed envisaged, hut were reserved for later and independent treatment, being quite separate from the other thing, — the general level, regarded as a real thing and as presenting problems of its own.
But the statement made was in either case no more than an introduction, a mere presentation of the problem. The form of presentation does serve to focus attention on the matters which we should know if we try to answer questions about general wages or general price. Perhaps it presents nothing more than a truism. But a truism is often a useful introduction; and truisms are often forgotten, in learned as well as in unlearned discussions. On the other hand, a proposition of this character cannot pretend to be a solution. Clearly much more must be done before that goal is reached or even approached. We must learn what are the factors which have made the constants such as they are, or are supposed to be, at the given moment, and what changes in them are likely to be brought about, and how. We must consider, too, whether there are really independent variables. In monetary theory, for example, we elaborate at once by examining what is meant by the "money," or circulating medium, whose quantity is of effect; rehearsing the familiar take about the credit instruments and the total means of payment. And then arises the more important and difficult question of interdependence: how far, say, an increase in the volume of goods of itself may bring about, or contribute to, an increase in the quantity of the means of payment. Analogous questions arise if we push on from the same sort of starting point with regard to wages; and some of these l have tried to bring out in this volume.
To repeal, then, the older theories, as to both problems, can be said to give what is simply a starting point, an introductory statement. And they do this, I am still inclined to think, in a way that is not only permissible, but helpful. Monetary theory, I judge, is going hack more and more to the good old quantity formulation as that which is the first step toward a solution. And a tendency of the same sort appears in the recent discussions of wages theory; though, obviously, when it comes to the later stages of the analysis of wages, the divergence from the old paths is great indeed, certainly greater than in the case of monetary theory.
On the main lines of reasoning in this introductory analysis, there is not yet a consensus of opinion among economists. But I stand my ground. The length of the period of production, the relation between present work and present consumers' income, what capital means and the part which it plays, the curious development of economic theory on these matters from Adam Smith to the close of the 19th century — on these essentials I find nothing of importance to modify. There is no occasion, however, and indeed no possibility, of entering here on a discussion of the course of thought and debate during the past generation. The book as it is now reprinted, unchanged in any particular, has played its modest part in the stir of economic theory during the life-time of its author; and I am glad to accept the judgment of the editors of the series that it deserves to be made accessible to students of a later day.
F.W. TaussigHarvard University, November, 1932
In the ferment of economic discussion which followed the appearance of the Wealth of Nations, other subjects than those with which the present investigation is concerned, were uppermost: Attention was given chiefly to external and internal commerce, and so to the questions of free-trade without and of unshackled industry within. Adam Smith's was a catholic mind, and he had the interests both of the scientific thinker and the practical agitator. But his immediate followers laid stress mainly on those parts of the subject in which he had called for prompt legislative reforms. It was the drift of the time, too, to treat economics chiefly with reference to production. The path of progress was believed to be by the increase of the production of wealth. This was to be secured chiefly by freeing exchange from all restrictions. So much done, general prosperity must follow. Not until the middle of the present century, when the complaints of the socialists began to demand attention in louder and louder tones, did distribution become the central problem in economic reasoning.
The urgency of some immediate loosening of restrictive legislation, and the importance attached to problems of production, thus caused Adam Smith's treatment of wages and capital to receive comparatively little attention. What was said by his immediate successors on this topic, was chiefly in acceptance of his views. So far from carrying his reasoning further, the economists of the next thirty years rarely succeeded in getting as far as he did. What was the general situation, will appear from an examination of the more prominent writers, both among those who accepted the doctrines of the Wealth of Nations with unquestioning loyalty, and those who ventured to differ, on one point or another, with their acknowledged master.
In France, the leavening influence of the Physiocrats, and the upheaval of the Revolution, prepared the way for a more rapid advance in economic thinking than at first appeared in England. Among the writers who took up the cause of reform, none was more enthusiastic than the historian Sismondi; none was more eager for the advance of freedom than he in the earlier stage of his remarkable intellectual career. In 1804, he published at Geneva two volumes, De la Richesse Commerciale, ou Principes d'Économie Politique, which are expressly stated in the preface to do no more than expound what Adam Smith had discovered. Much the larger part of the book is given to foreign trade and the subjects that go with it; though the wide range of interest which Sismondi showed in later life, appeared at this stage in the attention given to the other topics. Following Adam Smith, he points out that the division of labor brings a departure from the simple conditions of primitive industry. Rich and poor emerge; "comme tout homme est foré de consommer avant de produire, l'ouvrier pauvre ce trouve dans la dependance des riches." And later:
Toutes les fois qu'on met à l'ouvrage un ouvrier productif, et qu'on lui paye un salaire, on échange le présent contre l'avenir, les choses qu'on a contre celles qu'on aura, l'aliment et le vétement qu'on fournit à l'ouvrier contre le produit prochain de son travail. L'argent trentre dans ce marché que comme signe: il représente toujours une richesse mobiliaire, applicable à l'usage et à la consommation de l'homme, c'est cette dernière qui est le vrai capital circulant. Le numéraire est comme une assignation, que le capitaliste donne à l'ouvrier, sur le boulanger, le boucher, et le tailleur, pour qu'ils lui livrent le denrée consommable qui appartenoit déja en quelque sorte au capitaliste, puisqu'il en possédoit le signe.De la Richesse Commerciale, vol. I, pp. 36, 53.
The laborer and capitalist find it to their advantage to make the bargain, because the laborer has "rien enfin pour se nourrir ou se vêtir"; while the capitalist wants a profit. Sismondi notices that the laborers almost always have "quelque petit fonds accumulé" with which to subsist for a day or a week, until their wages are paid. But this fund only suffices until "l'échange de !'objet qu'ils ont produit soit accompli": and in any case it is capital, the laborers being in so far both laborers and capitalists.
This is a neat and compact statement of what Adam Smith had worked out; in some respects it is perhaps an improvement on what Adam Smith had said. There is a touch of originality, perhaps even a presentiment of modern ways of stating the situation, in the description of the laborer as bargaining away the future for the present; and the function of money in regard to wages could not be better put. On the other hand, Sismondi, like his master, evidently regards the period during which advances must be made to the laborers as that only which elapses until a salable product is made.
Thenceforth, in the brief attention he gives to wages in general, Sismondi speaks of them as determined in the first instance simply by the quantity of capital compared with the number of laborers: while other forces, again, are at work to determine them in the long run.
Quelque soit le nombre des ouvriers proportionellement au capital qui doit les nourrir, ils ne pourront se contenter longtems d'un salaire moindre que celui qui leur est absolument necessaire pour vivre: la misère seroit bientôt suivie de la mortalité, et l'equilibre seroit rétabli par ce contrepoids aussi redoutable qu'efficace. Quelque soit d'autre part le nombre ou la valeur des capitaux destinés a maintenir le travail, ils ne pourront jamais être réduits à ne donner aucun profit net. … Le propriétaire préféreroient alors de les dépenser en objets de luxe.Ibid, vol. I, p. 63.
This consideration of the permanent causes which determine wages still rests mainly on Adam Smith. There is again an original turn in the mention of a minimum and maximum of wages; which bears a curious similarity to a mode of stating the theory of wages common among German writers of our own time. But the treatment is summary; the subject enlisted Sismondi's interest much less than free-trade, internal and external, and the French legislation restricting it.
In later years, Sismondi recanted many of the doctrines of his first book. In the Nouveaux Principes d'Économie Politique, published in 1819, he joined the reaction against the optimist advocacy of the wonder-working effects of unfettered industry, and set forth the doctrine of over-production and "engorgement des marchées." His anxiety as to the excess to which free competition could lead colored his conclusions on international trade, corporations, population, poor-laws, and other subjects. But on wages he did not find occasion to modify what he had said. Indeed, the subject is treated even more briefly than in the earlier book. Capital is analyzed as resolvable ultimately into food: it is rather implied than explicitly stated that laborers must be supported out of capital. When the independent treatment of wages is taken in hand, the relation of capital to wages is not mentioned. Sismondi there discusses chiefly the need of high wages as a means of putting larger purchasing power into the hands of the masses and so supplying a market for the threatened over-supply of goods. Indeed, it was hardly to be expected that he should find occasion for revising what he had said in the earlier book on the relation of wages and capital; for the course of discussion in the interval,Nouveaux Principes, Book II, ch. iv, on the return from capital, and Book IV, ch. v, on wages. while it had elicited differences of opinion on other subjects, had tended to strengthen the hold of Adam Smith's views on this one. Practically nothing had here been done to advance or develop the results reached in the Wealth of Nations.
The same remark may be made of the treatment of economic theory at large by two other Frenchmen, — Say and Ganilh. Say's famous and popular Traité d'Économie Politique, published in 1803, was in the main an exposition of the doctrines of Adam Smith. Capital, according to Say, consists of tools, materials, and subsistence. Subsistence must be advanced to the laborers, and must be replaced in the product: "he [the employer] is obliged continually to make the advances."Traité, Book I, ch. iii. The husbandman's capital must include, besides buildings, tools, and cattle, "seed, ground, provisions, fodder for cattle, and food as well as money for his laborers' wages, etc."Ibid., Book I, ch. x.7 Here we find Adam Smith's farmer, and the subsistence for the laborers as part of the farmer's capital, without further analysis of the character and functions of this form of capital. When Say, in a later part of his treatise, discusses wages independently, the subject of capital, notwithstanding the earlier analysis of it, does not reappear.Ibid., Book II, ch. vii, § iv. Wages are said to depend on the laborer's subsistence as modified by his habits. They are adjusted by bargain between master and man; and Adam Smith is followed in the statement that the bargain usually works to the advantage of the master. But the part which the master's capital plays in the bargain is not considered: Say does not attend to the lead, uncertain as it was, which his chief had given. In truth, Say's books, wide as was their circulation and influence, were thin in intellectual quality, and could hardly be expected to reflect more than the current ideas of the time.
Ganilh's Inquiry into the Various Systems of Political Economy is in many ways not unlike Say's Traité; it is neat and lively, and shows the skill of the French in exposition. An eclectic performance, it yet follows in the main Adam Smith, differing with him only on a few topics, like the distinction between productive and unproductive labor and the doctrine of labor as a measure of value, on which Say and Lauderdale had undertaken to correct their acknowledged leader. On capital, Ganilh paraphrases Adam Smith without effort at independence. Capital is an accumulation of the produce of labor, including not only machines and instruments, but "the advances and raw materials necessary to all kinds of labor ... and produce kept in store for present, future, and distant consumption." But of capital in its relation to wages Ganilh has nothing to say. In the chapter on Wages,Book II, ch. vii. the fluctuation of wages with the price of provisions receive attention: but the proximate source of the demand for labor is not treated as it was by Adam Smith. The demand for labor varies with the progressive, stationary, or retrograde state of national wealth. This is an echo of the doctrine of the Wealth of Nations that wages are high only in advancing communities: it does not touch the detailed analysis of the demand for labor with which Adam Smith had begun. Neither Ganilh nor Say touched the really intricate and difficult parts of their subject.
Among English writers of this period, there was even less of direct discussion than among the Frenchmen of the relation of capital to wages. In England, as elsewhere, Adam Smith's attacks on the mercantile system chiefly attracted attention. What he said of capital in general, abstruse as it was, and far removed from the pressing problems of the day, aroused little discussion: what he said of capital and wages, apparently none at all.
Lord Lauderdale, to mention one of the ablest and most independent of Adam Smith's immediate successors, in his Inquiry, protested against several of Adam Smith's doctrines, notably those on labor as a measure of value, and "parsimony" as the mainspring of public prosperity. Lauderdale was a keen and able thinker, and his corrections of some of Adam Smith's doctrines deserved more attention than the later classic school gave them. But on the subject of capital and wages he made no advance, and indeed did not fairly attend to what Adam Smith had said. Capital he regarded as consisting only of tools and machinery, and (perhaps) materials; and these were treated as simply "supplanting" labor. Lauderdale failed to see that tools do not supplant labor, and that they are simply a different mode of applying labor. But this view of capital had no bearing on the relations of labor and capital; in fact, it tended to prevent a consideration of that relation. Commodities advanced to laborers were apparently not considered to be capital by Lauderdale. This is certainly a tenable view; but it does not obviate the need of considering the problem how the finished or nearly finished commodities, which are not dubbed capital, get into laborers' bands. To that problem Lauderdale gave no attention. His Inquiry, indeed, makes no pretence at covering the whole ground. It is a series of detached essays on certain points on which the author had thought for himself and had reached conclusions different from Adam Smith's. Like others of his time, he was concerned with questions of production rather than with those of distribution. His writings are of interest to the present subject because of the evidence they give that Adam Smith's discussion of it, when not followed in express terms, aroused no adverse comment.
Malthus is the most important figure in the interval between Adam Smith and Ricardo. The Essay on Population far surpasses any other economic publication of that time, both in the attention which it aroused with the general public, and in the influence it exercised on the subsequent course of economic speculation. Directly, it said little or nothing on capital, or the relations of capital and wages; indirectly, it had a very marked effect on the discussion of this part of economic theory.
Directly, Malthus in the Essay on Population touched very lightly on general economic questions. Indeed, he was then very slenderly equipped for doing so. He had drifted, as it were, into the discussion of economic topics, publishing the first edition of the Essay (1798) as a pamphlet against Godwin and Condorcet; and the pamphleteering spirit did not entirely disappear even when he enlarged it, with the second edition (1803), into the formidable volume which established his fame. Malthus had read Adam Smith, and even in the first edition of the Essay made reference to Adam Smith's discussion of wages; but it was not until a later period that the questions of wages and profits, and the theory of distribution proper, engaged his attention. Of his contribution to these questions in his later years, when he had become a professor of political economy, and had begun to write more on economic subjects at large, something will be said when the development of thought after the time of Ricardo comes to be taken up. For the present, it will suffice to note what Malthus had to say when his thinking still turned almost exclusively on the question of population. The only passage on the general theory of wages is in the sixteenth chapter of the first edition of the Essay, — a chapter which, though revised and rewritten in later editions, remained unchanged so far as the gist of the reasoning went.This chapter became chapter VII of Book III in the second edition of 1803, and is chapter XIII of Book III in the last edition. Its caption is: "Of Increasing Wealth as it affects the Condition of the Poor." Here Mal thus attacked, with a diffidence that was quite unaffected,"I can not avoid venturing a few remarks on a part of Dr. Adam Smith's Wealth of Nations; speaking at the same time with that diffidence, which I ought certainly to feel, in differing from a person so justly celebrated in the political world." Essay on Population, first edition, p. 302. The diffidence seems to have been no longer felt when Malthus reached his second edition; for these apologetic sentences do not appear in the volume of 1803. the doctrine which he attributed to Adam Smith, that the demand for labor increases pari passu with the growth of the total wealth, or the combined stock and revenue of society. Malthus maintained that the demand for labor came from "the real funds destined for the maintenance of labor,” — a phrase evidently derived from Adam Smith, and often repeated by Malthus. These real funds, in Malthus's opinion, must be mainly food; and so he brings the emphasis to the point about which the whole Essay centres, — the possibilities and probabilities of the relative growth of population and of food."Little or no doubt can exist that the comforts of the labouring poor depend upon the increase of the funds destined for the maintenance of labour; and will be very exactly in proportion to the rapidity of this increase. The demand for labour which such increase would occasion, by creating a competition in the market, must necessarily increase the value of labour; and, till the additional number of hands required was secured, the increased funds would be distributed to the same number of persons as before the increase, and therefore every labourer would live comparatively at his ease. But perhaps Dr. Smith errs in representing every increase of the revenue or stock of a society as an increase of these funds. Such surplus stock or revenue will, indeed, always be considered by the individual possessing it, as an additional fund from which he may maintain more labour; but it will not be a real and effectual fund for the maintenance of an additional number of labourers, unless the whole, or at least a great part of this increase of the stock or revenue of the society be convertible into a proportional quantity of provisions; and it will not be so convertible, where the case has arisen merely from the produce of labour, and not from the produce of land. A distinction will in this case occur, between the number of hands which the stock of the society could employ, and the number which its territory can maintain." Essay on Population, first edition, pp. 305, 306.In the second edition, this passage is retained with no substantial change; but Malthus now was more sure of his ground, and stated roundly that "the error of Dr. Smith lies in representing" and so on. Essay, second edition, p. 421. Malthus was on the right track, as Adam Smith had been before him, in saying that the real funds which constituted the demand for labor were the consumable commodities which constituted real wages. But he hardly got as far as Adam Smith in analyzing these funds. He simply told the world that mankind, physiologically considered, had the potentiality of multiplying much faster than the most important element in real wages-food-could probably increase. Other constituent parts of real wages, as manufactured goods, might be increased in quantity with comparative ease, and wealth in this form might advance rapidly; but such an increase would not mean a greater supply of food, and would not enlarge the real funds for supporting and maintaining labor. This was the only point of view from which Malthus approached his predecessor's doctrine of wages. Evidently it does not touch in any way the theory of capital, or of capital in relation to wages, or of the connection between the acts of the capitalist employer in hiring laborers and the mode in which the laborers' real income is determined. As we shall presently see, Malthus hardly got any further than this even in his later writings, directed though these were to a wider field than the Essay on Population. At all events, nothing that he said in this earlier period made any direct advance in the discussion.
Indirectly, however, the Essay on Population had a very great influence on that discussion. Malthus fastened attention on the standard of living as the determining cause of wages. Population tended, within the limits set by the standard of living, to press on subsistence; changes in wages, unless the result of a changed standard, were unimportant. However explicitly Malthus admitted the possible effect of moral restraint in checking the pressure of population, and however eloquently he preached the virtue of such restraint, he retained throughout a conviction of the strong probability that every increase in food would bring a corresponding increase in numbers, and that wages, in terms of the habitual food of the laborers, would remain at one dead level. When, twenty years later, Senior, in his correspondence with Malthus, maintained that as an historical fact food had increased faster than population, Malthus, admitting that this might be true, pointed out that his theory would not thereby be impugned.See the correspondence between Senior and Malthus, appended to Senior's Two Lectures on Population (London, 1829). He was thus ready to say, when squarely brought to the issue, that the simple tendency to pressure was the essence of his teaching. Yet the very need of such a question as Senior's showed how firmly he had impressed on his contemporaries the belief that the tendency to pressure was strong, and so little likely to be mitigated or counteracted as to leave it practically true that wages depended on a fixed low standard of living, and that an increase in subsistence meant simply an increase in numbers. The consequence was that the inquiry which Adam Smith had begun, as to the immediate causes determining wages, seemed superfluous. It was sufficient that wages were regulated by the "principle of population." The effect of Malthus's teaching in the Essay was to fix attention on the ultimate causes which determined wages, and to divert attention from the proximate causes and the exact mode of their operation.
The result of this chapter is thus mainly negative. No writer of the period between Adam Smith and Ricardo got beyond the point reached by the former in his analysis of capital at large, and of the place of capital in the payment of wages. Anything new that may appear on this topic in the period that begins with Ricardo, may therefore be treated as a direct advance from the Wealth of Nations anything old and familiar as derived from that source. It will be seen that the additions were, for a long series of years, slight in substance, and not even considerable in the mode of statement. The influence of Adam Smith, on his later followers as well as on those closer to his own time, was here greater and more lasting than on the treatment of almost any other parts of the theory of distribution.
It is not the object of the present volume to follow the discussion of the wages fund doctrine at the hands of the many writers of our own time who have expressed their views on the never ending controversy. The varieties of opinion are endless; on no topic in the range of economic theory would it be so difficult to extract any consensus of opinion. But, to understand the stage at which the discussion stands, it will be advantageous to follow two main trains of thought which have become conspicuous and important during the last twenty years.
After the weakness of the old doctrine had been made plain by Thornton's and Longe's criticisms, Mill's recantation, and Cairnes's attempt at rehabilitation, the attack was continued by a series of English-speaking writers of whom President Walker was the acknowledged leader. Not only was it continued; but it was carried farther than by Longe or Thornton. Not the rigidity and predetermination of the wages fund, but the significance of the payment of wages from capital in any form was doubted or denied. The initial step in distribution was thus declared to be, not the payment of wages from capital, but the division of shares in the current product of labor. On the other hand, a new mode of approaching economic theory was advocated in an entirely different quarter, without immediate reference to the old controversy, yet with important and unmistakable effects on it. The Austrian school developed a new theory of value, and from that a revised statement of the relation of capital to wages.
The most significant presentations of the first-mentioned train of thought, in which the payment of wages out of capital is absolutely denied, came from two American writers. The most unqualified was that of Mr. Henry George; the most influential and weighty that of President Francis A. Walker. An examination of their arguments will show how far the revolt from the old doctrines proceeded, and how much need there was for a complete revision of this part of economic theory.
George's attack on the old views was the later of the two in point of time; but it was the more extreme and uncompromising; and its consideration will most advantageously open this stage of the controversy. Progress and Poverty, published in 1879, has for the subject of its first book "Wages and Capital," and there handles the wages fund doctrine without gloves. The aim of the book is to show that all the evils of the social body arise from private ownership in land, and are to be cured by the virtual confiscation of land on the part of the state. As a preliminary to this result, it was necessary to dispose of current explanations of existing difficulties, and among them the explanation of low wages as caused by relative scarcity of capital.
The arguments against the wages fund doctrine are twofold, negative and positive. They are meant to prove both that the old doctrine is false in itself, and that another doctrine is sound.
The first argument to show that the wages fund doctrine is false is its incompatibility with an unquestionable fact, — the co-existence of a high return to labor and to capital. George points out that in new countries both interest and wages are high. High wages, according to the wages fund theory, denote a plenty of capital. High interest denotes a scarcity of capital. Therefore, if the theory be sound, high wages and high interest can not exist together. If in fact they do exist together, — and every one knows that sometimes they do, — the theory must be false. The same dilemma is presented with regard to the fluctuations of wages and interest in times of depression as compared with times of activity. When there is industrial activity, wages and interest are both high; yet if plentiful capital be the cause of the high wages, how can interest be high also? The converse case appears in times of industrial depression, when we have low wages, and yet an indication of a plenty of capital in the low rate of interest.
This would be promptly answered on the part of a writer like Cairnes by the suggestion that "capital" was used in different senses in the two conjunctions. Plenty of capital with reference to wages meant plenty of "circulating" capital, in the phrase of the older writers; or plenty of the wages fund part of capital, in the language of Cairnes. It is quite possible that capital itself should be relatively not plentiful, and yet that a large part of it should be "circulating capital," or wages fund. Cairnes so explained those conditions in new countries which George presented as inconsistent with the old-fashioned reasoning. In a country like the United States a larger part of capital is in the form of wages fund, a smaller in the form of plant and material.
This is a fair answer to a question like George's, even though, as an independent explanation of the high earnings of laborers in new economies, it does not cover the whole case. George at all events meets it indirectly rather than directly. This reply to his objections can not be maintained, he avers, as to the second part of his argument, — that high wages and high interest come together in "good times."
It is not improbable that the ordinary upholder of the classic doctrine would have been somewhat taken aback even by the first part of George's attack. Doubtless he would have found it still less easy to give a prompt answer to the objection in its second form. For in this reasoning as to capital in good times and in bad times, the term "capital" is used with that vagueness which was so characteristic of the usual statements of the wages fund doctrine: the quantity of capital being noticed as having a bearing both on wages and on interest, with no great discrimination as to the how and why in either case. In fact, looking simply at the surface phenomena of money wages and of the money market, it is easy to see that capital means different things in the two cases. In relation to money wages, it refers to the total money funds turned over by employers to the hire of laborers; in the other, to the money funds in the hands of lenders, chiefly for short-time loans, and offered by them to the active managers of business. It is quite conceivable that the one sort of fund should be large as compared with the laborers, while the other should be small as compared with the borrowers. At best, this sort of consideration gives attention only to the surface phenomena, — to money wages on the one hand, and on the other to the bargaining between one class of business men and another. Neither real wages nor the substantial return to capital at large can be brought into clear light by such reasoning.
There is another side to this particular phase of the slow-dragging discussion. George evidently had in mind that opposition between wages and profits which all the followers of Ricardo descanted on: high wages made low profits, and low profits high wages. The connection of this theorem with the wages fund doctrine has been touched on already. The manner in which it led George to think he had found a dilemma is not far to seek. A thinker of George's slender training, absorbed in his own panacea for the cure of all social ills, could not be expected to construe with accuracy Ricardo's involved expressions. Wages, like other words, was used by Ricardo in a peculiar sense: he meant by the word not money wages, not even real or commodity wages, but wages as representing the product of so much labor. When Ricardo said wages were high, he meant that wages got the product of much labor; when low, the product of little labor. So understood, it follows very simply that high wages make low profits, and it by no means follows that high wages, in the sense of high commodity wages, make low profits. Ricardo's proposition, moreover, applies only to the relations between laborers and capitalists in what may be called a completed cycle of production: it applies to the total of the advances made to a given series of laborers in the succession of seasons over which their productive labors extend, as compared with the total of finished commodities produced by this series during the cycle. It has nothing to do with that part of the advances which happens to be made to the laborers of any one season; while just this is the narrower question of the wages fund and of market wages. Here, as on other topics, Ricardo's definite and narrow proposition, stated in the obscure fashion of its author, had been mechanically repeated by the writers of the next generation, and had been applied to all sorts of cases with which it had nothing to do. George was hardly to be blamed if he used the much abused formula against those who understood its real bearing no better than he.
We may turn now to the positive part of George's reasoning: that which undertakes to show that wages are paid from product.
Here the basis of the argument may be stated in George's own words. "The fundamental truth, that in all economic reasoning must be firmly grasped and never let go, is that society in its most highly developed form is but an elaboration of society in its rudest beginnings, and that principles obvious in the simpler relations of men are merely disguised and not abrogated or reversed by the more intricate relations that result from the division of labor and the use of complex tools and methods.” Now the first laborers, in the simplest state of society, must have been supported from the product of their own labor; here is the key to the problem; all laborers are paid from the product of their own labor.
In this sort of reasoning, George doubtless walks in a well-trodden path. Ricardo had reasoned from the primitive fisherman and huntsman to the fundamental principles of value and exchange; and in very modern speculations on the same topic, the analysis of the simplest case is supposed to supply the key to all the phenomena. To give such reasoning validity, it must be shown that there is no essential difference between the conditions of the simple case and the complex. In George's deduction, the primitive workmen, — the gatherer of shell-fish or of berries, — gets a consumable commodity in the interval between meals; the laborer of the great civilized community does work which may not result in enjoyable goods for years. The element of time enters in the one case, not in the other; the difference is world-wide.
Too much space should not be given to the various turns which the reasoning took at George's hands. We are told that laborers always produce something: hence it is inferred that they produce what they live on. We are given a vivid description of "butter churned but a few days before, vegetables fresh from the garden, and fruit from the orchard"; as if all these commodities had been produced by present labor. We are told that the laborers always add to the wealth of their employers before pay-day comes around; which is supposed to show that they are paid from what they produce. In truth, the vogue of Progess and Poverty is not due to any solid and consistent reasoning, or to any novelty in principle. It is a consequence of the tide of social unrest, on which an earnest man, made eloquent by faith in a gospel of his own, has been carried to a commanding position and not undeserved fame. As to the wages fund doctrine, George's attacks are chiefly significant of the ease with which the old statements could be shaken, and of their failure to put in any clear light the basis of truth and fact on which the doctrine might rest. At all events his share in the controversy had little visible effect on the development of economic theory. Though effective in shaking the hold of the old doctrines among masses not usually touched by theoretic controversy, his writings exerted no great influence on trained students; a result due in part to the thinness of his thought, but perhaps quite as much to the ruthless sweep of the social remedy which he finally proposed.
A much deeper influence on the course of thought has been exercised by the other American writer whom we have associated with George, — President Francis A. Walker. This distinguished soldier, scholar, and administrator is justly regarded with respect, and with something more, by his associates in these various fields of activity. So far as economic science is concerned, whether or no all of the doctrines and measures advocated by him shall prove to stand the test of time, no one can deny that his independence and vigor powerfully stimulated discussion at a time when something very like stagnation had been reached in English-speaking countries, and that his writings in many ways mark the beginning of a new and fresher stage.
President Walker's views on the wages fund doctrine were matured at a comparatively early date. They are set forth in an article in the North American Review for January, 1875; and are repeated in the book on The Wages Question, published in 1876. They appear again in his contributions to more recent periodical literature, especially to the Quarterly Journal of Economics, and in the various editions of his text-book on political economy. The later publications handle the wages fund doctrine in a somewhat perfunctory and indeed contemptuous manner, the assumption being more or less explicitly made that it had already received its coup de grace. Hence the earlier discussions are the more significant; and, among them, the two chapters of the volume on The Wages Question may be selected, as containing the fullest and most careful statement of the author's views.
First in order, as the case is presented in that volume, comes a statement or argument that may be readily accepted, but hardly bears on the real problem in hand. "An employer pays wages to purchase labor, not to expend a fund of which he may be in possession." And again: "The employer purchases labor with a view to the product of the labor; and the kind and amount of that product determine what wages he can afford to pay. ... It is, then, for the sake of future production that the laborers. are employed, not at all because the employer has possession of a fund which he must disburse. ... Thus it is production, not capital, which furnishes the motive for employment and the measure of wages." So much is unquestionably true; and as to ,hat not uncommon version of the old view, by which the individual employer is supposed to have funds irrevocably committed to the hire of his laborers, it is valid and unanswerable. But the argument here is mainly as to the motive which influences the employer; and it may be readily admitted that the attainment of a product at a profit is his motive, without any admission one way or the other as to the nature or limitation of the funds which pay wages or form the measure of wages.
Next comes another point. An objection that might come from an upholder of the old view is stated and refuted. "It may be said: we grant that wages are really paid out of the product of current industry, and that capital only affects wages as it first affects production, so that wages stand related to product only in the first degree and to capital in the second degree only; still, does not production bear a certain and necessary ratio to capital?" This question Walker rightly answers in the negative, pointing out that production is affected by other things than the volume of available capital. The land, the natural resources, the industrial quality of the laborers, are important factors. So much is clearly true; and if it be granted that wages are primarily determined by product, it must follow that they are affected by capital only as one among many factors. But the adherent of the old view would never make the supposed admission, or resort to the supposed reply. The kind of connection between wages and capital which is to be disproved is the direct and immediate one. Wages depend, according to the old view, not on capital via product, but (if on product at all) then on product via capital; and the connection with the capital link of the chain is not to be brushed aside as lightly as this. To assume that wages are paid in the first instance from product, disposes of the whole question at issue.
This assumption becomes clearer in an illustration presented in the next paragraph. "Given machinery, raw materials, and a year's subsistence for 1,000 laborers, does it make no difference with the annual product whether those laborers are Englishmen or East Indians?" Clearly the question is to be answered in the affirmative; the quality of the laborers does affect the product. But the adherent of the wages fund doctrine would point out that, by supposition, there was but a year's subsistence on hand; and be would suggest that this was the "capital" important for the purposes of his doctrine. Until a new stock of subsistence could be got, — which presumably would require a year, — the laborers, whether Englishmen or East Indians, could get no more than there was to be had. Assuming that the capital, of all sorts, was owned by a set of employers, and that the only way for laborers to get the subsistence on hand was by bargain with the employers, the rate of wages during the first year would be a simple matter of division. These assumptions, as to the ownership of practically all wealth by one class, were made rather by implication, than in so many words, by the classic writers; but they should fairly be accepted for the purposes of their reasoning, and make it difficult, as to the first year's wages in such a case as Walker supposes, to find a flaw in that reasoning. The growth of capital, after the first year, under the influence of high profits, might make probable a new supply of subsistence and other things, and an eventual adjustment of wages to product. But this is very different from the direct determination of wages by "current product," which is assumed as the basis of Walker's argument, and is by no means proved as the result of it. Whether a case like that here supposed, with its fixed year's subsistence, is typical of the real course of production and distribution in modern communities, or even instructive in their analysis, is another matter. So far as the wages fund doctrine goes, the example is of the sort that serves to strengthen more than to weaken it.
The assumption of the thing to be proved, which appears in this argument as to the industrial quality of the laborers, is made again in the next chapter: where it is pointed out in more detail and with more emphasis, that the nature of the soil, the possibility of a stage of increasing rather than diminishing returns from land, the course of invention, the growing division of labor, may result in changes in product connected but loosely with changes in capital. Thence it clearly follows that these things directly affect wages, if product directly determines wages. Such reasoning, to repeat, may be set aside, as not pertinent to the case; and we may concentrate attention on the arguments which really touch the points at issue, — the relation of capital to wages, the extent to which advances are made from capital, and the exact mode in which wages are paid out of product or capital.
President Walker's attempt to deal with this crucial question begins with the proposition that, while" wages are to a very considerable extent, in all communities, advanced out of capital," they "must in any philosophical view of the subject be regarded as paid out of the product of current industry." What is meant by a" philosophical view" is not quite clear. It can hardly mean that wages, while in fact paid out of capital, are to be philosophically regarded as paid out of something else; though such an interpretation might be consistent with some of the speculations presented by philosophers of all ages. It may mean that wages are paid of product, not indeed for the time being, but in the long run. Yet in this sense there is nothing essentially inconsistent with the wages fund doctrine. We have seen that Cairnes's conception of profits as always within a handbreadth of the minimum, and as certain to be kept there by prompt accumulation consequent on higher profits, means simply that wages are determined, in not a very long run, by product: while yet Cairnes holds them to be proximately determined by the capital available for paying wages. It must be said that Walker appears not to be fairly conscious of this turn of the older reasoning, and sometimes speaks in a manner to imply that he too believes wages to depend on product in the indirect way there stated. Thus in the second of the two chapters now under consideration, we are told that "it is the prospect of a profit in production which determines the employer to hire laborers; it is the anticipated value of the product which determines how much he can pay him," — a phrase which might be interpreted to mean in substance very much what a writer like Cairnes would lay down on the theory of wages.
But Walker at bottom means something different from this: "current product" is the phrase which he prefers in describing the source whence wages are paid; the advance from capital is an accident; and we must inquire further as to his conception of the advance from the one source and the payment from the other.
"In all communities wages are, by the very necessity of the case, advanced to a very considerable extent out of capital. ... The tiller of the soil must abide in faith of a harvest, through months of ploughing. sowing, and cultivating; and his industry is only possible as food has been stored up from the crop of the previous year. The mechanical laborer is also removed by a longer or shorter distance from the fruition of his labor. So that almost universally, it may be said, the laborer as he works is fed out of a store gathered by previous toil, and saved by the self-denial of the possessor." Much seems here to be conceded to the old-fashioned economists. Almost universally, laborers are supported by the product of past labor; and the source whence they get their support is conceived to be food and other tangible things of a previous season's making.
But this admission is at once limited: "to the extent of a year's subsistence, then, it is necessary that some one should stand ready to make advances to the wage-laborer out of the products of past industry." And only subsistence need be provided: "this by no means involves the payment of his entire wages in advance of the harvesting of the crop or the marketing of the goods." Here we have the beginning of a shift in the point of view: the "marketing of the goods" appears as the last stage in production. Almost at once, thereafter, it is questioned whether wages are, after all, largely advanced out of capital; for the laborer does not get his money until after he has done his work for the employer, or indeed after the employer has sold the product. The employer may "realize" on his product before he pays wages to the workmen. Railways and steamboats are instanced as collecting cash daily, i. e., securing their "product," while paying wages monthly. "Quite as common, probably, even yet in countries which we may call old, as weekly payments are monthly payments; and here the probability that the laborer may receive his wages out of the price of this marketed product increases with the quadrupled time given the employer to dispose of it."
Observe the gradual transition here. First, we have the tiller of the soil, who gets his food, — his real wages,from the labor of the past. Here the securing of a consumable commodity is regarded as the last stage in completing the product. Next, we have the harvesting of the crop, without precise statement as to when this harvesting brings a "product" and yields wages: whether at the stage when bread is finally got, or at that when the crop of grain is sold. Last, we have the money view full fledged: the "marketing" of the goods and the "price" of the product are described as yielding wages. It is the old story in the wages fund, controversy: sale and money receipt are confounded with the .final attainment of food and other enjoyable goods, and the fund whence wages are paid is conceived as money or cash in the hands of the individual employer.
The railway company is said to pay wages out of product because it takes in cash before pay-day; though clearly its real product is the transporting of goods or men from one place to another, and so ordinarily no more than the advancement of productive operations by one small stage. The manufacturer who sells pig iron (say), pays his laborers out of the price of the product; yet the pig iron can not become a product, in the sense of being eaten and enjoyed, of satisfying any human want, until a long succession of further steps are taken with it. President Walker might fairly argue that, for polemical and negative purposes, he was justified in using "product" indifferently in the two senses here noted; because those who had long maintained and expounded the wages fund doctrine so often confined themselves to the money view of capital and product. But for progress in getting at the truth of the matter, reasoning which confounds these two things leaves matters in as ill plight, at the least, as they were before.
One further case, much made of by Walker, may be considered, because it presents the same question in a somewhat different way. Among the facts of concrete industry which he finds inconsistent with any necessary or universal advance of wages out of capital, are cases of partial advances of wages by employers. In the South and West of the United States, at the time of his writing, he notes that "the employer advances to the laborer such provisions and cash as are absolutely required from time to time; but the 'settlement' does not take place until the close of the season or of the year, and final payment is often deferred until the crop is not only harvested but sold." Here the provisions and cash first turned over in part payment are apparently regarded as coming from capital; while the cash paid when the crop is sold, comes from product. Yet it is obvious, if we once get beyond the money point of view, that the cash advanced out of capital is spent on finished, consumable commodities; and the cash paid out of the product, or crop sold, is spent on like commodities; that in either case these commodities constitute the real wages, whose amount and determination it is important to ascertain. What we need to know is whether these consumable things, whenever secured, and whether bought with money on hand before or after the sale of the crop, are to be regarded as product or capital; whether they are the current product of the laborers who buy them and enjoy them; whether they are rigid or flexible in amount. These essential questions President Walker nowhere touches.
The proposition that wages are paid out of product, supported in this unsatisfactory way, became the starting point of President Walker's theory of distribution, set forth in his text-books, now so much in vogue in English-speaking countries. It simplifies the perplexing problems so temptingly; it is so obviously true of the individual employer and of those direct wages which he pays his men in money, and which every one first thinks of when questions about wages confront him in concrete life, — that we need not be surprised if the theories of distribution which rest on it, presented as they are with rare skill in exposition, are found eminently teachable and a welcome substitute for the older beclouded views. But they do not really solve the problems in hand. Certainly, so far as the wages fund doctrine was concerned, this attempt at revision settled nothing. There is indeed a sense in which it is true that real wages, like real interest and real rent and real business earnings, are paid out of current product. But as a first step in the theory of distribution, the proposition that wages are derived from current product gives an inaccurate picture of the ways and processes of production; while the determination of wages as a residual share is even more unreal than its supposed payment out of product. President Walker's service in the wages fund discussion, and in economic theory at large, has been rather that of compelling a thorough overhauling of old views than that of substituting a new economic system of solid and permanent value.
Nevertheless, the general theory of distribution set forth by Walker gained an acceptance and influence probably greater than that of any writings in the English tongue since the days of the younger Mill. The textbooks in which they were set forth came into very wide use; and the virtual adherence of a large circle of eminent economists was a proof of more solid success. Jevons in England had reached similar general views at a somewhat earlier date, and readily fell into line. Professor Sidgwick, the weight of whose opinion was deservedly great, adopted the same mode of approaching the theory of distribution, and the same general conclusions as to wages. Followers were many, and dissidents few, in English-speaking countries. In France, where the old rigid views had never had much vogue, the new ones were welcomed by a considerable and influential circle; though sometimes with a certain Gallic courtesy in the admission of a degree of truth on both sides, which made it difficult to classify the French writers in one way or the other. The controversy waxed hot in Italy, where the books both of Cairnes and of Walker were translated, and a long series of books and of articles in periodicals maintained the views of the old school and of the new. Among the Germans less attention was given to the controversy; not because the old views held their own with any tenacity, but because, in this case, the Germans were singularly neglectful of an important phase in the development of economic thought. On the whole, the trend of the discussion for a decade or more was such as to justify President Walker in the assumption that there was nothing left of the wages fund doctrine, that the payment of wages from current product was an established theorem, and that the problems still unsolved were concerned with the details of the share in this current product which went to laborers.
Meanwhile another current of thought was being brought to bear on the wages fund discussion, from a very different quarter, and with very different objects and results. The speculations which are associated with the Austrian school, while directed mainly to the phenomena of value and exchange, have also led to important attempts at the reconstruction of the theory of capital, and these again, explicitly or implicitly, to a reconsideration of the theory of wages.
We are concerned here only with that part of the general theory of value developed by the new school which bears on capital and wages. The value of all economic goods, — to recall summarily the essentials of the new views, — is defined as their "importance" to the person whose wants they are to satisfy; and the exchange value of goods is made to depend on the play of such subjective importance in the minds of those who sell and buy. The diminishing importance of successive increments of any one commodity leads to the theory of final or marginal utility; and final utility becomes the main force acting directly on exchange value. It is probable that in this train of speculation, undue attention has been given to suppositions of fortuitous barter, in which the seller has possession of articles which might be used by himself; whereas too little attention has been given to the conditions of an advanced division of labor, in which the producers and sellers practically want none of the articles they make, and in which final utility to buyers alone has effect on the exchange values of commodities. It is part of the same defect that the consequences of the changing quantities offered by producers under the stress of competition, have been unduly thrust in the background. But these are matters not material for the present inquiry. For this, the essential thing is that value is conceived as affected primarily, not by the cost of articles, but by their importance, or final utility, as means of satisfying human wants.
The direct satisfaction of wants being thus the starting-point in the inquiry, it was inevitable that attention should be turned to the fact that a great mass of goods do not serve directly for such satisfaction. Inchoate goods, not ready for enjoyment, have in themselves no importance or utility. They serve wants only by being converted into commodities capable of yielding direct satisfaction. Hence they find their place in the revised theory of value as having a'' derived" importance and utility, dependent on the importance and utility of the enjoyable commodities which they serve to make. This train of thought led naturally to the consideration of the interval of time that must elapse for the conversion of inchoate goods into completed commodities; and this again to the relation of present labor to present product, the functions of capital, and that whole series of inquiries as to the nature of civilized production, which had been so long and so unhappily divorced from the discussion of the wages fund.
Some of the more significant steps in the development of this train of thought may now be mentioned; with a view not to sketch the history of the new doctrines, but to point out how they have tended to give a new course to the discussion of wages. At the outset there was no hint of connecting them with the old-fashioned theory of wages; and the unexpected manner in which they finally came to connect themselves with the old views, is one illustration the more of the slow and faltering steps by which even the shrewdest of men must feel their way to the results of a departure from familiar lines of thought.
The first careful and deliberate statement, in the terms of the new doctrine, of the relation of dependence between enjoyable and inchoate wealth seems to have been made by Gossen. The work of this erratic genius bore little fruit at the moment, and perhaps had no marked influence on the subsequent course of thought; but it may be referred 'to as an indication of the mode in which the remodelled theory of value gradually connected itself with the subject of wages and capital. Gossen worked out the theory of subjective value, of diminishing subjective value with the increase of quantity, and so of final utility; and applied to these topics the mathematical treatment to which they lend themselves so naturally. What is more pertinent to our subject, he divided goods into different classes, according to their availability for the satisfaction of human wants. The classes were three: ( 1) consumable goods ready for enjoyment; (2) goods not having all the adaptations necessary for enjoyment, as wheat and rye, which need to be made into bread, or a carriage, which needs a horse and driver before sufficing for final satisfaction; (3) goods which serve to make other goods, but never themselves minister to enjoyment, as tools and machines, and fuel consumed to make power. This classification, whether or no advantageous for the inquiries which Gossen conducted, would not be satisfactory for an investigation of the successive steps in production: for the carriage (which is ready for use) and the wheat (which still needs to be ground) are put together by Gossen, yet stand in different stages; while the fuel and the wheat may belong close together. But Gossen was concerned only with the dependence of the various incomplete goods, for their effectiveness in satisfying wants, on the finished commodities; for this purpose his divisions may be helpful, and at all events they brought out clearly the chain of connection. A point most essential for the theory of wages and capital was, however, not touched by him: the interval of time between the successive links in the chain. The idea of a succession in time between the several classes of goods seems not to have been in Gossen's mind, and certainly was not made prominent by him. This first step in the psychological theory of value thus did not bring into view that aspect of it which connects it with the theory of wages and capital.
It is curious that the next writer who followed the methods of Gossen in general economics, while again contributing virtually nothing to the direct application of the new reasoning in the theory of wages, yet also promoted that application indirectly. Jevons, in his Theory of Political Economy, of which the first edition appeared in 1871, worked out, independently and originally, the reasoning as to the general dependence of exchange value on final utility, and essayed with equal originality the application of mathematical methods to economics. In addition, he said some things that were true and important, even. if not entirely novel, on the theory of capital. But the theory, of final utility did not lead Jevons to consider the different ways in which inchoate goods and enjoyable commodities satisfy human wants; and he was thus prevented from making any satisfactory application of his new methods to the problem of general wages, or at least that part of the problem of general wages with which the wages fund discussion is concerned.
While no classification of goods according to the nearer or remoter fruition of enjoyment appears in Jevons, an essential function of capital is there grasped and stated with a directness which is refreshing after the long series of vague generalities among his English predecessors, and which had its strong effect on later thinkers of the same school. Jevons lays it down that capital is nothing but subsistence: it serves only to feed laborers over a lengthened process of production. The element of time is its essence. He states in italics that its effect is "to allow us to expend labour in advance." Not only is this fundamental fact emphasized, but the further fact is noted (though not so fully) that there is connection between the supply of capital, the march of improvement, and the length of time over which the period of production extends. "Whatever improvements in the supply of commodities lengthen the average time between the moment when labor is exerted and its result or purpose is accomplished, such improvements depend on the use of capital. And I would add, that this is the sole use of capital." Here the conception of an average duration of the period of production, and the function of capital in the lengthened course of production, are clearly set forth.
This is not new doctrine; but it is stated with fresh and needed emphasis, and indeed is soon carried almost too far. We have seen that the analysis of capital as a succession of advances of food to laborers was at the basis of Ricardo's reasoning as to value and as to distribution. It was set forth more or less distinctly by most of his followers. But it had been often buried under other matter, and obscured by deductions that were half true or applications that were false; and it had hardly ever been brought into clear connection with the wages fund doctrine. Thus it needed to be simply and emphatically restated and reapplied. But Jevons did no more than restate it, and took no further steps in its application. Indeed, he may be said to have stepped back; for not only did he lay it down that all capital is subsistence, — which is true if properly explained, — but he came perilously near to saying that all which is not subsistence is not capital, — which requires still more explanation to be intelligible and true. "I would not say that a railway is fixed capital, but that capital is fixed in the railway. The capital is not the railway, but the food of those who made the railway."Theory, p. 264. Elsewhere Jevons approaches the subject from a different point of view, and with a result substantially the same: maintaining that all forms of wealth, whether completed or uncompleted, whether in consumer's hands or not, are equally capital.Compare what was said on this topic in Part I, Chapter II, p. 39. His views, in truth, were not fully developed. He did not affect, in this volume on the theory of economics, to have reached definitive conclusions on the subject at large. He was concerned chiefly with advocating a new method and a new point of view: the method of mathematics, and the point of view of final utility. On capital, he had no well-matured opinions, and thus did no more than to redirect attention to its connection with the lapse of time between the beginning and the end of productive exertion.
This failure to mature his conclusions appears strikingly in what Jevons says specifically of the wages fund doctrine. That doctrine he professes to reject; yet with qualifications which, while professing to save something, show that he did not really see what was good in it and what bad. He sets forth in general a residual theory of wages. The laborers are paid from product and get what is left after interest and rent are provided for. He qualifies this by noting a temporary stage during which the wages fund theory applies. Such temporary application of the wages fund, however, has nothing to do with that lapse of time between the beginning and the end of production which he emphasized in his earlier analysis of capital. It has to do with a much briefer period. During the early stages of new enterprises or new industries, involving risks and uncertain profits, he finds that the anticipated outcome of the enterprise, rather than the actual product secured, will determine wages. This anticipated result will determine how much capitalists will then pay out to laborers. Only during this temporary stage of risk and uncertainty, he conceives the wages fund to be in operation. But when stable conditions are reached, and it is known what the outcome of a business — enterprise is to be — and such is assumed to be the usual and normal state of things — the laborer will receive "the due value of his produce after paying a proper fraction to the capitalist for the remuneration of abstinence and risk."Theory, pp. 292, 294, 295. The significant parts of these passages may be quoted: "It is the proper function of capital to sustain labour before the result is accomplished, and as many branches of industry require a large outlay long previous to any definite result being arrived at, it follows that capitalists must undertake the risk of any branch of industry where the ultimate profits are not known. But we have now some clue as to the amount of capital which will be appropriated to the payment of wages in any trade. The amount of capital will depend on the anticipated profits, and the competition to obtain proper workmen will strongly tend to secure to the latter all their legitimate share in the ultimate produce." In the early stages of a new industry (Atlantic cables are instanced), much will be paid in wages, if capitalists make a large estimate of probable profits. "At this point it is the wage fund theory that is in operation. ... The wage fund theory acts in a wholly temporary manner. Every labourer ultimately receives the due value of his produce after paying a proper fraction to the capitalist for the remuneration of abstinence and risk." The question at once suggests itself, is not capital as much needed when wages are normal as when they are ab normal, to perform the function of sustaining labor?
This curious and indeed unique version of the applicability of the wages fund is completely divorced from what Jevons had said, a few pages before, of the function of capital and its relation to time in production. As a statement of the final outcome of distribution, it is much the same as what would be laid down by either Cairnes or Walker, — in fact, by any writer who believed the return to capital to be sharply fixed by a minimum reward for abstinence. It is not very material, for this ultimate result, whether wages are conceived to be paid from capital or from product. But as to the process whereby the result is brought about, if at all, it is very material to remember that laborers in fact are not paid from what they produce, but from that capital which, in Jevons's own language, serves to sustain them through the period over which their exertions are spread. Evidently Jevons had in mind, in this sally on the wages fund, the case of individual laborers and their immediate employers, and the determination of money wages by the money value or exchange value of the product. He thought of the doctrine as referring solely to these proximate relations between capitalists and laborers. It has been sufficiently shown how much warrant he had, in the writings of the economists who had set it forth, for this conception of its scope. His general reaction — certainly a healthy one — from what he called "the maze of the Ricardian economics" disposed him to fling aside once for all a mechanical doctrine such as, in the current and authoritative versions, the wages fund theory was. On this topic, as on others, his impatience with the self-satisfied English political economy of his day led him to flat denial rather than to careful sifting of the true from the false. At all events, he contributed less than might have been expected, m view of his own conclusions as to capital, to the satisfactory statement of the relation of capital to the present reward of laborers.
Thus neither Gossen nor Jevons, who were the most important forerunners of the new mode of approaching economic theory, linked together the two chains of thought which were to lead to a fresh consideration of the theory of wages. Gossen pointed out that incomplete commodities derive their utility from those complete and enjoyable. Jevons, while following Gossen in the theory of final utility, and taking another forward step in the emphasis he laid on the element of time in its connection with capital, gave no attention to the relation between inchoate wealth and consumable commodities.In any attempt to trace the general development of the new theory of value, it would be necessary to refer to the contributions of Léon Walras. But I have found nothing in either edition of Walras's Élements d'Économie Politique Pure which bears on the present inquiry. There is some brief mention of the wages fund doctrine (see Leçon 32 in the second edition, pp. 359–364), but it is directed mainly to Mill's simple statement in the Political Economy, which Walras, like Cairnes, finds to be only a statement of the problem, and no solution.
The gap between the two lines of thought was soon closed. In 1871, the same year in which Jevons published the first edition of his Theory, Professor Carl Menger published his Grundsätze der Volkswirthschaftslehre, which contains, more or less explicitly, the characteristic doctrines of the Austrian school, and is rightly regarded by its members as the main source of their inspiration. With every allowance for the suggestions contained in the works of previous writers, such as Gossen, Walras, and Jevons, it must be admitted to be an original and powerful book. How far the general doctrines set forth in it will prove a complete substitute for the older views, how far will serve only to correct and qualify them, remains still to be seen. For our subject, however, the situation is comparatively simple: and what Menger contributed toward its elucidation can be stated in brief terms.
At the outset Menger distinguishes between different classes of goods. Things consumable and enjoyable are "Güter erster Ordnung," as bread; those not quite in the stage of enjoyment are of the second order, as flour, fuel, stoves; those of the third order are still farther removed from enjoyment, as grain and flour mills; and so on. He adds that the precise classification of goods, as being in the first, second, or third order, is not essential. The lines of demarcation can not be rigidly drawn; the classification is no more than an aid for the clearer explanation of a difficult subject. Thereafter he speaks, as a rule, simply of goods of lower order or of higher order: those of lower order being nearer the stage of completion and enjoyment, those of higher order more remote from it.Grundsätze der Volkswirthschaftslehre, ch. i, § 2. It should be mentioned that Menger includes among goods of higher or lower order the kinds of labor appropriate or trained for the use of the several classes of goods: the miller's labor being classed with the mill, the baker's labor with the bread. I have never been convinced that it is expedient thus to fit human labor into the same scheme of value as the product which it makes: the attempt to do so being the result of an unnecessary striving after formulæ of universal application.
The next step is in a direction already pointed out by Gossen: the value of goods of higher order is dependent on that of the goods of lower order which they serve to make.
Then comes the step important for the present discussion. Time must elapse before goods of higher order can be converted into goods of lower order. Menger criticizes Adam Smith for having ascribed the progress of the arts and the growth of wealth to the division of labor alone. The great cause of material progress he finds in the development of an extended chain of labor, by which enjoyment, instead being secured without delay, is the result of the orderly and progressive advance of goods of higher order to the later stage of consumption and enjoyment. Whether or no this criticism of Adam Smith is entirely just (Menger himself notes incidentally that an "appropriate division of labor" must concur to make effective the process described by him), the passage gives due emphasis to what we have called the successive division of labor, and so to the true relation between present work and present exertion.Grundsätze, ch. i, §§ 4, 5. Later this whole train of thought is still more fully developed. The succession of stages in production is sketched: first, the present, when goods of the first order are on hand and available; then a second period, during which goods of the second order can be advanced to the stage of completion; and so on. The conception of a general production period is also defined, — of the average length of time elapsing between the beginning and the end of the whole series of laborious acts by which the present supply of enjoyable commodities has been produced. Chiefly concerned, as he is, with the value of inchoate goods as derived from that of finished commodities, Menger does not enlarge on the element of time and the extension of the production period; but the essential truths are none the less clearly set forth.Grundsätze, ch. ii,§ 1, c; ch. iii, § 3. Menger not only points out in general that "Vorsorge," or planning for the future, distinguishes the activity of civilized man, but, in a note at p. 136, remarks that the longer the period over which the acts of production are spread, the greater the final productivity. This, however, is but briefly intimated; it remained for his successor, Professor Böhm-Bawerk, to develop the thought.
On capital Menger does not seem to have fully matured his thought, and certainly had not fully settled his choice of phraseology. It is said that the function of capital is to provide for present needs, and to make possible the devotion of present labor to the satisfaction of future needs; and that "capital" should refer to the stores of goods available for the use of the present and the future, enabling mankind to secure the gain which accrues from an extension of the period of production. This would indicate that the line of thought suggested by Jevons was uppermost in his mind We are told explicitly that the division of goods into those of higher order and of lower order does not coincide with the division between capital and not capital.See the extended footnote in Menger's Grundsätze, pp. 130–131. Many years later, Menger expressed himself again on the meaning of capital, but again with very brief statement of his own views; intimating only that the true conception was to be found rather by the analysis of the various ways in which property was made to yield income, than by a consideration of the intrinsic uses of economic goods.In an article "Zur Theorie des Kapitals" in the Jahrbücher für Nationaloekonomie, Neue Folge, vol. xvii, pp. 1–49 (1888). The article undertakes a critical review of the various conceptions and definitions of capital; repeats what was said in the Grundsätze, that the distinction between capital and other wealth is not the same as the distinction between inchoate and enjoyable wealth and suggests that the way to a solution of the question is by considering" das werbende Vermögen überhaupt," and the "Ertragserscheinungen jeder einzelnen Kategorie des werbenden Vermögens in ihrer Eigenart." This points to a different sort of inquiry and conclusion from that followed in Böhm-Bawerk's Positive Theory of Capital, which was in press when Menger's article appeared. Whether or no his views on this part of theory; if developed in detail, would have much affected the trend of thought, must be uncertain. The question proximately is one of phraseology, and so far not essential. On the crucial question of the relation in time between inchoate wealth and consumable commodities, Menger set forth clearly the important truths.
Finally, this phase of economic theory received its fuller development at the hands of a disciple of the Austrian school who may be fairly ranked with the leader. In 1888 Professor Böhm-Bawerk published the Positive Theory of Capital.The English translation appeared in 1891. Here again, however unmistakable and considerable may be the indebtedness to previous writers, we have the marks of vigorous independent thought; combined, moreover, with a skill in exposition not found in the leader of the school, and conducing not a little to the powerful impression which the volume made on economists the world over.
Much of the analysis of industrial operations which is contained in the Positive Theory of Capital has been accepted in the first part of the present essay; and it will therefore not be necessary to give so full an account as would otherwise be called for. On the other hand, we are not concerned with the refinements of the theory of interest which it aims to establish. That theory must indeed have a bearing, on the causes that determine wages in the end, and on the final outcome of distribution. The essential truths which it involves can be stated in much simpler terms than its author thought well to use; and so stated, would probably be found to involve a less radical departure from familiar ideas than we are told to expect. But as far as the immediate relations between capital and labor are concerned, it is not necessary to follow the ramifications of the reasoning by which the exchange of present goods for future is explained. The mode in which the particular subject of the present inquiry has been dealt with by this brilliant writer is comparatively simple, and can be described in brief terms.
The relation between present labor and present product; the successive stages in production; the yield of consumable commodities as the outcome of a lengthened series of exertions, — all is set forth methodically and in detail, in such manner as to make this part of economic theory henceforth an established and unquestioned possession of the science. The increase in the productiveness of labor with the advance in the arts of civilization is indeed linked perhaps too closely with the lengthening in time of the general process of production. We are told that, as a fact of experience, the greater the length of the period of production, the greater the final outcome in consumable commodities; while yet each prolongation of the period brings a less increment of commodities than that which preceded. This supposed close and regular connection between the period of production and the final yield of enjoyable wealth becomes later an essential postulate of the theory of interest: it being assumed that the extension of the period of production will always increase the final output, yet always increase it in diminishing ratio. It has been elsewhere intimated that we have here an unduly rigid version of the direction which is likely to be followed by progress and invention.See Part I, Chapter I, pp. 9–10. But so far as the relation of present labor to its product is concerned, it is not material whether we admit unreservedly, or qualify carefully, the proposition that the longer the time over which labor is spread, the greater will surely be the final yield. It suffices to have it established once for all that in civilized industry there is always the long interval between labor and fruition.
Next, capital is defined as the "future goods" of the community, — as the wealth not yet available for consumption. This is the community's real capital; whereas its real income consists of the utilities derived from completed consumable things. Whether or no the definition so chosen be found acceptable — and to the present writer, as has already appeared, it seems in its central idea convenient and consistentI say, in its central idea; because there is a difference between Böhm-Bawerk's definition and that adopted in the first part of this volume (see Part I, Chapter II). Those enjoyable commodities which, like dwelling houses, are durable sources of direct satisfaction, are considered by Böhm-Bawerk to be capital, in so far as the utilities which they yield arc available in the future. They are partly present goods, but partly future goods. To my mind, they, or the utilities they yield, are simply income, in so far as no further exertion is needed to bring them to the enjoying person. Consistently with his reasoning, Böhm-Bawerk maintains that these "future goods" yield interest precisely as other future goods, such as machines and materials, yield it. This seems to me doubtful. If there were no other "capital" than durable sources of immediate satisfaction, the phenomenon of interest as we have it in the modem world would probably not emerge. — it has the merit once again of bringing into clear light the real course of production in modern communities, and of getting rid of the difficulties which arise from considering capital in its relations to money wealth or to individual income.
Last among Böhm-Bawerk's contributions to the questions closely connected with the wages fund doctrine, we have the conception of the general subsistence fund. The total possessions of the community are reduced to a common basis by the description of all wealth as available sooner or later for enjoyment or subsistence. Omitting the land and other natural agents, all goods, whether now enjoyable or not, are conceived as serving in due time to satisfy wants. The machine ripens into the consumable commodities which, so long as it lasts, it helps to produce: some of the utilities it yields are thus available at an early date, some not till the distant period when it is finally on the point of being thrown away as old metal. Materials reach the stage of fruition more quickly and evenly. Goods whose more obvious physical manipulation has ceased, and which are awaiting purchase in dealers' hands, are nearly ready and available. All, however, are alike as containing more or less ripened utilities, and serving to provide for the wants of the community over a longer or shorter space in the future. They thus constitute in the aggregate one indistinguishable subsistence fund on which the community draws for the present and future; while present labor can do no more than advance commodities in their due order through the successive steps in production.
This is not an entirely novel conception. Indeed, its author does not present it as such. He remarks that it has some resemblance to the old theory of the wages fund. Like that, it emphasizes the stock of wealth already produced as the source. whence laborers are maintained and rewarded; though with a clearer conception of the nature and function of capital than had been reached by any of the older writers. It is clearly unlike the old view, in that it has regard to the whole period of production, and not to any one season.In noting the points of resemblance and difference between his own theory and that of the wages fund, Böhm-Bawerk summarizes the latter after the manner of Jevons and Cairnes: as containing simply the truism that wages depend on the ratio between the number of laborers and the amount paid them in wages. Positive Theory, Book VII, ch. v, p. 419. The off-hand manner in which the doctrine was often stated by its upholders, may give fair ground for such a version; but, as we have seen, there was more than this in it, and a more substantial resemblance to the doctrine of the Positive Theory than Böhm-Bawerk would imply. On the other hand, it has more than a family resemblance to Ricardo's analysis of capital as a succession of advances to laborers, — a resemblance to which the author does not call attention, hut which is none the less clear. It thus proceeds, in some part, on old lines; with yet a mode of statement of its own, and certainly an important advance in the understanding of the complex course of industrial operations.
The application of this conception to the theory of wages is not fully worked out, and criticism and comment must therefore be tentative. So far as its application to wages as a separate item in distribution is concerned, there is an obvious difficulty in the fact that the general subsistence contains the income not only of laborers, but of the whole community. So much is expressly pointed out by the author himself. It is true that this difficulty is sought to be avoided; but not with signal success. The fund is assumed at first, for the purposes of abstract reasoning, to yield advances to laborers alone. We are promised at a later stage an exposition of the manner in which other shares of distribution will then emerge.Positive Theory, Book VI, ch. v, especially the footnote at p. 320; and Book VII, ch. v. But that exposition is never fully carried out with regard to the subsistence fund. What we find, is that analysis of the exchange of present goods for future, and of the consequent emergence of interest as the inevitable result, which had already been set forth in essentials even before the discussion of the subsistence fund was reached. The causes which determine interest can probably be stated in simpler terms than we find in the elaborate analysis of the superiority of present goods over future, and the equally elaborate attempts to apply to them the psychological theory of value. In any case, these refinements go but a very little way toward explaining just how the total subsistence fund and its ripening instalments are diverted to one and another class in the community. No doubt, for the explanation of the fundamental forces which shape distribution, a sound theory of interest is essential. This, however, even supposing it to have been reached by our author, does not suffice for the purposes of that investigation of the machinery of distribution which is the essential part of the wages fund problem.
But, to repeat, the conception of the subsistence fund is advanced briefly by Böhm-Bawerk, and its application to the direct questions of wages is avowedly not completed. Criticism is therefore both difficult and likely to be unjust. No attempt is made to consider the concrete mode in which the fund reaches laborers. Still less is any attempt made to consider separately the special case the great and preponderating class of hired laborers, and the dealings with them on the one hand, and with the idle investor on the other hand, of the active manager of industry. Such a more detailed and concrete examination of the machinery of distribution is an essential part of the discussion ·of the wages fund question and all that hangs thereby.
We must be content, therefore, to accept as it stands the contribution which Böhm-Bawerk has made to the general position of the laborer in relation to past and present product. So far as he goes in his treatment of the relation in which the real reward of laborers stands to the capital and the total possessions of the community, it would be difficult to find a flaw in the analysis. The marshalling of the possessions of the social body; the mode in which these constitute a stock available for the needs of the present and the nearer future; the advance of present supplies to laborers who produce for future needs; the diversion of part of the inflowing real income to other classes than laborers; the determination of the share that goes to laborers by the play of motives among those who own the existing stock, — on these topics economic theory will gam by following the main trend of the exposition which has finally resulted from the labors of the Austrian school. It is not all new; but it is freshly and luminously stated; and it is deserving of all praise.
The subject of the present volume is the wages-fund doctrine and the immediate relation of capital to wages. To discuss adequately this topic it will not be necessary to consider every part of the theory of wages or of capital; yet some parts of the economic field will need to be traversed that may seem at first sight to lie beyond the limits chosen. More particularly, it will be necessary to begin with some description at large of the process of production, and of the manner in which the exertions of men yield them an enjoyable result. In the active controversy on the wages-fund doctrine which has been going on during the last quarter of a century, the question has gradually come more and more into the foreground whether wages come from the current product of labor or from a past product. This fundamental question must be disposed of before any real advance toward the truth of the matter can be accomplished.
In large part we are here on familiar ground, and might pass over it quickly and lightly. Yet the question is so important, and its bearing on the wages-fund controversy so vital, that no pains should be spared to set it in a clear light. The inquiry will therefore begin, in the present chapter, by considering with care and in detail what is the relation between the laborer's immediate exertions, the laborer's immediate product, and the laborer's immediate reward: between the work of to-day, the output of to-day, and the pay of to-day.
The work of to-day and the output of to-day go together. Taking a survey of the varied activity of a great civilized community, let us see what the laborers now do and what they now produce. Evidently the most diverse things. Some laborers are at work in mines digging out ore and coal. Others are at work conveying coal and ore, which had been brought out days or weeks before, to the spot where they are to be used. Others, again, at that spot are engaged in converting materials of still earlier extraction into pig iron. Elsewhere, men are at work fashioning tools and machinery from iron and steel; or using the tools or machinery for spinning or weaving; or making up cloth into garments wherewith to protect us from cold and wet, and to satisfy our vanity or caprice. Or, to take another phase of production: at the moment when some laborers are at work digging out ore and coal, and others are transforming ore and coal of earlier extraction into iron, trees are felled at one spot, timber hewn and sawed and fashioned at another; ploughs are made of wood and iron, fields are tilled, grain is in process of transportation from granary to mill, other grain is ground into flour, flour is carried to the bakery, —bread, finally, is baked and sold.
We naturally picture the various sorts of productive effort, as they have just been sketched, as taking place in succession: the ore is first dug, the ploughs then made, the field next tilled, the bread comes at the end. In fact, looking at the work and the output of to-day, these operations are all taking place simultaneously. If we follow the history of a loaf of bread or a suit of clothes, we find them to be the outcome of a succession of efforts, stretching back a considerable time in the past. But if we take a section, so to speak, of what the world is now doing and now getting, we find that at any one moment all these various sorts of work are being done together, and all the various forms of wealth, from ore to bread, are being made simultaneously.
It was suggested long ago that production can be best described as the creation of utilities. Human effort cannot add or subtract an atom of the matter of the universe. It can only shift and move matter so as to make it serve man's wants, — make it useful, or create utilities in it. Matter reaches the stage of complete utility when it is directly available for satisfying our wants; when it is bread that we can eat, clothes that we can wear, houses from which we can secure shelter and enjoyment. The object of ail production is to bring matter to this stage; or, to be more accurate, to yield utilities, whether embodied in matter or not, which give immediate satisfaction. But a great part of our wealth — indeed much the greater part of it — consists of things which are but partly advanced toward the final satisfaction of our wants. Consider the enormous quantities of commodities which are bought and sold, and which constitute huge items in the wealth of the community, in the form of plant and materials: coal and iron and steel, wool and cotton and grain, factories and warehouses, railways and ships, and ail the infinite apparatus of production that exists in the civilized countries of our day. All this is inchoate wealth. It serves as yet not to satisfy a single human want. It is not good to eat, nor pleasant to wear, nor agreeable to look on, nor in any way a direct source of enjoyment; unless, indeed, we make exceptions of the kind that prove the rule, for the cases where ships and railways are used for pleasure journeys, cotton soothes a burn, and grain yields the pleasure of feeding a household pet. Virtually, all the utilities embodied in such commodities are inchoate. These things, or others made by their aid, will in the future bring enjoyment; but for the present they satisfy no need and yield no pleasure. We are so habituated to the régime of exchange and sale, and to the continuous disposal of these forms of wealth by their owners for cash wherewith anything and everything can be bought, that we think of them ordinarily in terms of money value, and reckon them as equivalent to the possession of so much completed and enjoyable wealth. But, obviously, for the community as a whole, there is on hand at any given time a great mass of inchoate wealth which as yet can satisfy no want. And, at any given time, a great part of the labor of the community is devoted to making inchoate wealth, of which no part is directly of use or pleasure to any human being.
On the other hand, part of the labor of to-day is given to the close and immediate satisfaction of our wants. The baker bakes bread, the tailor makes clothes. The shopkeeper sells us things necessary or convenient or agreeable, and so brings them to the point where they finally meet our desires. The servant waits on our needs or contributes to our ease. In a multitude of directions it is the housewife through whom the last stage toward satisfaction is reached. Her labors have been celebrated less by economists than by poets; yet they play a very large part in that final activity through which a long series of past efforts is at last brought to fruition.
Compare now for a moment these two things: on the one hand, that part of the work of to-day which is given to inchoate wealth or uncompleted utilities; on the other hand, that part which serves directly to give satisfaction. Clearly the former is much the larger in volume. It must be remembered that commodities serve to give real satisfaction only when they reach the hands of those who use and enjoy them. That iron and stone, factories and furnaces, raw wool and cotton, grain in the bin, are not available for use or consumption, is obvious enough. It is equally certain, though not so obvious, that flour and cloths and boots are no more available, when simply carried to the stage of completion in the mill or factory. To reach the consumer, they must first pass through the hands of one or two carriers and two or three sets of middlemen, whose labors form part of the operation of production quite as much as those of the tillers of the soil and the workers in the factories. It is hardly worthwhile to lay down any hard-and-fast line in matters of this sort, or to try to define with precision where the very last step comes which brings completion of the products, and so satisfaction to the body of consumers. Ordinarily this stage would not be reached until the goods had been disposed of to purchasers by the retail dealer. While in the shopkeeper's hands, arranged by him and cared for by him, kept and stored in supply large enough and varied enough to meet regular and irregular demands, they are still to be considered as possessing only inchoate utility. Under the conditions of a complicated division of labor, those workers whom in common speech we call producers, as distinguished from the merchants and traders, advance matters a step nearer the end, but usually bring nothing to fruition. The small producer who deals directly with the consumer has not indeed disappeared; but in the communities of advanced civilization the consumer satisfies most of his wants by going to a shop where he finds commodities that have left the factory weeks or months before. The stores of goods that are accumulated in the warehouses of merchants, both of the large dealers and the petty tradesmen, are still on their way to completion, and still form part of the great mass of inchoate wealth. And, to repeat, this mass of inchoate wealth, in any moment, forms much the largest part of the possessions of the community.
It follows that most of the work which is being done at a given moment is work of no immediate service to any one. A few laborers are engaged in putting the finishing touches to commodities on which a complicated series of other laborers have been at work for years, or even decades, in the past. These few alone work to supply our immediate wants. The great mass of workers are engaged in producing tools, materials, railways, factories, goods finished but not yet in the place where the consumer can procure them — inchoate wealth of all sorts.
All this is part of the division of labor; it is, in fact, the most important form of the division of labor. While a few men put the finishing touches, the great mass are busy with preparatory work which is parcelled out among them in an infinity of trades and occupations. It is conceivable that some such apportionment of labor might have developed without a corresponding division of the different stages among different individuals. The same man might first mine the ore, then smelt it, then fashion his tool, then use it, and finally make his own clothing or secure his own food. But historically, the process by which so preponderant a part of the labor going on at any one moment has been devoted to preparatory work or inchoate wealth, has been accompanied by a corresponding growth and diversification of the division of labor. It may serve to make our subject clearer if we consider it for a moment in this aspect.
The division of labor may be classified, for the present purpose, as of two sorts, contemporaneous and successive. We may designate as contemporaneous that division by which one man does all the work of getting the food, another all that of making the clothes, a third all that of providing shelter, and so on; each carrying out all the steps, from beginning to end, involved in the production of his particular commodity. Under such an arrangement each worker would become expert in his trade and would work at it uninterruptedly. It is conceivable that in a primitive community, where all work was devoted to securing a finished commodity at short order, and few steps intervened between the beginning and the end of production, the productiveness of labor might be considerably increased by such a division of it. But vastly more important in the history of the arts and of civilization is that division which involves a separation of successive related acts — the division in which various steps in production are carried on, one after another, by different hands, and through which each commodity becomes the product of the complex and combined labors of a great number of men.This distinction is effectively brought out in Menger's Grundsätze der Volkswirthsaftslehre, chapter i, § 5. Compare what is said below, Part II, Chapter XIV of the services of the Austrian writers in this part of economic analysis. A set of porters, making a profession of carrying packs, develop their muscles and wind to an extraordinary degree, and become capable of carrying those heavy burdens which astonish the traveller in backward countries. Yet their achievements are as nothing compared with those of the successive divisions of labor. When one set of men attend to the making of roads, another to the rearing of horses, another to the procuring of iron and timber, others to wheels, wagons, harness, — we get in the end, through transportation by wheeled vehicles, an enormous diminution in the labor required for a given result. The contrast is still more striking if we consider the successive division of labor in the last form to which the art of transportation has been carried in the present century. The operations extending over a series of years for cuttings, embankments, tunnels, bridges, not to mention the tools for these, which engaged the energies of a still earlier series of workers; the making of iron and steel, of engines and cars, of the endless variety of railway apparatus, — all finally bring that extraordinary cheapening of transportation which has so completely revolutionized the industry of modern times. To find out how much labor has been given under these methods to any one wagon load or any one car load, we should need to consider, in due measure, all the successive steps. We should need to assign some slight fraction of the labor given to the making of the wagon-road or roadbed of the railway; a fraction, less small, of the labor for making the wagons, or the cars and engines; the whole of the labor of those, like the drivers of the horses or the trainmen of the railway, who are engaged immediately in transportation. To carry out directly a calculation of the labor involved in the carriage of a single ton or wagon load would be impossible; but an infallible test, — the price at which the service can be rendered, — shows how enormously more effective is the more extended and complicated mode of doing the work.
It would be difficult to find an historical example of the bare and uncomplicated use of the contemporaneous division of labor. The earliest form doubtless was more or less of the successive sort, and the two have developed hand in hand with the progress of the arts. The contrast between the primitive porter and the railway is obviously a contrast not between the contemporaneous and the successive division of labor, but between two phases of the successive division. The transporting of goods means only that materials are carried to those who are to manipulate them, or tools to those who are to use them, or enjoyable goods to those who are to consume them or sell them to consumers. It means but one step, — sometimes an early step, sometimes a late one, — in the successive division of labor. But it illustrates the contrast between shorter and longer ways of attaining a given end, and the mode in which the progress of invention has caused a long stretch of time to elapse between the first step and the last toward the satisfaction of human wants.
So overpoweringly great have been the results of the successive division of labor, that it is natural to think of its extension as a cause, or at least as a necessary incident, in the increase of the powers of mankind and the abundance of enjoyable goods. In a great number of striking cases we see the progress of the arts taking a direction similar to that which has just been sketched as to the art of transportation. The spinning wheel and the hand loom, easily and simply made, have given way to the jenny and the mule and the power loom, fixed in a great building, and moved by complicated machinery; all involving a longer stage of preparatory effort, and yielding the enjoyable commodity in the end on easier terms. Savages grind corn by rubbing it between two heavy stones which nature happens to have provided in something like the needed shape. The grist mill, with its hewn stones and its simple machinery, serving its own limited neighborhood, represents a considerable extension in time of the productive process, and a great increase in its efficiency. The modern steam mill, with its huge plant, its warehouses and machinery, with the enormous apparatus of railways and steamers for bringing the grain from the four quarters of the globe and transporting the flour to distant consumers, carries both consequences still further. Hence it has been laid down as a general proposition, by one of the ablest and most ingenious writers of our own day, that every increase in the efficiency of labor brings with it an extension in time of the process of production.Professor Böhm-Bawerk's brilliant analysis, in the opening chapters of the PositiveTheory of Capital, has done more than any other single discussion to emphasize the significance of the lengthened period of production. It is due to this able thinker to note that he describes in these chapters the connection between the extension of production over time and its increasing efficiency as a simple fact of experience, not as part of the nature of things; but in the corollaries drawn from the proposition in his later reasoning it is treated as if universally true. Compare, how ever, what he has said, in reply to some American critics, in the Quarterly Journal of Economic, for January, 1896. But it may be questioned whether anything like a connection of cause and effect can be traced, or anything more than a fact of usual experience found. In the past, those inventions and discoveries which have most served to put the powers of nature at human disposal have indeed often taken the form of greater and more elaborate preparatory effort. The railway, the steamship, the textile mill, the steel works, the gas works and electric plant, — in all these, invention has followed the same general direction. But that it will do so in the future, or has always done so in the past, can by no means be laid down as an unfailing rule. The railway, the telegraph, and the telephone, have served to shorten many steps in production; and elaborate machines, though it takes time to make them, do their work, once made, more quickly than simpler tools. Invention in the future may dispense with steps now thought indispensable; or it may enable elaborate plants to be dispensed with, as would be the case if the success of flying machines made the costly roadbed of the railway unnecessary. It would be rash to say that the productive process, under the successive division of labor, is likely to be either lengthened or shortened; for the ferment in the world of invention, and the glimpses of new processes in almost every direction, make either outcome possible. But it is in the highest degree improbable that any changes the future may bring will affect that feature of the industrial situation which is important for the subject here under discussion. Under any methods of production, considerable quantities of materials will be provided in advance, tools will be made with much labor, and consumable commodities will be brought to completion at the end of long stages of productive effort.
The beginning and the end of the process of production have been just spoken of; but clearly these are limits more easily described in general terms than fixed with precision in a particular case. The end of the process of production is indeed not difficult to fix. It comes when enjoyment begins, when the consumer gets the wherewithal to feed, to clothe, to shelter himself, to minister to his satisfaction or pleasure in any way. Ordinarily this stage comes, as to tangible goods, when they pass from the shelf of the retail dealer into the hands of the purchaser. But it is by no means easy to put the finger on the point where the process of production has its beginning. Bread is made from flour, and flour from grain; the sowing of the seed is our starting point in the process of production; but seed was grown a season before, and comes from an earlier stage of effort. The plough, too, was provided before the seed was sown, and that plough was made with tools which came from still an earlier application of labour. The mill in which the grain was ground into flour was erected years before, and the railway which carried the grain to the mill stands for another previous application of labour. Where shall we say that the process of production begins? If we would be mathematically accurate, we should need to carry it ages back, to the time when the first tool was made; for tools are made with tools, and each is in some infinitesimal part the result of labor applied to its predecessor of a thousand years ago. For practical purposes, to be sure, we can in large part dismiss this consideration. The labor given fifty years ago to smelting iron that was made into tools, which again served to make other tools, is so infinitesimal a part of the labor involved in producing the consumable commodities of the present, that we may say, De minimis non curat lex. But the complications of the labor of the present and of the immediate past are no less puzzling. The carpenter works one day at the frame of a steel mill, which will turn out steel beams to be used in buildings or ships; years may elapse before the first completed commodity emerges. The next day he makes a piece of furniture, or, rather, does his share in the making of it, — which conduces to the comfort of a householder within a week. The railway carries ore which represents a very early stage in the process of production; it carries wool, which may be made into a coat and may warm its wearer within three months; and passengers who at the moment are enjoying a pleasure jaunt. To measure exactly where the labor which builds and operates a railway stands in the process of production is practically impossible.
Hence it is practically impossible to measure how long the average process of production is,-to say how long an interval has elapsed between the time when all the consumable commodities now available were begun and the time when they were completed. We can, indeed, conceive of the meaning of such an average. We can say that the labor of the domestic servant issues in enjoyment very quickly; that of the operative in a woollen mill, after a few weeks or months; that of the farmer, after a year; that of the ship carpenter or steel worker, after years or even decades. If we could take the balance of short processes and long processes, we should ascertain how long, on the average, it had taken to make our present enjoyable possessions. We can even do more than picture to ourselves this possible grouping and offsetting of the various processes. We can say, from general observation, that the tendency of invention has been to lengthen the average. The process of production, as a whole, has probably tended to become longer; and if invention follows the same lines in the future as in the past, the process, on the average, will become still longer. But it is impossible to say how long it now is, whether two years or five or ten. The complications of the case make any statement in figures out of the question. When we consider the immediate history of the most common sources of satisfaction,-food, clothes, shelter; and reflect how long a time has elapsed, even after the needed tools were on hand, since the grain and cotton were sown, the sheep raised for the wool, and the cattle for the leather, the bricks made, the trees felled, — we may be sure that the average period of production must be stated in terms of years. And this vague conclusion, unsatisfactory as it would be for statistical purposes, is sufficient for the purpose now in hand. It is clear that production is spread over a period of years; and it is clear that the greater part of present labor is given to production at stages preceding by a longer or shorter interval the attainment of the enjoyable result.
Before leaving this subject one further circumstance may be noted in regard to the length of time over which, under the modern division of labor, the operations of production extend. One part of the period, the last of all, is perhaps susceptible of measurement. To repeat what has already been said, the work of the merchant and trader is as fully productive as that of the artisan and carrier. Each does his share toward bringing commodities to the stage where enjoyment finally begins. It would doubtless be possible to ascertain how long the last stage endures; to find how long a period elapses, on the average, between the moment when goods pass from the hands of the manufacturer and artisan into the hands of the dealer, and that at which they pass from the last dealer into the hands of the consumer. The great mass of commodities pass through the hands of two or three middlemen; they go first to the wholesale dealer or agent, then to the jobber, finally to the retailer. Each of these keeps them a space. Barring perishable commodities, like meats and vegetables, a turn-over of more than six or eight times in the year is unusual; as to many articles, one of three or four times a year is common. The inference is plain. Months elapse, on the average, between the time when goods are finished, in the everyday sense of the word, and the time when they reach that stage of enjoyment which is the real aim and end of all effort.
So much as to the first part of the inquiry undertaken in the present chapter, — the relation between the work of to-day and the output of to-day; an inquiry which has proved to involve some consideration of the work of yesterday as well. Whether as to the work now being done, or the work which yields the consumable goods now available, we have the same result. The work of to-day is applied preponderantly to inchoate wealth, to preparatory stages in production; and the output of to-day consists mainly of goods not yet in enjoyable form. Most of the labor being done at the present moment will bring consumable goods at some time in the future; while the consumable goods now available are mainly the product of past labor. The whole process of production is extended over a period not, indeed, to be measured with accuracy, yet certainly to be stated in terms of years.
We may turn now to the second part of the inquiry: what is the pay of to-day?
The answer here is simple, and could be given in the briefest terms. The immediate reward for the exertion of labor consists of completed and enjoyable commodities. Food, clothing, shelter, things that satisfy our needs and our desires, — these are the pay of to-day. The laborer's bread and meat, his tobacco and his whiskey, his house and his clothes, things that may do him good or harm, but are at all events desired by him, constitute the reward he now gets.
This is so simple that it would seem not to need another word of explanation. Yet on the subject of wages, as on many others in economics, it is the failure to bear in mind very simple and obvious facts that most frequently causes error. In discussions of wages, of the source whence they are paid and the factors that affect their amount, nothing has been more common than to consider only the machinery by which laborers are enabled to get their real wages. The cash paid them by an employer, or received by them in direct pay for their product, has been mainly thought of. The obvious distinction between real wages and money wages makes its appearance in every book on the elements of economics, but it is too often forgotten when the causes determining wages come to be examined. When a question arises as to the relation between the laborer's output and his pay, it is common to speak of his product and of his pay in terms of money. When it is asked whether the laborer is paid out of capital or out of product, the first impulse is to think of capital as money funds in the hands of the employer and of product as the money value of what is being turned out. In answer to the proposition, attributed more or less justly to the older English economists, that laborers get their wages from a rigidly predetermined source, it is often said that the wages which employers can pay may be increased by quicker sales or by the use of credit, — which obviously refers to money wages. The inquiry as to the direct relation between laborers and employers, and as to that first step in the apportionment of wages which comes through money payments from one to the other, is important and fruitful, as will elsewhere appear. But on the crucial question of the cause pf general high wages in the sense of general real prosperity among laborers, it leads only to confusion. If we would learn what makes wages high, in the sense which is mainly important for the workmen as a class and for the community as a whole, we must bear in mind that real wages alone are to be thought of,-things consumable and enjoyable.
What is true of the laborers is true of all classes in the community. All, whether idlers or workers, get their real reward from the same source — the completed commodities which satisfy human wants. These, as they appear in recurrent supply, form the net income of the community. Whether there can be any possibility of separation of this net income into parts destined for any one set of persons, or appropriated to them; whether one part of the available supply can be said to constitute a wages fund, another a profit fund, a third an interest fund, a fourth a rent fund, — these are questions that will engage our attention at a later stage. Here we may content ourselves with the simple and unquestionable proposition, that all real income of any sort comes in the form not of money, but of goods and wares that minister to our wants.
Still further to emphasize this elementary yet all-important proposition, we may consider for a moment where we should find, in any given community, this immediate reward of the laborer. It must proceed chiefly from the stocks in the hands of the retail dealers. Their wares are in the last stage which production goes through, and are on the point of ripening into full completion. A good part of wages, no doubt, must come from elsewhere. House shelter, partly a necessity and partly a source of comfort and luxury, is ordinarily already on hand, needing no further labor toward complete fruition than occasional repairs. If owned by another person, as is commonly the case with the house occupied by the hired laborer, that person is in possession of the source whence so much of real wages is derived. If the laborer owns his own house, he spends the money received for present labor in other ways. The shelter and comforts of the house he owns form no part of his real reward for the work of to-day; they are the reward of past labor, or past claims or rights of some sort, and no more form part of his pay for present work than the enjoyments which the idle rich buy with their money incomes form reward for any present exertion. His wages for present exertion are what he buys with the cash which, under a money regime, he receives for the day's or week's work; and questions as to the sources of his real wages, their limits, their flexibility or predetermination, are questions as to limits and determinateness of the stocks or forthcoming supplies of goods now chiefly in the hands of shopkeepers, which he will buy with his money wages.
We are now in a position to give an answer to one part of the question with which this chapter opened: whether wages are or are not paid from present or current product. The answer to the other part of the question, — whether or not they are paid from capital, — must still be postponed, requiring, as it does, some further consideration of the definition and function of capital. But wages are certainly not paid from the product of present labor; they are paid from the product of past labor. Present labor produces chiefly unfinished things; but the reward of present labor is finished things. Real wages are, virtually to their full extent, the product of past labor. At this moment, or within a few days, the last touches toward completion have indeed been given to the commodities now being enjoyed. But the great bulk of the labor whose product all of us, whether laborers or idlers, now enjoy, was done in the past.
This fact is obscured, in our everyday thought, in two ways: we think of the product in terms of money, and we think of the laborer who gives the finishing touches in production as the "maker" of the article. When we want to compare the amount which a laborer produces with the amount which he receives, the simplest and most obvious way is to compare the money value of the two: a method the more tempting because for many purposes, not least for the business ends of the individual employer, it is all-sufficient. Thus we think of product and wages as similar things, and of product as preceding wages; forgetting that in concrete reality they are different things, and that present real wages must be on hand long before present product is completed. On the other hand, the baker is said to make bread, the tailor to make clothes, the carpenter to make furniture; though, with the inconsistency characteristic of that early stage of classification which is crystallized in common speech, we never speak of the merchant or shopkeeper as "making" anything. In fact, the baker and the tailor do no more than their small shares in the making of bread and clothes; a long series of farmers and wool-growers, manufacturers, merchants, and carriers constitute with them the complete chain of the producers of the articles.
There is a sense, it is true, in which we may speak with accuracy of wages as coming from current product; and it is one which deserves attention, because it brings out the relation between some older speculations on wages and capital and the more recent turn of the discussion.
The classic economists were in the habit of speaking of the commodities consumed by laborers as a fund or stock, described in a way that implied a great store on hand, ready and available at once, likely to be replaced after a season by another similar store. This, at least, as their practice when they described the wages fund as a concrete thing, made up of commodities which would yield real wages. Too often they spoke and thought of funds and capital in the money sense, and of wages as coming from the employing capitalists' money means, thereby introducing a confusion which runs through almost the whole of the century's literature on the subject. Ricardo, however, and the abler of Ricardo's followers, usually kept to the first conception, of a wages fund made up of commodities, not of money. In the Ricardian system, again, wages were measured in terms of food, and especially of grain or corn; and the wages fund consisted of a stock of food. For shortness of reasoning and of statement (too often with the result of confusion in both) this stock was reasoned about as if it were owned by the immediate employers and handed over by them directly to laborers who ate it. The miller and the baker were put aside; and, what was more dangerous to accurate thought, it was assumed for brevity that the capitalists who employed the laborers were the individuals who owned the grain. The source of wages was then easily conceived as a fund stored up, all ready for use, controlled by employers, limited in amount for the time being, and entirely the product of past labor. The seasonal harvesting of the crops made it impossible this year to procure more than had been sown and harvested; and the real wages fund had nothing to do with current work and product.
The error of this view is one of degree rather than of kind, of insufficiency rather than of inaccuracy. It is no grievous departure from literal truth if we speak of grain as consumable by laborers, omitting for brevity, the operations of transporting and grinding and baking it. And we may perhaps fairly think of the grain on hand this season as fixed in amount, incapable of being increased or diminished. Doubtless there are here some elastic limits: a heavy crop may be carried over in part to another season, and a lean one consumed at once to the last bushel m anticipation of better times soon to come. This sort of averaging of the yield certainly could take place under modern methods of storage and preservation, and may have taken place even in the days when Ricardo wrote. It is more important to correct the older view in other directions. Food is not the only article consumed by laborers; none of the various commodities that make real wages, not even breadstuffs, exist in the shape of accumulated stores of finished goods. Further, the capitalists who directly employ laborers have usually no ownership of the commodities which make real wages. If these real wages come from capital, the capital is certainly not in the hands of the employers.
Considering both of the last-mentioned facts in the situation, — the variety of the commodities which go to make real wages, and the widely distributed ownership of these tangible commodities, — we reach the conception of a flow rather than a fund of real wages. The community possesses at any given moment a quantity of goods in all stages of completion: some just begun, some half finished, some very nearly or quite finished. The last touches are being given at every moment; enjoyable commodities each day are consumed, new commodities advance each day to take their place. We have no great stores of completely finished goods, but, as Professor Marshall has happily said, a steady flow of accruing real income.
No doubt the old conception of a fund fits the facts of the case in some regards quite as accurately as the new one of a flow. The distinguished Austrian writer who has contributed so much to the clearer understanding of this part of the machinery of production, has suggested that all the possessions of the community may be reduced to an equivalent in terms of subsistence or other finished goods. What he calls the general subsistence fund is made up of all wealth whatsoever, — machines, materials, completed goods. Its volume may be measured by ascertaining how much labor is embodied in this sum total of wealth, and how long the wealth, completed and enjoyable, which so much labor could produce, would continue to satisfy the wants of the community at its habitual rate of consumption. In this sense we may say that the community owns at any given time a subsistence fund for, say, five years; meaning not that there are stores of finished goods which will last five years, but that the wealth on hand has embodied in it five years of the community's labor, and, simply carried to completion without the initiation of a stroke of new work, would last for a long period.As to the relation between the amount of the subsistence fund, measured by the quantity of labor embodied in it, and the number of years over which it may enable production on the average to be spread, see the Positive Theory of Capital, book vi, chapter v, and the appendix at the close of that volume. The refinements of this calculation, however, are not likely to lead to results useful for the explanation of concrete phenomena, and at nil events are not important for the purpose of the discussion in the text. Here we have a statement of the case, useful for some purposes, which looks to a fund rather than to a flow. And from still another point of view the conception of a fund has its justification. The stock of available finished commodities, if a flow, is affected in its volume by sources which possess some of the characteristics of a reservoir or fund. The number of loaves that can be put forth from day to day depends on the season's stock of grain; that of clothes, on the wool and the sheep on hand, and on the machinery available for manipulating the materials; that of boots, on the hides and the cattle and the available machinery. — How far the volume of consumable goods now obtainable is limited by such conditions; how far determined once for all by the materials and tools of past making; how far capable of enlargement or diminution by changes in the labor of the moment, — these are questions which may engage our attention at a later stage. For the present it is necessary only to get a clear conception of the sense in which there is on hand at any given time a supply or stock of finished goods for the consumption of laborers and others. It is a flow of finished goods from goods partly finished, constantly wasting away and constantly renewed; greatly affected, perhaps determined once for all, by the mode in which past labor has been given to tools and materials; yet certainly not without some degree of flexibility at any given moment, and certainly not an accumulated or rigid fund.
We can see now in what sense it is true that wages, — or any other form of income, for that matter, — are paid out of current product. The goods which laborers get, or, to be literally accurate, the goods which they buy with their money wages, in a sense are made from day to day; they are current product in the sense that the last touches are given them from day to day. Something of this sort has doubtless been in the minds of the writers who have maintained that wages are derived from present or current product. Unquestionably a confusion between real wages and money wages has also had its share in the adoption of their view. Current money wages obviously do come largely from the money value of the present product, and the proposition that wages are paid from the current yield of industry in this sense is as undeniable as it is immaterial so far as the source of real wages is concerned.
We may now summarize the results of this chapter by a graphic representation of the course of production and enjoyment in a modern community. A diagram showing the relation between the work of to-day, the output of to-day, and the pay of to-day may be constructed thus: let A represent the workers who stand in the earliest stage of production, say the miners and lumbermen; let B represent those in the next stage, say the makers of pig iron and of sawed timber; let C designate those who carry on operations in the next stage toward completion; D, those in the next; and E, finally, those who give the finishing touches and bring to market a consumable commodity. The same letters may indicate the products turned out by the different producers, A standing for the iron ore, and E for the bread and meat. A, B, C, D, E may represent the workers and their output in a first year; A., B., C., in a second year; and so on. We could then array the operations of a series of years in this fashion:
In each year all the various operations are going on simultaneously. A, B, C, D, E are at work on their separate tasks, and are turning out all shades of products, from the crudest material to the ripened commodity. In successive years the A's and the E's continue alike to repeat their work: the miners remain in the mine, the shopkeepers serve their customers in the shops. In any one year the community, while producing all the products A, B, C, D, E, has at its disposal only the commodities E. These alone are consumable and enjoyable; these alone can constitute real wages or real profits or real income of any sort. In the year 1890 E would be available; in 1892, E2. The question whether wages in 1894, which must come out of E4, are the product from past or present labor, can be answered by inquiring what labor produces the E commodities of any one year; say E4 of 1894. If we suppose present labor, then E4 will be the product of the work indicated by the horizontal line A4, B4, C4, D4, E4. If past labor, or chiefly past labor, then E4 will be the product of the work indicated by the diagonal line A, B1, C2, D3, E4. It needs no argument to show that the workers E4 can not be completing the material which A4 are bringing forth at the same time. Each stage in the successive division of labor requires time. E4 must be at work on products which came from D of an earlier period, say the D3 of 1893; D3 got them, partly advanced toward completion, from C2 of 1892; the first steps were taken five years ago by A of 1890. The diagonal line marks the labor which yields the enjoyable commodities of 1895 — labor mainly of the past, and only in small part of the present.
It hardly needs to be explained again that a simple scheme of this sort is far from corresponding to the complexities of real life. The earliest and the latest stages of production are so interwoven that any brief statement or simple diagram can give no more than a crude and inaccurate picture. The commodities which we have typified in the E's, and which are represented as lately finished, after having gone through a regular series of previous operations, are sometimes made very largely with recent labor, sometimes very largely with past labor. Personal or domestic service is an important source of enjoyment; as productive of satisfaction, and therefore of wealth in the important sense, as the labor that makes bread and wine. Here exertion and satisfaction are coincident; there is no chain of successive producers. On the other hand, the shelter and comfort which are now yielded by a dwelling are in greatly preponderant proportion due to labor exerted in varying stages of progression in the past. And at the other end of the scale, commodities in the early stages of unripeness may reach fruition by a longer or shorter route. Pig iron may be made into a stove and may serve to diffuse grateful warmth within a month; or it may be made into a machine which will be used in making another machine, and may not issue in a consumable commodity for years. Any scheme, or diagram, or classification of the stages in production must have a rigid and arbitrary character, and can not conform to the endless complexities of the living industrial world. Nonetheless, it may bring into distinct relief the general truth which underlies all the variety of detail, — that production proceeds by successive stages, and that the community at present is supplied with necessaries and comforts made mainly by the labor of the past.
The fact that present labor gets its substantial reward from a product made chiefly by past labor was the basis of the reasoning of the classic economists. The products of the past which served to support and remunerate laborers they called capital. They inferred — indeed, assumed as a thing so obvious as hardly to need inference — that wages were paid from capital. In the second part of the present volume we shall have occasion to note how briefly and inadequately they presented this cardinal proposition. Here we shall proceed at once to consider how far it is sound; how far the products of the past are to be called capital, and how far the proposition that labor gets its reward from past product is equivalent to the proposition that wages are paid from capital.
The question of phraseology and definition, which we are thus compelled to face, is from one point of view indifferent, from another very material. From the first point of view any definition can be made to serve, provided it is used consistently. The term capital can be used in any desired sense, if only it be always remembered precisely what it is to connote. Thus a writer may freely use the term capital in a sense different from that of the older economists; only, if thereupon he should deny that wages are paid from capital, he would not squarely meet the question presented in the traditional theorem.A neat example of this sort of procedure is furnished by Mr. Henry George in Progress and Poverty, who gives a meaning of his own to capital, and then denies with vigor that wages are paid from capital. The fact that his own definition of capital, when carefully considered, is not so different as it purports to be from the traditional one, does not redeem the operation. Compare what is said below of George's position in the wages controversy (Part II, Chapter XIV). Yet — and here is the other point of view — something more than simple consistency is involved in the choice of phraseology. The object of definition and of classification is not fully achieved if we fail to group together under one head things that are alike, and to distinguish by different terms things that are unlike. One sort of labor, for example, maybe designated as productive, and another sort as unproductive; the distinction has its solid justification only if it appears in due course that some propositions hold good of the one sort which do not hold good of the other. The difficulty with the much-disputed terminology which Adam Smith and his successors adopted in their use of the phrase “productive labor" was of precisely this sort; it did not and could not point to substantial differences in regard to that satisfaction of human wants which is the object of all labor. And, to come closer to the present subject, one form of wealth may be called capital while another may be called non-capital; no logical difficulty will result if the terms are always used in the same sense. But the object in view, an understanding of the phenomena of wealth, — will not be effectually achieved unless we succeed in grouping under each term things that are alike, and as to which the same propositions hold good.
The mode in which these simple general principles bear on the subject in hand can be best illustrated by sketching the historical development of the conception of capital. Adam Smith, with whom the whole modern discussion begins, defined it as the wealth which yielded a revenue to its owner. This definition had a vogue for a while, and has not been without its adherents in our own time; and for some purposes it may still be used with advantage. To the individual, capital is that which he uses not for the immediate satisfaction of his own wants, but for securing in the future a revenue wherewith to satisfy them; whether the capital be in the form of ships and warehouses, materials or goods in stock, cash ready for investment or a dwelling let to a tenant. But for the community as a whole, and with regard to the mode in which different sorts of wealth bear on general prosperity, such a distinction is far from satisfactory. The dwelling owned by A and let to B is capital, under Adam Smith's definition; but if bought and occupied by B it ceases, under the same definition, to be capital.Compare, however, what is said below, in Part II, Chapter VII, page 147, of the manner in which Adam Smith qualified his definition in regard to these forms of durable wealth. The place which it has among the possessions of the community does not change by its sale and transfer; it still forms part of the apparatus for shelter and enjoyment. Again: the horses and carriages of the stable-keeper would be capital, in Adam Smith's sense, since he uses them as a means of securing revenue; but the equipages maintained by those rich enough to own such a luxury for themselves would not be capital. Here, too, both forms of wealth clearly belong together, so far as their position and effect in the welfare of the community are concerned. Since the causes that affect the prosperity of the community, and not those that affect the prosperity of the individual, primarily come within the scope of economic science, it is inadvisable to use a definition which, like Adam Smith's, gives different names to things that have the same relation to the general welfare.
The next generation of the classic writers, under the lead of Ricardo, did not usually fall into the error of considering economic phenomena from the point of view of the individual rather than of the community. Indeed, their greatest errors often arose from an excess in the other direction: they regarded things so much in the mass that they neglected many important details. So far as capital was concerned, they gave up Adam Smith's definition, and substituted one in more general terms: capital was the wealth used for the production of further wealth. What was to be included under capital was explained more explicitly by the retention of the division of capital into fixed and circulating. Adam Smith first applied this distinction and the words for indicating it ; but the later writers adopted a different line of division from that of the originator.For the history of this phase of economic speculation, which is touched here in the briefest way, the reader is referred to Mr. Cannan's thorough and accurate History of the Theories of Production and Distribution from 1776 to 1848. Fixed capital consisted of tools and implements used in a succession of operations. Circulating capital consisted of things that could be used only once and then were gone; it was divisible into materials on the one hand, and means of support for laborers on the other. Gradually there developed the tradition of separating capital into three constituent parts, — fixed capital, raw materials, and wages fund; an enumeration which gave point and precision to the vague phrase that capital consisted of the wealth used for producing more wealth.
The part of the later classic definition of capital which is pertinent for our purpose is the wages fund. For two generations no one thought of doubting that the food and other goods which supported laborers were part of capital. Even in the fir.st attacks on the wages-fund doctrine there was no disposition to proceed to a revision of the conception of capital. Yet no satisfactory solution of the controverted questions about wages is possible without some overhauling of the older classification and definition of capital.
Bearing in mind still that our point of view must be not that of the individual, but that of the community as a whole, we can readily see how the commodities which form the wages-fund part of the capital of the classic writers, in some ways at least, are of a different sort and perform a different function from the other constituent parts. Food, clothes, boots, house-room, ornaments, — any and all the commodities consumed by laborers, — constitute the wages fund. These are enjoyable and consumable commodities. Plant and materials, whether called fixed or circulating capital, are inchoate wealth. The former are real income — the latter are not. The question on which economists in our day differ, and in regard to which there are serious difficulties, is whether the enjoyable form of wealth called the wages fund is so like the inchoate as fairly to be grouped under the same general name of capital.
On the one hand, it may be urged in favor of the old-fashioned view that the laborers must have the wherewithal to live and to keep themselves in working condition in order that productive operations shall be continuous and effective: The succession of efforts which was described in the last chapter, and the extension of the working process over a long stretch of time, make it necessary that a considerable stock of commodities should exist in completed or partly completed form. In order that the successive division of labor may achieve its wonderful results, there must be not only tools, machinery, and materials, but bread, meat, and clothing for the active workers. Some such supplies there must be at once, for the needs of to-day; others must be ready, or nearly ready, for the morrow. A stock of enjoyable goods is as essential for effective and abundant production as is the array of inchoate wealth through all the stages of productive effort. The necessary enjoyable commodities are thus like the inchoate wealth, in being indispensable parts of the provision essential for any production advanced beyond the most rudimentary stage.
The view that such enjoyable commodities are to be regarded as capital was strengthened by the belief of the older writers as to the quality and quantity of real wages which laborers were likely to get. In the days when the wages-fund doctrine and all that went with it held full sway, the laborers were usually thought of as getting "natural" wages and no more. This, again, was rather assumed and implied than expressly and carefully stated. It was the result partly of a very old tradition; for before the days of Adam Smith and of the classic school the common statement in regard to wages, and indeed almost the only statement, was that they depended on what was needed to maintain the race of laborers. It was partly due to the conditions of the time when the wages-fund doctrine got its hold, day-laborers' wages being doubtless little above the minimum in the early part of the century in most European countries. It was in good part due to the indelible impression which Malthus's writings on population made on two generations of thinkers. At all events, for one reason and another, laborers were commonly described as getting "natural" wages, and no more; only so much as in the nature of things they must have.
Here, again, there was a curious intermingling of very different trains of thought. The "natural" wages, which Ricardo said laborers must have, were not stated to be the simple physical necessaries. They were the wages which habit and custom rendered necessary; the wages without which the laborers would not marry and rear children, and which, if exceeded, would lead them to marry earlier and have more children. In this sense, necessary or natural wages, as fixed by the standard of living, might be a great deal more than the bare necessaries of life. But while Ricardo and his followers of the wages-fund school said explicitly that natural wages were determined by the standard of living, not by the physical minimum, they thought of that standard as universally low. Any general statement they might make at the outset as to a possible high standard was usually forgotten or put aside as they went on. Half unconsciously, they converted the original conception of habitual "necessaries" into a conception of physical necessaries. Largely for this reason the wages which laborers got were thought of as needed in their entirety to maintain working strength. Thence it was a natural step to think of them as necessary for the maintenance of productive effort, and therefore as capital.
So much as to the grounds, and the reasons for the former easy acceptance, of the view that commodities indispensable for the workers are to be called capital. But that view is open to objections for the purposes of almost any economic inquiry, and to very serious objections for those of the inquiry here in hand.
In the first place, the situation of the laborers in general is not so desperate as Ricardo and his followers were apt to assume. Even at the time when they wrote there were great strata among the workers who got more than the minimum needed to keep them in working condition. In our own more prosperous days the large majority of laborers are in this better situation. Hence only part of the commodities which they get could be considered capital in the sense of being indispensable to production. Only what the older writers called "productive consumption" could be so classed, — the consumption without which the maintenance of efficient production was impossible. It would follow that, in the great majority of cases, wages must be regarded as paid in part not out of capital but out of some other source; the unproductive consumption having no resemblance to tools and other effective apparatus of production. The proposition that wages are paid from capital, stated and limited in this way, would be a different one from that of the classic school; for this school, to repeat what was said a moment ago, regarded all wages as paid entirely from capital. Modified as the proposition must be in view of a more prosperous condition of laborers, it makes an unexpected division, and on the face of things an illogical one, of real wages into two parts, derived from different sources.
This difficulty becomes even more serious if we enlarge the meaning of the terms "laborers "and "production," in the manner likely to find acceptance among most economists of our own day. The older English writers, when speaking of wages in general and of the wages fund, commonly thought of those engaged in manual work alone as "productive laborers." In every direction the conception, if it is to be consistent and satisfactory, must be enlarged. Not only those who work with their hands, but those who work with their heads, are productive; not only those who turn out a tangible product, but all who serve human wants. This is not the place for a disquisition on these much-disputed questions of terminology. It is clear that the engineer and the business manager are as productive as the hod-carrier and the mechanic. It is clear, too, — though not so universally admitted that there is no ground for real distinction between those whose labor does and those whose labor does not issue in a "material" commodity. The actor and the painter, the maid-servant and the maker of table linen, alike minister to the ease and enjoyment of life, and in this essential sense are alike productive. In neither of the directions here suggested did the older writers think of applying their reasoning as to capital and the wages fund. The income neither of the active business man nor of the house servant was thought to have anything to do with the payment of wages from capital. Yet the "productive" consumption of these, as well as of manual laborers, is essential for the procuring of the community's enjoyable revenue. It may be a question how far we should extend the term " productive " as applied to labor; and some would doubtless not be disposed to go as far as the present writer.* If a distinction between productive and unproductive labor is still to be made, it would seem that it could be done only on the lines of separating that labor which is essential and effective for the processes of production as now organized, and that labor which is only an incidental and perhaps dispensable adjunct of them. No one would deny that the merchant whose activity serves to bring together commodities and then to despatch them where needed, is productive. But side by side with him is the speculator who but watches the tricks and turns of trade; indeed, the merchant himself is often, in half h1s activity, no more than a speculator. The banker, again, aids to put capital into the hands of those likely to make good use of it, and so is productive; but who would say that any and every "banker and broker" in our great cities performs functions really serviceable for the community? No doubt it is difficult to draw the line in all such cases between the activity which contributes to social welfare and that which does not; and some allowance must be made for the inevitable useless hangers-on in every occupation. Yet, when every allowance is made, it is difficult to believe that all the work of the crowds of speculators, brokers, "business men," in the cities of modern times, is in any solid sense helpful for the organization and direction of industry. Much of it means simply that the conditions of a complicated division of labor make it possible to pick up, by shrewdness or by luck, large or small shares of income that represent no contribution to general welfare. Something of this sort doubtless underlies the distinction between unproductive and productive labor (and capital as well) wh1ch has been laid down by one of the most ingenious and suggestive of the theoretic writers of modem times, — Professor Loria, in the Analisi de la Proprieta Capitalista. Exaggerated and often forced as are the attacks on "unproductive" labor and capital by that writer, they yet seem to point out the way to an instructive line of distinction. Much of the activity of lawyers, of financiers, of those who buy and sell on 'Change, can be said to be but incidental to the really effective work of modern industry, not essential or even perceptibly helpful. But it would be impossible to stop, as the older economists did, with manual laborers. What is needed to maintain the active manager of industry and the merchant, the engineer and the inventor, the physician and lawyer (so far as the services of such are needed to keep laborers in health and business affairs smooth-working), — all this is surely capital in the same sense as the indispensable food of the ploughman. We thus should get a conception of capital and the wages fund applicable not to all the income of a part of the laborers, but to a part of the income of all of the laborers.
Once this conception is reached, however, it becomes more and more difficult to maintain that there is a real resemblance between wages-fund and other capital, and a real distinction between one and the other part of real income. After all, the commodities which go to one and another sort of laborers, whether necessaries or comforts or luxuries, are immediate sources of satisfaction. They are consumed, not to enable work to be done, but as the result of work being done. They represent, not a stage in the production of wealth, but the consumption and enjoyment of wealth. Men are not to be regarded as cattle, fed and tended as a means toward an end. Their consumption is the object of all production. Therefore it is to be regarded as income, and as single and indivisible income.
The total flow of enjoyable goods and services which is regularly coming into the possession of society is thus best considered as one great mass of homogeneous income, different from the inchoate wealth which is on all bands admitted to be capital. The members of the community, whether capitalists or landowners, headworkers or handworkers, idle or industrious, all form one body of consumers. There are, indeed, differences in the causes which bring income to one set or another; and even among those whose income is only a return for labor, there are important differences both in the forces affecting the size of the income and in the machinery by which it gets into different hands. But all together constitute the community, and the whole fund or flow of enjoyable things constitutes their real income. If we conceive the community to be organized on a collectivist basis — a procedure which often helps to bring out the essentials of social life — we readily see that the total of enjoyable things secured in any one season would be regarded as its real available income, apportionable among the various members in any desired manner, partly necessary for life and strength, partly luxury, but not to be called part capital and part non-capital.
It would seem best, therefore, to let the term capital stand simply for inchoate wealth: for all the possessions that do not yet serve human wants. Tools and machines, factories and warehouses, raw materials and half-finished and nearly finished goods, — these all go together as being not directly conducive to enjoyment; while all forms of finished commodities, — food, houses, clothes, ornaments, — belong together as enjoyable wealth and as income. The successive steps by which inchoate wealth is finally converted into enjoyable wealth were described in the last chapter; the same description would serve now to distinguish capital from wealth in general. Hereafter capital will be used in the sense indicated: the tangible apparatus for the production of wealth, and so all the goods still in the stage preparatory to final enjoyment.Whether or no the term capital should be used in the narrower sense to which preference is given in the text, or in a wider sense to include the things needful for workers, it seems to be agreed that some phraseology should be adopted for distinguishing the two parts which in some regards are so essentially different. Thus Professor Marshall, many years ago, in his Economics of Industry, suggested the term "auxiliary" and "remuneratory" capital; and in the third edition of his Principles of Economics uses the phrases "production capital" and "consumption capital." Such a practice may cause ambiguity when the word capital is used alone, and, on the whole, does not seem to me indispensable in order to bring out the fact that some supplies for the workers are needed for the operations of production.
These questions of terminology and classification, however, happen to be of less importance for the purposes of the present inquiry than for some other parts of economic analysis. In whatever sense we use the term capital, it will still appear that current wages, considered with reference to any but a very short period of time, are derived in the main from capital. The grounds of this statement, apparently in contradiction with the outcome of the preceding discussion, need some detailed explanation.
In the last chapter it was pointed out that flow rather than fund was the word appropriate for describing the mode in which the community's income of enjoyable commodities becomes available. If this is true in regard to the process by which productive labor yields its regular return, it is still more true in regard to the accretions of real income which form current wages.
Doubtless some of the enjoyable goods now available possess the characteristics of a fund rather than of a flow. Those of a more durable sort exist rather as a fund, those of a more perishable sort rather as a flow. Houses and house furniture are fully finished and ready, available now and likely to remain available for a considerable space to come. Food stands at the other extreme, being usually perishable, and existing in no great stock. Grain in the bin, flour in the merchant's stock, cattle on the fields, — various half-way stages, — these are the more typical forms in which supplies of food available for the early future exist. Clothing stands midway: a present stock is immediately available, and will last some little time, yet needs constant renewal at comparatively short intervals. The difference clearly is one of degree, not of kind. One of the important commonplaces which the classic economists insisted on was that all wealth is being constantly consumed and reproduced, the differences in durability being simply differences of degree. But these differences are very great; so great that we may speak of the commodities of which dwelling houses are the familar and typical example as being for considerable stretches of time a present and permanent fund of enjoyment.
If these more permanent sources of satisfaction, now existing and available, were the things from which the real income of current work were regularly and mainly derived, they would have some resemblance to the "fund" of which the older writers spoke. But, in fact, they are usually the reward of the labor of the past. They have played their part in distribution, and are now the established possessions of those whose former labor, or other source of income, has enabled them to be bought. Clothes, household furniture and implements, food in the larder, these have been bought with the money income of former days, and now are the settled property of their owners. They have nothing to do with current wages or profits or rents. No doubt they can be sold, though usually at a disadvantage. But when sold, they merely pass from one hand to another: what one gains in the way of fresh real income another loses. The total available for the community becomes no more or less. Moreover, since their sale rarely causes them to shift from one class in society to another, the real income of the several classes becomes no more or less. They belong to the distribution of the past, not of the present.
It may be remarked, incidentally, that commodities of the sort now under discussion have sometimes been called capital in a sense different from any yet noticed, and perhaps deserving a moment's attention. They are durable sources of satisfaction. While they may be described as a fund, because not needing prompt renewal, they may be also described as yielding a continual flow of utilities. The utilities which they yield can not all be enjoyed at once; they are of necessity distributed over some stretch of time. The house or suit of clothes may be considered as throwing off, so to speak, successive instalments of satisfaction. They are thus analogous to machines, which may also be considered as continually throwing off utilities, embodied in the enjoyable commodities which they serve to produce. Hence various thinkers, of curiously different schools and tendencies, have come to the conclusion that the durable sources of immediate satisfaction are capital, like machines and other means of providing utilities; and, since duration is only a question of degree, have concluded that all material commodities of any sort are substantially capital.See Hermann's Staatswirthschaftliche Untersuchungen, 2d edition, pp. 221 seq.; Jevons's Principles of Political Economy, 2d edition, pp. 280–287; Cohn's Nationaloekonomie, § 147. In general, I have endeavored to avoid cumbering this first part with literary references, reserving such matters to their appropriate places in the second part. But this particular phase of the discussion on capital will not again be touched. But there remains an essential and indeed all-important distinction between the commodities of which the dwelling house is the type, and those of which the machine is the type. While both may be said to yield successive utilities, the one does so without further human exertion, the other only after more or less of labor. The dwelling house is a completed enjoyable thing, available, until the moment for repair or renewal comes, without further labor. So are clothes and boots and household effects in their several degrees. They are in this important sense income, and so distinguishable from wealth still inchoate; even though they are income that from its nature stretches necessarily over some space of time.
To return from this digression to the main course of the argument. It has been said that durable sources of satisfaction usually belong to the distribution of the past, being secured and realized wages or profits or rents. To this general statement there is at least one important exception: in the case of dwelling houses occupied by others than their owners. Such houses are paid for by the tenants out of their current money income, and the shelter which they yield is thus a constituent of their current real income. They therefore play a part in the process of distribution which is going on in the present. The exception is particularly important in regard to those classes with whom we usually associate the word wages and with whom the wages-fund doctrine is supposed more especially to deal. Hired manual laborers are more often tenants than owners of their dwellings. Their clothing, household furniture, and some stock of food on hand they usually own, these having been bought with income of former days. But their dwellings are not commonly their own property. The shelter and comfort which their houses yield are thus paid for out of current income, and are part of current real wages. The dwellings themselves, being enjoyable at once without further labor, are part of the community's real income and not of its capital. The source of this part of current wages is, then, not social capital, but social income.* It may indeed be contended that the final stage in the work needed for full enjoyment is not reached until the letting of the house is accomplished. As the labor of the shopkeeper is the last step in the long series of efforts which bring his goods to the consumer's hands, so the house agent or active landlord does his share in the work of bringing the dwelling at last to serve the tenant's wants. The relatively high rent of the tenements occupied by the poorest laborers, which require much care and repeated attention in the business of letting them and collecting the rents, is the concrete expression of this fact. The dwellings hired by tenants might thus be said to emerge from the stage of capital into that of enjoyment and income by successive slight acts of exertion. But it would be a mistake to make anything of refined reasoning of this sort. Substantially, the dwellings, whether hired or owned, may be regarded as available and enjoyable, and as present sources of real income. — For another case in which substantial truth is reached, even with some violation of theoretical nicety, compare what is presently said in the text, at page 42, of the purchases of household tools by retail buyers.
More commonly, however, the commodities which constitute real wages are, at the time when the work is done, still in the last of the inchoate stages: they are just on the point of emerging from capital into income. They are in shopkeepers' hands, awaiting purchase. The last step in production is not completed until they reach the hands of the consumer whose wants they satisfy. Until that moment they are still strictly to be considered as capital. Hence, the source of real wages exists, in the main, in the form of capital at the time when the work is done.
This is more obviously and more completely the case if we consider not a short period, but any considerable stretch of time. It is not to be doubted that the wages of such a longer period exist now mainly in the form of goods not yet enjoyable. The bread for the coming season must come from the grain now in store; the clothes from the cotton and the wool, the yarns and the undyed stuffs; and so on. Whatever our conclusion as to the income of this day or this week, it is certain that the income of the current year is to be derived mainly from what has been capital during its course.
Lest there be misconception, some further aspects of the sources and constituents of real enjoyment may be briefly considered. It has been tacitly assumed in the preceding paragraphs that real income is secured, and enjoyment begins, when commodities pass from the counter of the retail shopkeeper into the hands of the purchaser. In literal strictness some modification of this assumption would be needed. Flour in the larder, though owned by those who are to enjoy it, is not yet a source of enjoyment; and a cooking stove or sewing machine belongs to the class of inchoate wealth as much as a baker's oven or a spinning mill. Not a little apparatus is thus beyond the last stage in buying and selling, and yet still in the stage of inchoate wealth. In a strict enumeration and classification of the community's income and capital, such apparatus would need to be put in the latter class. But for the purposes of everyday life, it may be questioned whether anything is gained by following the division between capital and non-capital beyond the last stage in the processes of exchange. The retail purchaser considers the commodities which he buys as serving for the direct satisfaction of his wants from the moment they pass into his possession. Even though they serve, like the cooking stove or the sewing machine, for an ulterior purpose and a later satisfaction, they do not stand in his mind side by side with the tools of his trade.
It often happens, indeed, that current income is intentionally used in a manner to postpone satisfaction: when it is saved and invested. Saving may take the form of a direct purchase of inchoate wealth, as when the manufacturer buys more machinery and materials out of his current gains. Quite as often it takes the indirect form of the purchase of securities and obligations, whence a fixed future income is expected. In either case there is a conscious postponement of enjoyments which might now be had. Some of the effects of this sort of postponement on the problems connected with the wages fund will receive attention at a later stage. They are referred to here by way of contrasting them with the postponement which is, so to speak, unconscious. For all practical purposes, real satisfaction and real income may be said to begin when the consumer buys goods or services for his own direct use; whether that use yield him enjoyment at once, or only after some further labor has been applied by himself or his household. The things so procured, bought ordinarily over the counter of the retail shopkeeper, may be considered, without sensible departure from the substantial truth, as real income; and that income does not emerge finally from the stage of capital until the moment of purchase.
In this sense, then, we may lay it down broadly that wages are derived from capital. In terms, the proposition is very similar to that which the classic writers had maintained; but the terms are used in different senses. Wages mean all the income of all laborers; capital means that supply of inchoate goods, in all the stages toward completion, from which the steady flow of real income is derived. In the main, the commodities from which the labor of the immediate present and the early future gets its reward exists not as a store of already enjoyable things, but as a varied assortment of things nearly finished. Those from which the labor of the present season — a longer stretch of time — gets its reward, exist as an assortment of things less nearly completed. Some of the more durable forms of enjoyable wealth, such as houses, furniture, clothing, do indeed form rather a store or fund, not needing still to be brought to the stage of fruition; but these are usually possessions in hand, the reward of past labor or the realization of past income, secured in a form which continues to yield satisfaction for a longer or shorter stretch of time. The case of house shelter presents an exception, where houses are hired and current income is spent for the use of a durable source of direct enjoyment. Bearing in mind such exceptions, it may be said in general that the labor of the present and of the near future, still more the labor of the current season or cycle of production, get their reward in some part doubtless from commodities which are now so fully finished as to be virtually enjoyable, but in much the larger part from commodities still in the inchoate stage, and therefore capital.
The proposition that wages are derived from capital, in the sense in which it has been developed in the preceding pages, evidently has a different meaning from the same proposition as it would he understood by one having in mind the relations between capitalists, employers, and hired laborers. Indeed, in any sense of the word "capital" which has regard to functions essential for the community, employers and hiring are of no consequence. Whether in the old sense of a stock of food and other necessaries, stowed away and essential for supporting laborers, or in the sense of a supply of inchoate wealth gradually being carried forward to the stages of fruition and enjoyment, — capital must refer to real and tangible things. It must mean food ready or soon to be ready, clothes in hand or soon to be in hand. It has nothing to do with money or with money wages, or with the hiring of laborers by employers, or with the wealth of the individual capitalists. The relation of wages to capital, as described in the preceding pages, would be the same under any social organization: whether under one where capitalists and laborers were completely separated and laborers got earnings only in the form of payments stipulated between them and their employers; or under a régime of co-operative production, where groups of laborers owned their own tools and materials and shared their earnings; or under a system of complete collectivism, where the community owned the inchoate wealth, and apportioned among the members only the accruing increments of enjoyable commodities. In all, production would be spread over a considerable stretch of time, and the reward of present work would have to come, for any longer period, mainly from goods still in the making.
But the payment of wages from capital has been closely associated, in most of the controversy on the wages fund, with the direct dealings of employers with the laborers whom they hire, and so with the organization of society typical of modern times. It has been supposed to be the result of the separation of capitalists from laborers, and of the payment of wages by the former. This association began almost with the first stages of the discussion. The classic economists started with a conception, incomplete though not without a solid basis in truth, of the relation between present labor on the one hand and product and capital on the other. But their conception was not only incomplete; it was vacillating. Most of them spoke, more or less often, of the funds in the hands of the immediate employer as capital whence wages were paid. The capital was sometimes described as food, clothes, and quantities of things consumed by laborers; but quite as often it was enumerated in terms of money and of millions sterling. This double use of the term, and the recurring confusion which ensued, will receive abundant attention in the second part of the present volume. But it may be well at this stage of the discussion to show how great is the confusion to which it leads, and how imperative is the need of keeping to a consistent use of the term capital: which can best be accomplished by considering one or two typical cases as to which it has been debated whether or in what way wages are paid from capital.
Perhaps the commonest case that has caused perplexity is where the employing capitalist sells his wares before he pays the wages to his laborers. Wages may be paid monthly or fortnightly; meanwhile the employer sells a part of the product, and so secures funds for paying the laborers. How, it is asked, can wages in such a case be said to be paid from capital? Clearly they are not paid from capital, if we mean by that term money funds on hand and accumulated when production begins, or if we think of capital as necessarily owned by the individual who pays wages. But it need hardly be pointed out that all such reasoning and questioning does not touch real capital or real wages. What is real capital? Under any rational conception, not money or funds, but things tangible or usable; under the definition accepted in these pages, tools, machinery, and materials, and all things not yet in enjoyable form. What are real wages? Again, not money, but the enjoyable commodities which the laborer gets. These he buys with his money wages; and the important question is the relation between real wages and the commodities, enjoyable and on the way to enjoyment, which form respectively income and capital for the community.
Another case may be mentioned. The question whether the source of wages at any given time is an elastic quantity or a rigid and predetermined one, has played an important, almost a decisive part, in the wages fund controversy. In discussing it there has been a constant tendency to run off to questions of the employers' means and the direct money wages which employers pay to hired laborers. What the bearing of hiring and of employers' activity is on the controverted questions, we shall presently consider. But it would never be denied, though it has often been forgotten, that the real and important question as to the elasticity or rigidity of a wages fund must refer to real wages, not to money wages. Larger payments by employers would not avail, unless there were more commodities ready for purchase. Whether there are more commodities; whether the supply of enjoyable goods, available or soon to be available, is settled by causes that have worked in the past, or is easily swelled by causes working in the present; these are the substantial questions. Whether employers can pay more or less, is only one step, and by no means the crucial one, in answering them. Still more inadequate for a satisfactory answer is the consideration whether the individual employer's means for paying laborers are fixed or elastic. Of all this, to repeat, more will be said in one and another part of the pages to come. At present let the reader bear in mind that real income, real wages, and real capital are the essential things, and that any propositions which we may lay down must be applicable to the relations of wages and capital in this sense.
It has already been suggested that the conclusions of this chapter, as to the relation between capital and real wages, have a wider application than the old doctrine of the wages fund. The reasoning, while directed to wages, applies equally to every other form of income. Not only laborers, but all classes in the community, get their present remuneration from the now accruing increments of enjoyable goods. That these enjoyable goods form the total income of the community was, in fact, the first step in the reasoning. Hence everything that is true of wages is true of interest, and rent, and business profits. All are derived from capital in the same sense. Interest or rents received some time ago may have been put into durable forms of enjoyable wealth, and may still exist, as mansions or cottages, perfect works of art or primitive ornaments; and these things are not capital. But the interest and rent received from day to day are nearly all spent from day to day, and are spent, in the main, on commodities which do not reach the stage of enjoyment until the purchase is accomplished. In this sense all forms of present income alike, while made up of enjoyable goods, were capital but a moment before. If any law of wages has been reached, it is a law equally applicable to all present rights and claims. It is but a statement of the fact that all the enjoyment of to-day comes from commodities which are the product of past labor, and have ripened to-day, or yesterday at best, into the finished form which makes enjoyment possible.
Herein, again, certainly we have a conclusion different from that of the classic economists. They never dreamed of applying to profits and to rent the same reasoning that was applied to wages. Wages, according to them, came from a different source and were determined by different causes from those that affected the other sorts of income which are usually associated with prosperity and wealth. According to the views just developed, all alike come from the same source and are determined by a chain of past events whose general influence is the same as to all.
Not only are interest, rent, and wages to be considered together from this point of view, but the different sons of wages also go together. It is immaterial what the machinery is by which wages are turned over to the laborer: whether in the first instance in the form of money wages by an employer, or in the form of money received directly by the laborer for a product sold by him; whether daily wages to an unskilled workman, or a yearly salary to a high official. All get their real wages from the same source and in the same way, by spending their money receipts on consumable commodities. This was, again, by no means the scope of the older wages-fund doctrine, which was declared more or less explicitly to refer to hired laborers only, and was always stated and applied in a manner to show that, even among these, only manual laborers were thought of. Whether or no the old doctrine was meant by its authors to be limited in its scope to hired laborers, the important truth which has been set forth as underlying it holds good in the much wider sense which has been explained in the preceding pages. Past product, existing for any season mainly in the form of unfinished goods, is the source whence all laborers, hired or not hired, and all capitalists, and all the members of the community, get the income of the present and of the immediate future.
And yet there is something more to be said of wages and capital, and of laborers, hired or other, than this general proposition as to the source of the whole community's income. It is obvious at the least that there are differences in the machinery by which this income reaches one hand and another. Hired laborers get the money incomes which constitute their claims to the accruing real income of the community in one way; independent workmen in another; rent receivers and interest receivers in still another. The unmistakable differences in the mode in which the various members of the social body get their share of the general income bring some important consequences, both as to distribution at large and as to wages and the wages fund. The examination of these differences and the consequences which flow from them will form the subject of the next chapter.
The conclusions reached in the preceding chapters, if not of universal application, are at least of very wide application. They hold good of any community which has got beyond the most primitive stages in the arts, and in which the development of the arts has brought any complicated series of productive acts. They would hold good of a socialist community as well as of one maintaining the régime of private property. They are conclusions as to real income and real wages, which have nothing to do with the ownership of capital or the inequalities of wealth, or with the money incomes and money wages which are such important elements in the existing machinery of distribution in modern communities.
In the present chapter we have to do with precisely this machinery. Here money and money income play a vital part. Money wages, money interest, money rent, arc the only avenues to the real income of consumable commodities. We can make our conclusions concrete, can follow them out in all their ramifications, only by following the actual working of the intricate money machinery of exchange and distribution. In doing so we shall find, as is the case with every investigation that goes beyond first principles, new premises, new points of, view, new conclusions.
For the simplification of the inquiry, let it be assumed at the outset that the money régime has reached its complete development; let it be supposed that the division of labor, and its consequences of exchange, money, and sale, have been carried so far that no one consumes any of the things he produces. Every article produced comes to market and is sold. This is so largely the case in the advanced communities of modern times that conclusions reached on the assumption of its being universally the case can not diverge seriously from the truth. It follows that the total product or output of the community is sold for money. It follows also that all income of every sort appears first in the form of a money receipt. All real income is thus derived from the use of money income. The inquiry as to money income becomes an inquiry as to the first step, and a most important step, toward the final receipt of consumable goods.
But while real income under these conditions is derived only by the expenditure of money income, the total money income of the community is by no means the same as the money price of the real income. This total is much greater; it is the money price of the entire output of the community. Real income is the flow of consumable goods which are regularly reaching completion, including also a due fraction of the value or utility of the stores of durable finished goods. The output of the community, while including this real income, includes in addition all the inchoate wealth or capital which is being steadily produced. But this clear distinction between output and enjoyable income does not appear either in the case of the individual's money income or in that of the community's total money income. Here income and output, in the first instance certainly, run together. Whatever is produced, no matter in what stage it may be with reference to the final emergence of enjoyable wealth, is sold. Every form of output is measured by its owner in terms of money, and is reckoned as a receipt. The gross money income of all the individuals in the community is thus the money yield of the total output. Each producer's net money income is some part, possibly the whole, of the receipts from the things he happens to make and sell, irrespective whether those things do or do not belong to the real net income of the community.
Let us now suppose a simple case, perhaps never to be seen in the actual world, yet largely typical of what goes on in it, and at all events serviceable as a first step toward understanding its complexities. Suppose a capitalist, active in the conduct and management of a productive enterprise, to own all of his plant, and to start at the outset with funds sufficient to pay all laborers and buy all materials until sales are made. Such a capitalist buys for cash and sells for cash, pays laborers out of funds in his own possession, and has his assets always under complete and ready control. His product, whatever it be, whether an article nearer or farther removed from completion so far as the community's real income is concerned, yields him an available income as soon as sold.
That income he is free to spend as he pleases. He may spend the whole of it for his own immediate pleasure; he may reinvest the whole of it, or, rather, may reinvest everything over and above what is necessary for his support and the support of those whom he cherishes as part of himself. If he reinvests, he devotes this gross money income to the purchase of more materials, the enlargement of plant, or the payment of more laborers. If he spends, he devotes it to the purchase of real income, of enjoyable wealth, for himself and those dependent on him. The mode in which he shall apportion his money income between these different objects is a matter at his discretion.
We should not usually think of such a person as unfettered, or as free to spend for immediate enjoyment as much or as little as he pleased of his money receipts. We think of him as committed to maintain his capital intact. Even if he has not borrowed, and so is under no obligations to provide out of his receipts for principal and interest of a debt, he is expected to keep his own principal unimpaired. The habit of maintaining accumulations intact is so strong in the social strata to which the managers of business belong, that we forget that it rests on the steady and recurrent exercise of a choice. The capitalist would ordinarily set aside out of current receipts enough to replace the funds which he has spent for wages and supplies, and to repair his plant or accumulate in due time enough to replace the plant when it had worn out. Only the excess over what is needed to maintain the principal intact is thought of as free income, available for expenditure on enjoyable things. In reality, however, it is all free. The fact that a choice is usually exercised in a particular way does not prove that no choice exists. If the man is not prosperous for a season, he may very likely fail to keep up his plant or to replace in full his working capital, trusting that better times will come. He then exercises his freedom in such a way as to trench on his capital and get a share of the community's real net income, even though he has secured no net income in the sense in which that term is used with regard to an individual. On the other hand, if he has been prosperous, he may add to his capital, and spend for the necessaries and luxuries of life less than his private net Income would bring within the bounds of prudence. On the average, the latter is the typical case. As a class, the active men of affairs get as net income more than they spend for enjoyable wealth. They exercise their freedom in such manner as to add to capital, or, in the everyday phrase, make money: a fact which is of no small importance in the working of the machinery of distribution.
Let us now stretch still further this supposition of simple conditions. Let it be assumed that all the capitalists of the community are of the sort just described: that there are no idle investors, no bankers or other lenders, and that all buying and selling are for cash. Every active producer owns his own plant and materials, and every shopkeeper and every merchant his stock. All these persons collectively own the capital of the community: that is, the real capital of the community, the inchoate wealth which is to be advanced by successive stages to fruition. Further, let it be assumed that all laborers are hired by these capitalists. None work on their own account, or sell anything but their labor. None own capital, or have any source of present income, beyond pay for the labor of the day. They may have some accumulations in present enjoyable form, such as houses, furniture, and food in the closet; but these must have been derived from income of the past. Their income for present work comes exclusively as pay from the capitalists. The older English writers constantly assumed, by implication if not explicitly, that such was the situation of all laborers. The assumption may be used advantageously as a point of departure in reasoning about the social conditions of modern times, if only it be not forgotten that the complications of real life and their divergence from the simple assumed conditions must receive in due course a careful consideration.
In such a society, then, the total money income would flow in the first instance entirely into the hand of the capitalist managers. All things produced, whether real capital or real income for the community, would be their property. Under a completely developed division of labor, all things produced are sold; and the money yield of all the output would be the gross income of the capitalists. That income they can use as they please. They may spend it all for themselves or invest it all. They may spend only their net income, i.e., the excess over what they must use to keep intact their capital (and so the community's capital); or may spend less than their net income, and so cause capital to be added to.
The laborers, on the other hand, would be dependent for their present income on the manner in which the capitalists chose to spend their gross income. If the capitalists were frugal, spent little for personal pleasure, and added much to their accumulations, then more money income would go to the purchase of plant and materials, and more to the hire of laborers. If they chose to spend much for present enjoyment, less money income would go to the laborers. There is, indeed, a case, of no small importance in actual life, in which it would be immaterial to the laborer, at least for the time being, whether the capitalists turned their income to enjoyment or to investment. This is where the enjoyment of the capitalists takes the form of abundance of personal service: where they take their pleasure not in food, clothes, and adornments, but in footmen and maids. Here the alternative is not whether more shall be spent on goods and less turned over to laborers as wages, but whether wages shall be paid for one sort of work or another. The tendency in modern times, however, is for luxurious expenditure to take the form of personal service less and less. In the main, an increase of expenditure for enjoyment means proximately that a smaller part of money income is turned over to laborers; while an increase of investment and a disposition to add to capital mean that more is turned over to them. At all events, what the laborers get under the conditions here assumed would be determined by the use which the capitalists made of the money income.What is aid in the text applies, of course, to the immediate effects of a change in the direction of the capitalist's expenditures. After the first stage, the change from investment to enjoyment means simply that laborers are employed in one way rather than another. The later effect is on real income: laborers make commodities for the enjoyment of the potential capitalists, rather than for the enjoyment of other laborers.
It will be observed that money income alone has so far been spoken of. That money income, to serve its real end for laborers or capitalists, must be spent on commodities. But if we examine in what manner capitalists can spend the gross income which has just been described as freely disposable by them, important limitations to the conclusions just stated appear.
Real income, to repeat, is enjoyable commodities; and if the capitalists wish to enjoy, they must buy the finished goods which alone constitute the real income of the community.Strictly, an expenditure on servants would need to be considered, this being a case where immediate satisfaction and immediate real income are secured. It is a case in which the quantity of real income available for the well-to-do happens to be peculiarly elastic, and forms an exception to the general reasoning of the text. Quantitatively, the exception is in modem times probably of no great importance. The quantity of such real income existing at any time is limited; for the moment it consists of the finished goods now purchasable. For the season, it consists of such supplies of partly finished goods as can be got to the stage of completion within the season. It is limited by the quantity of materials, worked up in part or in whole, which may be on hand, and by the tools and machinery existing wherewith to carry on operations. The total real income available in any season is obviously less than the output of that season. In a community which has reached a high stage of industrial organization, which has spread the operations of production over a considerable stretch of time, and in which a large part of labor is steadily given to the earlier stages of production, the output IS very much larger than the real income. But the total money value of the output is the total money income of the capitalist, in the case now assumed. The real income which they can buy is therefore, in its normal money value, very much less than that total income which has been described as freely disposable by them. Even the whole of the real income available for the community is not, in any substantial sense, at the disposal of the capitalists. They can get enjoyment only from finished commodities of the kind and in the variety that their tastes and needs call for. A large part of the commodities now on hand would not serve their turn. The supply of bread and flour and grain at any moment is adjusted to the expected needs of the whole mass of consumers; and after our capitalists had had their fill, the rest of the breadstuffs would be virtually incapable of giving them any satisfaction. Other commodities would be too coarse for their tastes, or would pall long before the total available quantity was used. The effective choice which the capitalists would have as to the disposal of the gross money income which was freely theirs, would then be confined, for the time being at least, within limits not very elastic.
Limitations of the same sort appear as to the real wages and real income of the laborers. Like the capitalists, they can get for the money turned over to them only such consumable commodities as exist or will be ready within the season. We may suppose, for example, that the capitalists have been moved to abstain from personal expenditure, and have reinvested largely and heavily, the process involving a transfer of an increased part of their money income to the hired laborers; or we may suppose — to put a case that has played no small part in the history of the wages controversy — that a general trades union of all the laborers has put the capitalists in a position where, under pain of ceasing investment entirely, they must raise money wages. Whatever the ultimate outcome in this much-debated case, it may be averred without hesitation that the laborers' combination might win a victory in the first step in their campaign, — the advance of money wages. That step is' the only one of which laborers or capitalists usually think, and, it must be confessed, is the step with which alone economists have too often busied themselves. But the real gain (apart from the joy of victory) for the laborers must come in the purchase of more commodities in the way of food, drink, clothes, shelter; and of these no more can be bought than there are. How elastic the inflowing supply of such commodities is for any season, how great and rigid are the obstacles to an immediate or rapid change in the available real wages, we need not yet discuss. What is plain is the existence of some limits in the nature of the available supplies of finished and half-finished goods. The capitalists, in the case supposed, can turn the money income in any direction they please: keep it all for themselves, or turn more or less of it over to laborers; but the real income which can be secured and enjoyed is in some degree predetermined in quantity and quality.
All this means simply that the machinery of production at any given time is arranged for the supply of the habitual and anticipated wants of the community. Each individual capitalist produces the commodities which he has sold before, and which experience leads him to expect to sell again. The pig-iron maker has a reasonable faith that his iron will be bought by the maker of machinery, and he again that his machinery will be bought by the person who means to use it in making one product or another. That process of investment and accumulation by which existing capital is maintained and new capital is added, is thus prepared for and virtually accomplished before the individuals commit themselves to the decisive step of turning their money income to investment rather than to enjoyment. The producers of luxuries go their way in the same fashion. Some create or maintain machinery for silks and satins, others prepare the raw material, others finally buy the products from the manufacturer and arrange them in the shops of the cities for the expected purchases of the consumers, who will presumably do as they have done in times past, — spend part of their inflowing money receipts for enjoyment. Not least, the makers of the commodities for laborers continue to produce these on the accustomed scale, anticipating the transference of money income by capitalists to laborers in the course of that continuance of investment of which the purchase of machinery and materials is the other part. The output of the season, produced and owned under our supposition by the capitalists as a body, is sold again to these capitalists as a body. They own the whole output at the start, and get the whole money income. A part of the output they buy directly, either as plant and materials for further production or as commodities for enjoyment; a part is sold to them indirectly through their transference of money income to the hired laborers. But the assortment of goods, finished and unfinished, that is on hand at any time depends, not on the apportionment of their money income which is then made by the capitalists as spenders, but on the apportionment which these same capitalists as producers have been expecting and planning for during a considerable stretch of time in the past.
So much as to the nature and the causes of the limitations by which the capitalists would find themselves fettered during any one season in the really free disposal of their incomes. Over a longer stretch of time the case would be different. Here their choice would be effective not only as to the disposal of money income, but of real output and real income as well.
The steps by which this real control over the product and the income of the community would be exercised need no elaborate explanation. Assume that there is a sudden change in the manner in which the capitalists choose to use their money income; for example, that they become more frugal and more disposed to invest. Less of luxuries and comforts will be bought by them; the merchants who deal in such commodities will find trade dull; the series of producers who make them will in turn feel the depression. Eventually less will be made, and the constitution of the real income of the community will in time conform to the new apportionment of the money incomes of the capitalists. On the other hand, the money formerly spent on the luxuries and comforts will be turned in other directions. The makers of machines and materials will find a brisker demand for their products. More money income will be turned over to laborers, and the makers of the commodities consumed by them will similarly find trade good and profits "satisfactory." A shift will eventually take place in the direction in which the productive apparatus of the community is turned. In the long run it is thus true that not only the money income of the community is freely at the disposal of the active capitalists, but that its real income and its real output exist in such forms and in such apportionment as their choice determines. Allowing for the time needed to enable the productive apparatus to accommodate itself to demand, we shall find so much real income for capitalists and laborers, and inchoate wealth in such quantity and variety, as the capitalists' use of the total money income calls for.
Before going on to the next stage in the analysis of the machinery of distribution, one corollary from the preceding proposition may be noted. It is true that the supposed simple community of completely independent employing capitalists and completely dependent hired laborers is still under consideration here. As to the complex phenomena of the actual world, we shall find here after occasion for much qualification of the preliminary results. But one part of the conclusions holds good for any community in which the institution of private property exists: it is, that the maintenance and accumulation of capital depend on the disposition and the will of those who become recurrently the owners of the money income and so of the real output of the community. This was what the old economists had in mind when they said that it depended on the will of the owner whether a commodity should be capital or not capital. They sometimes spoke as if his will could become operative at once; as if by magic he could convert a pack of hounds into a cotton mill. But the truth which underlay their dissertations on this topic is an important and solid one. In every community in which private property exists there are inequalities in wealth; in almost all, great inequalities. The money income of every season flows first, in very large part, into a comparatively few hands, and is directed by them at their discretion into one channel of purchase or another. The inequality in possessions may be regrettable, and the stewardship which it involves of the community's capital may be well or ill administered; but the facts are not to be gainsaid, and must be faced if we would get a true understanding of the industrial world. The importance of this force, as of others that are constant and familiar in their operation, is often forgotten. The recurrent exercise of the choice of the capitalist takes place habitually in much the same way: changes in the direction of greater or less expenditure, or greater or less (usually greater) accumulation, come slowly and gradually. The motive power which thus drives and controls the apparatus of capitalistic production works in the main so steadily that we forget that it consists of the collected volition of hosts of individuals, each and all of whom are free to do as they will with their own.
We may now proceed to make our conclusions fit more closely to the facts of real life, by introducing, step by step, the complications which appear in the actual organization of the machinery of production and distribution.
In the first place, no active capitalist is in that position of complete independence which has been assumed: of neither borrowing nor lending, of buying for cash and selling for cash. He buys on credit, and thus is under obligations to turn over part of his money income, as it flows in, to his creditors; while those to whom he has sold on credit are under similar obligations to him. As between the direct managers of industry, the obligations which thus follow each one do not change the case for the mass. Collectively, they are still free and uncontrolled as to the disposal of the general money income. But quite as important as their relations inter se, are their relations to the great body of bankers, brokers, moneylenders, middlemen of all sorts and degrees, whose business it is to make advances to the more immediate directors of business affairs. The banks of discount and deposit find their chief function in such advances, and are the great types of this factor in the industrial world. Side by side with them are to be found, in every considerable centre, other parts of the same credit organization. Brokers negotiate loans whenever they find funds offering for investment over those short periods for which the regularly recurring debts of the business manager are contracted. The great wholesale houses play a most important and effective part. They buy on credit, make advances on consignments, nurse this producer and drive that one to the wall; they themselves meanwhile borrow largely from the banks. Their action goes far in settling when and how and where money income shall flow into the hands of those who are in the more direct and obvious sense the directors of production and the employers of labor. In other words, the body of persons whose judgment and discretion determine how the gross money income shall be used, and what part of it shall be turned over to laborers, is much larger than the group of the immediate employers. In the discussion of the wages-fund doctrine, and indeed in most academic disquisitions on wages and business management, this has been often lost sight of. The immediate employers are thought of as the only persons who decide primarily how and where laborers shall be hired, and whose resources determine what direct advances of wages shall be made them. In fact, the immediate employer is controlled, in greater or less degree, by his relations with this large and complex body of lenders and of middlemen. He can sell rapidly to the merchants who are his first customers, if their judgment approves of his wares, and he can get advances from them if they have faith in his capacity and integrity. Similarly, he can borrow from the bankers and brokers according to his repute for success and character. If a long career of successful ventures and of punctual probity has given him not only large means of his own, but a high standing in the business world, his immediate resources are almost limitless; he can secure at a moment's notice the command of millions. On the other hand, a rumor of disaster, a revelation of dishonesty, may practically wipe out his means.
Thus we must consider the resources of a large and varied body of persons, if we would examine the immediate source of the money wages of hired laborers. Such an examination at best is incomplete; the inquiry as to the source of real wages remains the important one in the background. But the questions as to the machinery of immediate money wages are important enough; and, to repeat, they are to be answered only by examining the doings of the whole array of employers and middlemen and lenders who collectively form the active managers of industry. In recent discussions as to the source of wages, it has been asked not infrequently whether the funds of the immediate employers, available for paying money wages, are predetermined or limited. If any question of this sort is to be raised, it should be, not whether the funds or means at the disposal of the individual employer, but whether those of the whole complex body, are limited. The answer will be considered in the next chapter: it may be said at once that the degree of elasticity and indeterminateness is much greater for the individual member than for the whole group. However this may be, it is clear that the control of the total output of society, and so of its gross money income, which was assumed at the outset to be entirely in the hands of the immediate producers and employers, is exercised in reality by a much larger and more varied body.
Next we have to consider another difference between the real world and assumed conditions-one of far-reaching importance for many questions of social organization, but less important for those here under review. The employing capitalists, — we may now mean by that phrase the complex body which directly or indirectly is active in business management, — were supposed to own all the capital. But in fact we find, separate from them in the main, a great number of investors, who own capital and derive an income from it, but take no direct part in its management.
The investors have made loans to the active businessmen. They have received an engagement for the payment of interest at stated terms, and for the eventual repayment of the principal. They may be conceived, for many social purposes, as the owners of a great part of the community's capital. When a plant is erected with borrowed capital, the lender is in so far virtually its owner. While legally but a creditor, in the eye of the economist he may often be regarded as an owner of real capital. As it happens, however, the legal relation fits exactly the economic relation, for the purposes of the present inquiry into the working of the machinery of distribution. If it is asked, who, in the end, owns the capital of the community? the answer must be, the idle investor as well as the active business manager. But if it is asked, who controls the capital of the community and first becomes owner of its total income? the answer must be, the active manager, indebted though he may be to his creditor. The output became his as it goes to market and is sold, and the gross money income passes first into his hands. He must simply pay the stipulated interest to his creditor. In so far only is he subject to a direct and immediate limitation in his control of the inflowing money receipts.Investments of what may be called the "productive" sort are chiefly referred to in the text. Those large loans which are made to states present, in the main, a different chain of phenomena. The money income is here promised the investor by a public body, which in tum gets its funds by taxes; these funds being again derived, if the taxes are indirect, chiefly from the money receipts of the active capitalists, and, if the taxes are direct, from any and every source of money income. Where the proceeds of the Joan are used for public works yielding an immediate money revenue, the situation is more like that described in the text.
It may be suggested that the business man is subject to a further important limitation in that he must repay the principal when due. But while this is clearly the case so far as the individual is concerned, it is not the case for the whole body of active managers. Investors usually spend for enjoyment only their income, not their principal. The principal, as it falls in, is reinvested — that is, the funds are turned back into the hands of one or another active capitalist, to be again at his free disposal. Substantially, therefore, it remains true that the existence of a separate class of investors affects our supposed case only in one point — the money income which the capitalists get is not wholly at their disposal, but is subject to periodic drafts for interest payments to investors.
It may not be amiss to refer for a moment to the mode in which the operations of the investors are connected with that determination of capital through the choice of its owners, which was the subject of some of the preceding paragraphs. At any moment the investors have put their principal beyond control; it has been turned over to the active capitalists, who have spent it for plant and materials or have paid it out in wages.* The reader conversant with economic theory will readily carry the reasoning here in another direction, and will remark that ultimately all the funds are found to have been directed to hiring laborers. Tools and materials are made by labor, and (under the supposition that laborers are hired) represent in the end nothing but advances to laborer. This point of view is the one to be taken if we were to consider the whole series of operations which intervene between the beginning and end of production, For the inquiry carried on in the text, however, the operations of a single season only are pertinent; and for a season the funds turned to hiring laborers should be treated as entirely separate from those turned to the purchase of tools and materials. Usually, funds borrowed for a considerable time from investors are spent for plant and other durable forms of capital, while loans for purchase of materials and for wages payments are obtained from the bankers and other middlemen who are the active co-operators in business management. The plant lasts a long space; the investors have put their means beyond control. This irrevocable commitment of the investor's means finds its other side in the irrevocable commitment of part of the community's gross income to the form of capital. As time goes on, the plant wears out and is renewed, the loan falls due, and the principal is reinvested. These two operations go on side by side; not in the sense that the renewal of actual capital and the reinvestment of investors' funds coincide in individual cases, but in the sense that, for the community at large, they form two aspects of the one process by which capital is maintained. Here again the actual making of concrete capital, — of buildings, machines, apparatus, materials, — does not take place as the direct consequence of the investor's decision to keep his principal intact. It precedes the decision, or takes place pari passu with it, in anticipation of that habitual reinvestment which goes on as a matter of course in modern communities. Like other habits, it rests on the repeated exercise of volition in the same direction; the effect, while almost invariable, being none the less caused by the exercise of a choice which, time enough being given, is unfettered.
What has been said of interest payments holds good of rent payments. Important and fundamental as is the difference between interest and rent, the machinery by which they reach the hands of their owners is the same. If the business man uses for his operations a site which enables him to achieve a given result with less outlay than his competitors, he will pay the price of the advantage to the fortunate owner of the site, in the same manner as he would pay interest on borrowed capital. If he happens to own the site, the inflowing receipts are so much the more completely under his control; precisely as, if he owns all his capital, he is not fettered in his expenditure of the gross receipts by the obligation to pay interest. In neither case is there a distinguishable part of the total income, appearing at the outset as separable interest or separable rent. Both represent, so far as they are distinct payments at all, obligations which the active business manager has incurred for a specified diversion of a part of his total money income. They are independent of what may in fact be received by him in consequence of his possession of the capital or the site; they are often different from that usual or "normal" gain accruing from their use, which economists call true interest or true rent. They are simply money payments which the business man has promised to make out of the general inflow of his income.
The reader will readily follow the same line of reasoning in other directions — to monopoly receipts, royalty payments, and other sources from which the idle well-to-do and the prosperous business men get accretions of income. So far as the business man is owner, he gets in these ways additions to his unfettered means; so far as he has borrowed, he has undertaken stipulated payments to others. The business corporation of modern times presents all possible varieties of the relation between active manager and idle investor. Nominally, the stockholders are a group of associated active capitalists. Practically, they range from shrewd managers to the most helpless of inactive investors. Throughout, in all the complexity of the meanings and final causes of these various payments, we find the machinery for effecting them to be the same. In the last analysis, the payments may be regarded as interest, or interest plus earnings of shrewdness, or rent, or monopoly extortion; but they all come from gross receipts flowing first into the hands of the active capitalists, who may then be under bonds to make the payments to other persons.
So much as to the mode in which the simple conditions assumed at the beginning of this inquiry are affected by the varied and scattered ownership of capital and other instruments of production. A different modification, and a more important and instructive one, comes in another direction. At the outset, as all capital was supposed to be in the hands of active business men, so all laborers were supposed to be hired by them. It is time now to consider how far laborers in fact are in this condition, and how far the conclusions derived from the analysis of the simple case need to be modified in regard to the laboring classes.
Clearly, in almost every country great numbers of persons who are usually spoken of as laborers are not hired by capitalists. It happened that in England, at the time when the classic economists were developing their system, a larger proportion of manual workers were in this situation than has been the case in any other time or place; hence, the easy assumption of such conditions by these writers, and hence (in good part) their easy acceptance of the wages-fund doctrine. But even in England there were and are unmistakable exceptions. Cobblers, carpenters, cabmen ply their trades independently, either owning or hiring their tools. In other countries the exceptions are more important and numerous. The tillers of the soil, who in England are employed by capitalist farmers, elsewhere are very commonly owners or tenants. In countries like France or the United States, millions of men whose work is mainly hard, monotonous manual labor, are owners of plots of land, and as independent of hire and of stipulated wages as any great employer. On the continent of Europe generally, production on a large scale has not permeated manufacturing industry as much as in English speaking communities, and the independent artisan holds his own in larger degree against the capitalist producer. The blacksmith, the carpenter, the shoemaker, the weaver, have nowhere been entirely crowded out by the factory, with its régime of hired workmen. In many countries such laborers still form a large part of the body of persons whose income is essentially reward for physical exertion.
The question may be raised whether such independent workers can be said to get simply wages. They usually have some capital; indeed, they must have some small possessions of their own in order to maintain their position of independence. They may perhaps be described as capitalists, and as receiving something different from wages; this term being confined to the hired workmen who get stipulated sums from employers. Any one who is familiar with the traditional plan of economic textbooks, inherited as it is from the classic days, will see with how uncertain a voice most writers have spoken on this topic. Distribution is usually set off under the rubrics of wages, interest, rent; profits being sometimes added of late years as a fourth independent constituent. Wages are described to mean any reward for immediate exertion, regardless of the mode in which the reward comes. In the detailed discussions of wages, however, the case of the hired laborer and of what the employer will pay him occupies the chief place. In everyday speech, too, this is the person whom we think of as receiving wages; and the large array of persons who get a return for labor in a different way are left without any distinctive designation.
The same question of classification and nomenclature appears in the suggestion that the independent workman is not a laborer but a business man, — an entrepreneur. So considered, he would be said to receive, not wages, but that mixed and vexed income which Mill called wages of superintendence, and which in our own day is entitled sometimes business profits, sometimes profits simply, sometimes managers' earnings. And certainly a good degree of justification for this course is to be found. The gap between the poorest independent craftsman, and the great employer whom we think of as primarily a capitalist and as earning something different from wages, is filled by a series of different workers, among whom it is hard to find any sharp line of division. Where do business profits cease and mere wages begin?
We need not stop for any prolonged consideration of this question, which involves not only matters of terminology, but very substantial problems. Probably the best plan for the exposition of distribution at large is to describe all reward for exertion as wages; thereafter pointing out, however, how various are the forms of exertion, and how different the causes which affect the reward of different forms; and in the end going so far as to give a special name, such as business profits or managers' earnings, to the wages for some peculiar kinds of work. Certainly for most purposes of classification we should not be consistent if we drew the line between wages and not wages according to the bare independence of the workman. The cobbler who works alone in his petty shop gets, in the main, a return for labor as much as the workman in the shoe factory; the peddler and the shopkeeper's assistant, the small farmer and his hired workman, all earn an income by labor. No doubt the shrewdness and judgment of the farmer or peddler affect his income, as the skill and capacity of the hired workman affect his. No doubt, too, the class of which the farmer and peddler are types own some of the instruments of production, capital or land, and get their earnings in the course of using such instruments. But the earnings come, in a multitude of cases, without that conscious consideration of the income-yielding possibilities of capital and land which accompanies the work of the large capitalist and large landowner. Theoretically the earnings may be parcelled off as partly interest, partly rent, partly wages. Practically they come in as the return for so much work, shrinking or swelling with the fortunate or unfortunate use of such labor and capital as the individual may have at his disposal.
But in one important respect the receipts of the independent laborer, even though they be regarded for most purposes as wages, are to be put in the same class as those of the well-to-do capitalists who were supposed at the outset of the present inquiry to be the only owners of capital and the employers of all laborers. The independent workman gets a primary and not a derivative share of the total income of society. With regard to the machinery by which distribution is accomplished, he belongs in a different class from the hired laborer, and belongs in the same class as the active capitalist. He becomes legal and absolute owner of a part of the output of society, and so comes into direct control of part of the gross money income. He may be fettered by debt, as his fellow on a large scale may be; but he is dependent on no fixed bargain for the money income which will serve him to procure a share in society's real income of consumable goods. Herein his situation differs essentially from that of the hired laborer, and herein the phenomena of real life differ essentially from those assumed at the beginning of this inquiry. The hired laborer gets his money income as the result of a bargain by which he sells his working power for a space. The independent workman gets his money income directly from the sale of what he makes. The situation is not always advantageous to the latter. The peasant proprietor and the petty craftsman do not necessarily prosper more than the hired mechanic. But the hired workman is directly dependent for his money income on an employing capitalist; the independent workman is not.
For an understanding of the machinery by which distribution is accomplished in modern times, the classification of sources of income should thus be different from that to be adopted for an explanation of the fundamental causes. For the latter purpose the different sources of income may still be appropriately divided into wages, interest, rent, with possibly business profits as a fourth term. But so far as the concrete mode in which money income (and this is the first step to real income) reaches different hands, we must put on one side all the independent producers, whether they conduct operations on a large scale or on a small; on the other side, all receivers of stipulated interest or stipulated rent, and all hired laborers. The former get a primary, the latter a derivative share of the total income of society.
Both the primary and the derivative shares, as they appear in fact, may or may not be what the economist would analyze as simple incomes. The independent producers may be great capitalists, and their net receipts, separated into the constituent parts which are important for the permanent explanation of things, may be made up of interest, and rent, and wages ordinary and extraordinary; or they may be small fry, in whose earnings wages for very common sorts of labor play so large a part that the other constituents may be dropped from consideration. The other dependent persons may similarly get mixed or simple incomes. The interest paid by a corporation may stand in part for natural advantages which have been capitalized and converted into a bonded debt; that which is interest in form being thus rent in substance. On the other hand, the payment which, in ordinary parlance, is rent for building or for a plot of land, is usually a mixture of the rent and interest of the economist. Concrete wages, too, may be a complex return, including in the case of a highly trained workman not only wages for labor but interest for the capital sunk in his education. Thus distribution, as analyzed in its last elements, is an abstraction: its demarcations rarely correspond to the actual receipts which are seen in the industrial world. It may explain the situation, and in that larger sense describe it; but it does not describe with accuracy the direct phenomena. On the other hand, the analysis of distribution which has formed the subject of this chapter presents the literal facts of the case. The incomes of independent producers, large and small, are the primary sources of distribution; interest payments, rent payments, wages of hired laborers, are derivative, and their recipients may be described as dependent.
The point has now been reached where we can observe the differences, in their relation to capital, between the wages of the hired laborer and those of the independent workman. The hired laborer is undoubtedly dependent on capital, and gets his wages from capital, in a sense in which the independent workman does not. His money income, the first and the essential means toward getting a real income, is turned over to him by capitalists. It comes from funds in the possession of a body of which his immediate employer is a member, and which includes all the active co-operators in the management and control of industry. Except in so far as he has made a contract covering some length of time, his wages depend recurrently on their disposition to use for productive operations their inflowing money receipts. In this sense his earnings depend on a wages fund — on the sums which the employers judge it expedient to turn to the hire of labor; and in this sense the independent workmen evidently do not depend on capitalists or on a wages fund.
In another sense, all workmen, whether hired or independent, get their wages from capital and are dependent on a wages fund. This is in the sense that all real income is derived from consumable commodities; that these are the product of past labor; that the supply of them available for fresh use at any time is small; and that the supply for any considerable stretch of time exists mainly in the form of inchoate wealth. The real income of all classes in the community comes from past product, and in the main from real capital. This is a very different wages-fund doctrine from the other. It will hold good under any conditions of society, so long as the arts are carried on in such manner that a long stretch of time elapses between the beginning and the end of the successive steps in production.
These two things have been curiously interwoven and confounded in the long controversy over the source and measure of wages. The wages-fund doctrine, in the form in which it so long held sway, was supposed to apply primarily to laborers hired by capitalist employers. It was supposed, rather than explicitly stated, so to apply, for the limitation was more often tacitly assumed than pointed out in terms. Adam Smith's brief but pregnant paragraphs had directly connected the payment of wages from capital with their payment from the funds of employers. Scarce one workman out of ten in Europe, says he, is an independent artisan; hence the wages of the great mass depend on what the masters can and will pay them. Later English writers had the same organization of industry in mind, though they did not often say so. While their theories were stated in general terms, they were framed with an eye to the conditions and the needs of the England of that day, where, as it happened, the great mass of laborers were of the hired and dependent class. At a later stage in the discussion it was more often pointed out in express terms that hired labor alone was meant to be within the scope of the wages-fund doctrine. When the whole subject then came to be overhauled, it was seen that this assumption had been more or less overtly made, and the avowed scope of the doctrine was accordingly limited. Its advocates set forth that it pretended to do no more than explain how the wages of hired laborers were determined. Its opponents accepted the limitation, and retorted either by pointing out how large was the number of cases so left unconsidered and unexplained, or by questioning whether it could be maintained even within the chosen limits.In his direct discussion of wages, the younger Mill said that "wages depend on the demand and supply of labour, or, as it is often expressed, on the proportion between population and capital. By population is here meant the number only of the labouring class, or rather of those who work for hire." (The italics are mine.) Political Economy, Book II, ch. xi, §1. Much the same sort of expression appears in the chapter on Profits, Book II, ch. xv, § 6. Yet, in his first consideration of capital, Mill had pointed out that "when the labourer maintains himself by funds of his own, as when a peasant farmer or proprietor lives on the produce of his land or an artisan works on his own account, they are still supported by capital-that is, by funds provided in advance." Book I, ch. iv, § 2. Compare what is said of Mill below, in Part II, chapter xi. Cairnes, in commenting on Mill's statement of the wages-fund doctrine, remarks parenthetically that "the question at present is exclusively of hired labor." (Cairnes himself puts the word "hired" in italics). Leading Principles, Book II, ch. i, § 5. Hence Sidgwick remarks, at the beginning of a chapter on general wages, that " since other economists generally denote by 'wages' (when used without qualification) the remuneration of labour hired by employers, it seems convenient to adopt this meaning in the critical discussion [of the wages-fund doctrine chiefly] which will occupy the first part of this chapter." — Principles of Political Economy, Book II, ch. viii, § I.
Yet, in fact, for the solid truth which underlay the doc trine as to real capital and real wages it was not necessary to exclude from its pale all other than hired laborers; while, on the other hand, so far as these hired laborers were concerned, the support which it got from their relations with their immediate employers was a treacherous one. None other than these direct employers were usually referred to as the holders of the funds on which laborers were dependent. When it began to be asked whether the money funds which they could pay laborers were rigid or elastic, the only possible answer was that nothing in the nature of a predetermined fund existed, and that the sums which they had at command, whatever causes might affect them, were not in the nature of an accumulation that was fixed once for all when the bargain between them and their workmen was made. With this negative answer the whole traditional mode of dealing with wages and capital was given up. It was forgotten that in an important sense hired laborers are primarily dependent for their wages on the funds which the whole body of active capitalists can and will turn over to them; and that in a still more important sense all laborers, hired or independent, get their real remuneration from that product of past labor to which the earlier economists had given the name of capital.
One further topic may be touched before this lengthened inquiry is brought to a close. So far as the machinery of distribution is concerned, the receivers of rent and interest payments and the hired laborers have been described as alike getting derivative incomes, and as in that sense alike dependent. It may be asked whether there is any greater degree of dependence for the laborers than for the others.
In one respect the laborers are certainly more dependent. The engagements with them are usually for a shorter period of time. The active capitalist often binds himself for years with those to whom he pays rent or interest; for weeks only, as a rule, with those to whom he pays wages. This is not always the case. The growing strength of organization among hired laborers has led in modern times to more permanent engagements, in which both sides bind themselves for months or a year. Usually, however, the contract with the hired laborer covers a brief period. He is liable to be called on at short notice to show his strength in bargaining with the employer.
The longer term over which the rentier (to use that convenient Continental term) makes his bargain is not always to his advantage. He commits his principal irrevocably for a series of years, and takes his chances that his debtor, the active capitalist, will repay it when the loan falls due, being meanwhile powerless so long as the interest instalments are met. That investor whose stipulated income would be called by the economist rent is indeed usually in a more assured position. The natural site or resource which enables him to get the business man's promise of stated payments is likely to endure in another's hands as well as it would in his own; and if his rent does not appear punctually, he usually finds its source unimpaired when he retakes possession. But so far as the investor of capital proper, the recipient of true interest, is concerned, the advantage which he may have over the laborer from the more permanent nature of his contract with the business manager, is conditional on the care and judgment with which he selects his debtor. Economic history, ancient and modern, presents a plenty of cases in which the greater security of the investor's position over short periods has proved his ruin in the long run.
Much has been said of late years in regard to another phase of the hired laborer's dependent position: the importance of his strength in bargaining. Recurrently, — as a rule at short intervals, — the contract on which his income depends must be renewed. If he stands alone; if he has no savings from past income which would enable him to wait and see what the market offers; if he is ignorant and generally helpless, — he bargains at great disadvantage. If he is banded with his fellows, if he possesses the wherewithal to make a trial of strength, and if he has shrewd and well-informed leaders, he bargains to the best advantage. The strength which the trades union gives the hired laborer in dealing with his employers was not doubted even in the days of greatest faith in the natural laws which were supposed to regulate economic phenomena in general, and wages in particular. No one would question it in these less conservative times. The bargaining of the outside investor with his active debtor is not affected at bottom by factors so very different from those just mentioned. Usually he can wait a bit for his income: therein his ordinary position is better than that of the hired laborer. He is often, but by no means always, reasonably shrewd and intelligent, and knows what the general market affords. He gets advice, which may or may not be good, from the large class of bankers and brokers who make a business of placing investments As to his legal position and the mode in which the machinery of justice enables him to enforce his claims, he may have been in former days better cared for than the hired laborer who is also a creditor of the active capitalist; but the mechanics' liens of modern legislation give the workmen much the best of it here, apart from the fact that the more rapid recurrence of his stipulated payments diminishes the sum which at any one time is at stake.
This brief notice of some aspects and effects of the hired laborer's dependent position will serve to explain the sense in which the term dependence is to be understood. We may keep far from that pessimistic view which finds its expression in the turgid description of the laborer as the slave of the employer, without going to the opposite extreme of concluding that the laborer is no worse off than the investor, because both alike are dependent for income on what the active business manager has promised or will promise to pay them. Neither the helpless widow and orphan, nor the down-trodden laborer, — two familiar figures confronting each other in the literature of social controversy, — are really typical of the practical outcome of this dependence. As to the hired laborer, his position does indeed show that the ownership of wealth in modern societies is very unequally divided, and in so far is not consistent with that ideal organization which, under ideal conditions, would doubtless bring the maximum of human happiness. But it is consistent with a steady improvement in his condition, in his place and power in the community, and in his sources of happiness; and therefore we need not despair if, men, manners, and morals being what they now are, it is perhaps the only position he is likely to have for a long time in the future.
We may now conveniently consider the treatment of the wages fund doctrine by the economists of Continental Europe; and among these, chiefly by the Germans. Chronologically, this phase of the history of the doctrine should have an earlier place; for an unmistakable departure from the lines of reasoning traditional among the English was made by Hermann before the days of the younger Mill. But the insular condition of social and political speculation in Great Britain in the middle of the century, and the stagnation of economic thought in particular, prevented any breath of influence from reaching English thinkers. The Germans went their way, unnoticed by their English-speaking contemporaries, until, in very recent times, links of connection were formed, and the international exchange of thought has rebegun.
Outside of Germany, there is, before our own days, practically nothing on the subject. The French never were much influenced by Ricardo; and consequently that simplification of the theory at Ricardo's hands, by which wages were assumed to be paid once for all from a specific quantum of capital, never appeared among them in emphatic form, and never received great attention. They commonly said that wages depended on capital; but with less emphasis and less definiteness of statement than among English writers. To go through the hasty and uncertain versions of the relation of capital to wages, which are to be found from Say to Bastiat and Cherbuliez, would be to repeat, with even less satisfactory results, the story of inconsequent thinking which we have found in the English successors of Ricardo. Among Italians, also, nothing of interest or importance appears; and we may turn at once to the Germans.
Hermann has already been referred to as the writer who began the breach with the English theorists. Before his time it is difficult to find much that is promising in German economic thought, beyond the work of popularizing and spreading the views of Adam Smith. Hermann was an incisive and original thinker; and his reasoning on wages and capital is as unquestionably the source of the treatment of this subject in German text-books, as Ricardo's on international trade is of the handling of that subject among the English. He was, moreover, one of the few Continental writers who, before the present movement in economics began, had read Ricardo with care, and had been affected by his example of rigid analysis and unrelenting reasoning; and he approached the subject, unlike Jones and Sismondi, in a mood to develop rather than to question the classic doctrines. The first edition of his Staatswirthschaftliche Untersuchungen was published in 1832. The second and enlarged edition of 1874 served rather to amplify his reasoning than to add anything substantially new. The high intellectual quality of the book and the independence of its thought are beyond question; and the German economists are certainly not without justification in their admiration of Hermann's work and in their willingness to accept his doctrines.
As to wages, Hermann objects to the doctrine then current in England on several grounds. First, the number of laborers paid directly out of the income of consumers is too large to be overlooked; and Hermann notes with approval that Adam Smith had made "revenue" as well as "stock" a source from which wages are paid. Next, the proportion of wages fund to other capital is not defined in the current statements. This objection had been sporadically presented in England before Hermann made it; but neither there nor in Hermann's reasoning is it given the prominent place which it received in later times. The radical objection is the last one. Capital, after all, is not the real source from which wages are paid. That real source is the income of those who buy the products made by the laborers, or, briefly, the income of consumers. Here is the objection accepted as conclusive by Hermann's followers in Germany, and serving as the basis of their own statements of the causes determining wages.Staatswirthschaftliche Untersuchungen, first edition, pp. 280–285; second edition, pp. 474–477. It is significant of the change in social conditions in the interval between the two editions (1832–1874) that in the first Hermann says the wages fund doctrine is practically harmful, because it encourages arrogance among the employers, who are taught to think themselves the real payers of wages, and so entitled to favors and bounties; while in the second he finds it harmful because it teaches laborers to look on employers as the real wages-givers, and so lures ignorant workmen into hopeless strikes.
To understand the views of any writer on the whole range of subjects of which the wages fund doctrine is a part, it is needful to consider his views on the nature and functions of capital at large, and more particularly on the place in the analysis of capital of finished commodities consumed by laborers. Unfortunately, on this vital topic we find Hermann speaking with uncertain sound. Not that he had failed to give careful thought to the analysis of capital. To the word "capital" he gave that larger significance which has already been referred to.See above, Part I, Bk. II, p. 39. Virtually all wealth he regards as capital: classifying it as consumer's and producer's capital, according as it is or is — not yet in the hands of those who are to derive enjoyment for it. This suggestive distinction has been permanently incorporated into most German text-books; while his description of the mode in which circulating capital (a part of producer's capital) constantly passes into commodities for immediate use, and so into consumer's capital, anticipates much modern thought as to the steady ripening of inchoate wealth into enjoyable commodities. Clearly Hermann meant by consumer's capital what has been described in these pages as enjoyable wealth; while producer's capital signifies what. has here been described as simply capital. For a consideration of the fundamental relation of capital to wages, it would be necessary for Hermann to set forth clearly what place he would assign to the enjoyable commodities constituting the real reward of laborers: whether they are to be regarded as producer's capital or as consumer's capital.
But on this topic he did not fully work out his conclusions. In agricultural operations he classes food for laborers as part of circulating capital, i. e., as producer's capital.Staatswirthschaftliche Untersuchungen, p. 307, 2nd edition. Elsewhere he clearly implies that all consumable commodities of a perishable sort, whether used by laborers, by capitalists, or by idlers, are not part of producer's capital at aII.See the analysis of Nutzkapital at p. 221, and of flüssiges Kapital at p. 283. In discussing wages, he speaks of the employers' capital as a fund which could act but once in paying wages, and which would be dissipated unless constantly replaced from the sale of the product, — a statement which implies that this capital is at least the immediate source from which the laborer's wages are first derived. Here are doctrines not clearly formulated and not entirely consistent with each other; defects which illustrate once again the difficulties which beset the thinker in this tangled subject.
We are compelled, therefore, for our guidance in following Hermann's views, to rely on the comparatively brief passages in which he advances directly the doctrine that consumer's income is the real source of wages. This, as we have seen, was virtually the doctrine put forth by Longe, at a much later date, though with much less consistency of statement. Something has already been said in explanation and criticism of it; but in view of the prominent place it has had in the theoretic literature of Germany, something more may be added.
The difficulty with a view like Hermann's is that it does not clearly distinguish between particular wages and general wages, — between the causes which affect the wages of one class of laborers as compared with another, and the causes which determine the wages of all laborers. The nature and extent of the consumer's demand for the products made by a particular set of laborers have an obvious effect on the wages of these laborers; and the inference is easy, however unwarrantable on closer thought, that all wages depend on consumer's demand or income. The transition is made the more natural by the habit of considering capital in terms of money, and the capitalist employer as the possessor of a fund of cash which represents the apparatus of production controlled by him. Even before the time of the younger Mill, the English economists, whom Hermann followed and criticised, frequently spoke of it as a money fund. Ricardo had set the example of reducing all capital to terms of money; his immediate successors did more, and spoke of wages capital as if it consisted of cash and nothing more. Hermann saw that the wages fund, in this sense, so far as it existed at all, was constantly replenished from the sale of the disposable product; and he was naturally led to regard those who bought the product as the real payers of wages. And, to repeat, the wages of any particular set of laborers do depend precisely on this. Their money income and their share of the goods available for consumption are settled by the terms on which their products sell in the market. The appearance of the capitalist employer as a middleman between them and the purchaser does not alter this situation, so long as the competition between capitalists is free. What the employer can pay the individual laborer, or the group of individual laborers, and what he will pay if competition is free, depends on what the consumers pay him.
of the disposable product; and he was naturally led to regard those who bought the product as the real payers of wages. And, to repeat, the wages of any particular set of laborers do depend precisely on this. Their money income and their share of the goods available for consumption are settled by the terms on which their products sell in the market. The appearance of the capitalist employer as a middleman between them and the purchaser does not alter this situation, so long as the competition between capitalists is free. What the employer can pay the individual laborer, or the group of individual laborers, and what he will pay if competition is free, depends on what the consumers pay him.
Bearing in mind that the wages fund doctrine is worth discussing, or replacing by something else, only as an attempt to discover the causes determining general wages, we find very great and very obvious difficulties in the way of applying Hermann's reasoning to the wider question. At bottom, he presents the old question whether demand for commodities is demand for labor; and on that question the reasoning of the classic writers was in essentials so simple and so sound that there is no escape from answering, as they did, in the negative. We may intelligently measure the remuneration of an individual section or class of society in terms of money, and so may seek the measure .of particular wages in the Zahlungsfahigkeit, or money demand, of those who buy the laborers' product. But for society as a whole, and for laborers as a whole, consumable commodities are the only measure of income, — money and exchange being but devices for sharing this real' income among the different members. The ultimate source can only be the output of real goods from the labor of society, — the steady flow of enjoyable things which issues from the exertions of men. This is the total consumer's income, — the source from which all of us, whether laborers or idlers, get remuneration or tribute or alms. It is clear that Hermann did not mean to lay down the proposition that wages come from consumer's income in this sense. He had in mind the money payments of those who buy goods from the employer, and so recoup him for his outlays. But these purchases are of importance only in determining the share of real wages or real consumer's income got by a particular group of laborers: they play no part in the causes determining wages at large.
The same fundamental difficulty emerges from another point of view. Laborers are themselves consumers, in many countries the largest and most important body of consumers. They buy commodities with their wages; and their demand, according to Hermann's reasoning, is an ultimate source of wages. Wages are thus an important source of wages, — reasoning which runs so obviously in a circle that we must be surprised to find it unnoticed by a mind as acute as Hermann's. If it be objected that there are consumers, like rent receivers or pensioners, who are not laborers, the situation is not bettered. Unless we suppose the laborers to produce only commodities bought by these separate consumers, and to buy among themselves no commodities made by other laborers, we still find that consumer's income includes in its constituent parts a larger or smaller element of wages, and that an undefined portion of the source of wages is simply wages.
Hermann's doctrine, ineffective as it is in grappling with the question of general wages, nevertheless has found its way into almost every German book on general economics. On the one hand, the confusion between money and real wages; on the other, the natural disposition to fasten attention to the dealings between the immediate employers and their hired laborers, — make its acceptance easy of explanation. Moreover, in Germany economic discussion has always been, much to its advantage, more concrete than that of Ricardo's followers in England; and the liberal space given to an enumeration of specific causes affecting the wages of different sets of laborers, indicates an attitude toward the whole subject such as would make natural the ready acceptance of an apparently straightforward and practical explanation of wages as determined by consumer's demand. At all events, hardly a book on economics from a German hand since the time of Hermann can be found in which his lead on the subject of wages is not more or less closely followed.
While Hermann himself, so far as spirit and method are concerned, did not diverge far from the classic school, his views on wages seem to have gained acceptance in proportion as the breach with the English writers became wider. In Rau's treatise, which expounded economic principles to two generations of German students on the familiar English lines, we still find the old doctrine that wages depend on the quantity of capital. In later editions Rau referred to Hermann's doctrine in his notes, and there admitted, with caution, that the latter had rightly divined the ultimate source of wages; but the classic theory maintains its place in the text in the dignity of large type.Rau’s Lehrbuch, eighth edition (1868), § 195. In Mangoldt's Volkswirthschaftslehre, which, though not published until 1868, represents the methods and traditions of an earlier date, the subject is discreetly given a wide berth. Apparently, Mangoldt was not disposed to commit himself either to the old doctrine or to Hermann's modification.It is due to this subtle and independent thinker to say that his Volkswirthschaftslehre was printed posthumously, from a manuscript not left in finished state. But in a book like Roesler's on Wages, which, though it made no deep impression on German thought, reflected the drift of things at the time of its publication (1861), Hermann's views appear with marked emphasis. We are told, in italics, that the employer's capital is indifferent to the laborers, who draw their wages solely from the consumers, the employer being merely a middleman.C. F. H. Roesler, Zur Kritik der Lehre vom Arbeitslahn (1861), p. 141; 141; compare also p. 87. Roesler follows Hermann closely on other doctrines, especially in regard to the separate productivity of capital. Roscher's Political Economy, in which the independent German movement first took shape in a general text-book, also accepts Hermann's view. Roscher's statement is sententious, in accordance with his general practice; but it is none the less clearly an adoption of Hermann's view.Roscher's Nationaloekonomie, §§ 165, 166. The rendering of these passages in the English translation of Roscher is far from satisfactory. The year of his first edition (1854) may be noted as a date after which Hermann's doctrine appears in almost every German book on general economics.
The next important and independent step, with effects clearly traceable in the theoretic parts of current German treatises, was taken by a writer still active among us, Professor Lujo Brentano. Shortly after the publication of Thornton's book On Labour, and of Mill's review of Thornton in the Fortnightly, Professor Brentano printed in the Jahrbücher für Nationaloekonomie a paper on the theory of wages as developed by English economists.Die Lehre von den Lohnsteigerungen mit besonderer Rücksicht auf die englischen Wirthschaftslehrer. Jahrbücher für Nationaloekonomie, I Fogle, vol. xvi, pp. 251–281 (1871). Some further discussion of the subject was undertaken by him in the second part of his book on the English trade unions (Zur Kritik der englischen Gewerkvereine, 1872); and it is again considered briefly in the volume on Die Arbeiterverhältnisse demass dem heutigen Recht (1877). The later publications add little to the theoretic matter of the paper in the Jahrbücher, which deserves careful attention, as being, after Hermann, the most influential of German contributions to the theory of wages.
Professor Brentano's paper divides itself into three parts. First comes a sketch, admirably done, of the history of the wages fund doctrine among English writers; then a consideration of that doctrine; and, finally, an effective criticism of Thornton's theory of wages. It is the second part, on the wages fund doctrine, which chiefly concerns us here. With it goes a discussion of the theorem that demand for commodities is not demand for labor. That theorem had been used by the classic writers, and especially by Mill, chiefly as an answer to the notion that the luxurious expenditure of the rich was beneficial to the poor; but Professor Brentano rightly treats it as a simple corollary of the doctrine that wages are paid from capital, and as significant in its relations to that doctrine.
Like Thornton, Professor Brentano is on one point more conservative than some later critics of the old doctrine. Wages he admits to be paid in the first instance from capital. "There must be a stock of accumulated products of previous labor — that is, of capital — sufficient to feed the laborers engaged in production." But, like the English writers of earlier and later date, Brentano does not linger over the why and how of this need of an "accumulation" of real commodities. The point of view is soon shifted to that of the advance of capital by employers to hired laborers, without notice of the difference between this and the advance from an accumulated stock of products. In the book on English trade unions, the importance of capital as the proximate source of wages is again admitted; but it is urged that it is only a vehicle which serves to convey wages to the laborers from their real source. It is on the fixity of the fund, and the ultimate source whence it is replenished, that he professes to differ with Mill and Mill's teachers. He points out with truth that the predetermination or fixity of the wages fund was never laid down emphatically by Mill in the Political Economy; and, at all events, he reaches unreservedly his own conclusion that there is no such fixity. The capital which employers will turn over to laborers is an elastic quantity. It can be swelled by the use of credit, or by trenching on the funds which the employer had meant to use for his own consumption; and it accommodates itself readily to changes in the ultimate source of wages. As to that ultimate source, Brentano expressly accepts Hermann's views: the source lies in the income of those who buy the laborer's product.
The essential thing to note in Brentano's ingenious and able discussion is, that the capital which is described as the proximate source of wages is still conceived as wholly in the hands and at the disposal of the immediate employer of labor. It is still a" fund," though one which can be swelled in one way or another. The best illustration of this limitation of his analysis is to be found in the treatment of the mode in which the capital at the disposal of employers can be enlarged.
As was noted a few moments ago, he examines Mill's statement of the proposition that demand for commodities is not demand for labor. Mill had asked how, even with a high demand for velvets, they could be produced, or a demand for labor could set in, unless there were food, the product of former labor and therefore capital, wherewith to support the laborers who make the velvet. Brentano's answer to Mill is a simple tu quoque. In an advanced community there can never be any difficulty in securing or augmenting capital; for, according to Mill's own doctrine, the distinction between capital and non-capital lies only in the mind of the owner. An increased demand for velvets would cause some owners to change their minds, and so transform part of their possessions into capital; thus an effective demand for labor would appear. This turns the tables on Mill very neatly; for Mill had expounded his doctrine as to the determination of capital by the mere intent of the owner, in language which perhaps fairly warranted Brentano's use of it. But that doctrine itself is tenable only in the limited sense which has already been indicated.See Chapter III, pp. 62, 67, and Chapter XI, pp. 225–227. In the long run, unquestionably it is true that, under a régime of private property, the disposition of the owner decides whether wealth shall be used for immediate enjoyment, or for producing further wealth, that is, as capital. At any given moment, however, tools, implements, and materials are of necessity capital; while finished commodities and food exist in a quantity which, whether rigidly fixed or not, certainly cannot be augmented ad libitum by a mere change of intention.
Brentano had in mind more or less clearly the case of the individual capitalist, who can sell his house or his diamonds or his factory, and can use the money-proceeds in hiring laborers; so transforming, by a mere change of intention, his luxuries or fixed capital into wages-capital. Mill perhaps had a similar possibility in mind; at all events, his language, not only in the passages referred to by Brentano but in plenty of others, looked to the funds and means of the direct employers of labor. As to the funds of an individual capitalist and employer, it is mockery, as Thornton said, to ask whether they are fixed or predetermined. Brentano could have no difficulty in disproving the fixity of the wages fund from this point of view. But such an inquiry can tell us nothing as to the constitution and limits of the total money funds which the whole class of active capitalists have at their disposal for the hire of laborers; still less can it tell us anything as to quantity or the predetermination of the consumable commodities from which laborers get their substantial reward.
We have but another phase of the same difficulty when Brentano refers, as others had done before him, to the possible use of credit as a means of swelling the sources from which wages are paid. He remarks that the capitalist will always be willing to grant larger wages, provided he can get them back through higher prices paid him by the consumer; and, if it happens that he does not himself possess the funds for the larger payment, he simply borrows them. Of the individual employer this is unquestionably true; and of the process by which a particular set of laborers may get better terms for themselves it is an accurate account. But it is hardly necessary to point out, after what has already been said, that a stretching of credit can not possibly affect the supply of commodities from which real wages must come, nor serve to increase wages at large. This mode of approaching the problem of general wages is as hopeless as that which makes the wages fund expansible by a change in the intentions of employers. When Brentano, in his book on trade unions, gives a statement of the wages fund doctrine, preparatory to a refutation of it, he defines the fund as "the property [Vermögen] of a country which can by possibility be used, either directly or as a means of obtaining credit, for the payment of wages."Zur Kritik der Englischen Gewerkvereine, pp. 200–203. Here the word Vermogen is used with the same connotation of money available for paying wages that appears in the traditional use of the word "funds" by English writers. The refutation of the doctrine in this form does not advance matters more than the advocacy of it did.
If the negative part of Brentano's reasoning is thus unsatisfactory as to the real difficulties of the subject, the positive part is no more conclusive. It is true that Hermann's theorem is cited in terms, and is accepted: consumer's demand and income, we are told, are the real source of wages. But Brentano does not fail to see the difficulty arising from the fact that laborers themselves are consumers. A rise in wages, he points out, may be secured partly at the expense of other wages, and so may be nugatory for laborers as a class. It may be secured also, in part or in whole, from the incomes of other classes, — from those of employers or investors or rent-receivers, and so may represent a substantial change in distribution to the advantage of the receivers of wages. All this is true; and followed out to its last consequences, would bring the writer face to face with the problem of the elasticity of the total money funds and the total real funds which may go to laborers as a whole. But Brentano does not proceed to this stage. He accepts Hermann's theory as a needed correction of that version of the wages fund doctrine which had been brought into renewed prominence by the attacks of Longe and Thornton; he hints at the deficiencies of Hermann's solution, so far as general wages are concerned; and then remarks that after all wages at large are an abstraction, a vague and indeterminate generality, and that the only thing worth discussing is the concrete rise or fall in the wages of specific sets of laborers. This is not an unnatural conclusion, in view of the unsatisfactory character both of the old views and of the substitutes offered by writers like Thornton and Longe. It is obviously natural, more especially, to a writer who, like Brentano, had given detailed study to the history and doings of trade unions, and thus had been brought into contact with the effective causes that bear on the fluctuations of particular wages; causes which, as has been pointed out elsewhere,See pp. 101–108, infra. have little to do with the general flow of the real wages fund.
The final conclusions reached by Brentano are thus sensible enough, so far as application to practical questions goes. The source of general wages is elastic; there is no iron-clad obstacle in the way of an advance in wages for any particular set of laborers; such an advance does not necessarily mean a corresponding loss to other laborers; a general simultaneous advance for all laborers is not indeed theoretically impossible, but is not worth discussing because outside the practical possibilities of real life. All this is true; and if there is ambiguity as to the cause of the elasticity of wages, — whether of general or particular wages — it does not affect the truth of the conclusions as to the limits to trades — union action. But the theoretical basis of the whole does not go deep. There is no complete statement of the function of capital in. the production or distribution of wealth, or of the relation between the operations of the individual employer and the source of real wages.
Hermann and Brentano are the two writers who have taken the lead among the Germans in the discussion of wages; and the result of their combined labors has been to push aside, in the text-books and hand-books of the Germans, the simple formula of the older English writers, and to leave nothing very distinct in its place. It would carry us beyond the scope of the present inquiry to examine the variations of the theory of wages as they appear in the different text-books of recent years.For a brief review of the treatment of the topic in some of the well-known German books, see the Quarterly Journal of Economies, October, 1894, where the substance of the present chapter was published, with some further details and examples. In most of them a "relative" truth in the wages fund doctrine is admitted, or at all events something is said as to the importance of capital for the immediate payment of wages: and then there is some further reference, more or less explicit, to Hermann's proposition as to consumer's demand as the ultimate source or determinant of wages. On this topic, as on others, the theoretic views of the German economists of the last generation mark a transition stage. The clear-cut doctrines and unqualified statements of the Ricardian school in England were found inconclusive and unsatisfactory. But nothing very precise and definite took their place. The old sharply-defined conclusions were sometimes rejected without attempt to put anything in their place; sometimes the edge was taken from them by qualifications and corrections which made it difficult to say how much was really left. This tentative mode of expounding the subject was unquestionably better than the bold and uncompromising dicta of M'Culloch, and in many ways was preferable to Mill's exposition, with its emphatic elaboration of the Ricardian deductions. But it could not lead to anything definitive; and certainly on the wages fund it served rather to bring out the deficiencies of the English writers than to substitute any new doctrine of substantial value.
This book, written in 1892–1895 and published in 1896, has long been out of print. The London School of Economics (University of London) now honors me by undertaking a reprint in its series of scarce books and monographs.
The book should be read in the light of the stage at which economic theory stood when it was prepared. Large matters of principle were then in a ferment, which in England and the United States had led to revolt against the older doctrines and against the dominance of John Stuart Mill. On no point was that revolt more effective than on the subject of wages. The wages fund doctrine, so long the accepted basis, or at least starting point, of the treatment of wages, was strongly attacked and weakly defended. In England, Longe, Thornton, and Cliffe-Leslie, were among the more conspicuous of the dissenters; and Mill yielded to Thornton, giving up the doctrine. The only serious attempt at defense came from Cairnes, who vet endeavored not so much to maintain the old view as .to remodel and rehabilite it, — with no real success, and with no effect in stemming the contrary tide. In Germany, there had long been discontent with this doctrine, as with the general drift of the British school; not, to be sure, with such sharpness and consistency as to have any influence on the general economic formulations of the time, yet so wide-spread as to promote the reaction in theory.
It was in the United States that the attack was most vigorous. The most conspicuous assailant was Francis A. Walker. Of him one of the keenest critics and eclectics of his day, Henry Sidgwick, remarked that he had at last given the coup de grace to the doctrine. Henry George argued on lines very similar to those of Walker, with the fluent and effective style that brought this, with the rest of his teaching, to the notice of an enormously large circle of readers. These were joined shortly by J. B. Clark. By the time of that scholar's contributions, the old doctrine was so shattered that he could deal with it as almost negligible, and could proceed without further ado to the formulation of very different theories of his own. It became quite the fashion among Americans to show one's modernity by a contemptuous dismissal of the wages-fund doctrine and of all that went with it.
In these debates it seemed to me at the time, and seems to me still, that there was great confusion of thought. Both the older writers and the newer were partly right, partly wrong. In particular both failed to distinguish the process by which the money wages of hired laborers get into their hands from that by which the laborers get the real income of goods and services emerging from the complicated operations of production. The older writers had usually started on the right track, but soon got astray (following Adam Smith) by treating it all as a matter simply between the immediate employer and his men. Most of the dissidents did not even start right, and at all events went astray in the same way as their predecessors. It was a case of throwing out the good with the bad.
I have to confess that, feeling quite sure that there was this confusion, the spirit of counter-reaction was unduly strong in me. Some things which are in this volume could certainly be said in a better way. I have no doubt there are other things which, to say the least, call for modification. Especially as regards the continued use of the term "wages fund," I should change what I wrote forty years ago. The phrase is of more than doubtful expediency, having connotations which, even tho they be explicitly disclaimed, are not easily shaken off. However defined and explained, it implies the existence of a constituent in the social income which is set apart or determined in advance with some sharpness. But the reasoning with which the first chapter of this book starts, and which gives its keynote, is applicable only to the social income ("real income") as a whole, and to the "predetermination" of that. I hope and believe there has been no failure in the volume to perceive this distinction, or call attention to the qualifications needed when applying the notion of predetermination to any one form of income, such as contractual wages. Very likely the qualifications are even more important than is indicated in these pages. At all events the term "wages fund" should be discarded.
What now, irrespective of terminology, remains of the old formula and what saving remnant may there be in and for new formulations? The answer can be indicated, I think, by comparing the old wages doctrine with the doctrine on money and prices which was its contemporary. The two belong in the same class, and reflect on the attitude characteristic of economic thought at the time of their vogue. In both the statement is of independent variables which are confronted with each other. The terms of exchange establish themselves once for all. It is tacitly assumed in both that the amounts are not dependent variables. The number of laborers (the "population") depends on one set of causes; the wages-fund ("the capital") depends on quite another. Similarly, the quantity of money is supposed to be settled by causes which have nothing to do with those that bear on the volume of commodities.
Both formulas, however, try to find a simple statement and a simple solution for phenomena that are highly complicated. The one tries to find out what determines the general price level; the other what determines the general wages level. In neither case, it may he noted, was any doubt entertained by the older writers whether there was any such thing; no question, of the sort which has been raised in later days, whether there really exists such a phenomenon as "general wages" or "general prices." Particular wages and particular prices were indeed envisaged, hut were reserved for later and independent treatment, being quite separate from the other thing, — the general level, regarded as a real thing and as presenting problems of its own.
But the statement made was in either case no more than an introduction, a mere presentation of the problem. The form of presentation does serve to focus attention on the matters which we should know if we try to answer questions about general wages or general price. Perhaps it presents nothing more than a truism. But a truism is often a useful introduction; and truisms are often forgotten, in learned as well as in unlearned discussions. On the other hand, a proposition of this character cannot pretend to be a solution. Clearly much more must be done before that goal is reached or even approached. We must learn what are the factors which have made the constants such as they are, or are supposed to be, at the given moment, and what changes in them are likely to be brought about, and how. We must consider, too, whether there are really independent variables. In monetary theory, for example, we elaborate at once by examining what is meant by the "money," or circulating medium, whose quantity is of effect; rehearsing the familiar take about the credit instruments and the total means of payment. And then arises the more important and difficult question of interdependence: how far, say, an increase in the volume of goods of itself may bring about, or contribute to, an increase in the quantity of the means of payment. Analogous questions arise if we push on from the same sort of starting point with regard to wages; and some of these l have tried to bring out in this volume.
To repeal, then, the older theories, as to both problems, can be said to give what is simply a starting point, an introductory statement. And they do this, I am still inclined to think, in a way that is not only permissible, but helpful. Monetary theory, I judge, is going hack more and more to the good old quantity formulation as that which is the first step toward a solution. And a tendency of the same sort appears in the recent discussions of wages theory; though, obviously, when it comes to the later stages of the analysis of wages, the divergence from the old paths is great indeed, certainly greater than in the case of monetary theory.
On the main lines of reasoning in this introductory analysis, there is not yet a consensus of opinion among economists. But I stand my ground. The length of the period of production, the relation between present work and present consumers' income, what capital means and the part which it plays, the curious development of economic theory on these matters from Adam Smith to the close of the 19th century — on these essentials I find nothing of importance to modify. There is no occasion, however, and indeed no possibility, of entering here on a discussion of the course of thought and debate during the past generation. The book as it is now reprinted, unchanged in any particular, has played its modest part in the stir of economic theory during the life-time of its author; and I am glad to accept the judgment of the editors of the series that it deserves to be made accessible to students of a later day.
F.W. TaussigHarvard University, November, 1932
We come now to the period of active discussion which begins with Ricardo and ends with John Stuart Mill; the period in which the doctrines of the classic economists gradually secured their strongest hold on students and thinkers, and in which the wages fund doctrine is often supposed to have arisen and flourished. All of the writers of the period were contemporaries of Ricardo; most of them knew him, or might have known him, in person. Their writings, however, were published after his, and with hardly an exception were profoundly affected by his compact array of clear-cut and consistent doctrines. On wages, as on other subjects, they showed the unmistakable traces of his influence; and it is very doubtful if all their discussion on this topic added anything substantial to what had been built up by Adam Smith and Ricardo.
In following the discussion by these later writers, it will be convenient to neglect the chronological sequence of their publications, and to group them according to the temper in which they approached economic questions. We may consider first those writers who, like the elder Mill and M'Culloch, followed Ricardo and Adam Smith with loyal fidelity, and made little profession of differing with their masters or of improving on them. Thereafter, the writers of earlier or later date may be taken up, whose attitude was more independent and critical; whether, like Senior, they were in general accord with the dominant views, or, like Richard Jones, protested vigorously against them.
First in the list of the Epigonen, as the Germans, not without a good show of reason, dub this group of writers, comes James Mill, the intimate friend of Ricardo and Bentham. James Mill probably exerted a more enduring influence on the course of economic thought through the remarkable training in Ricardian economics which he gave his son, than through his own writings;See the younger Mill's Autobiography, pp. 27–29. yet these have an independent value, and are significant of the stage which the theory of wages now had reached.
In the opening chapter of his Elements of Political Economy,First published in 1821; a second edition appeared in 1824, a third in 1826. I quote from the second edition, the only one I have seen. James Mill starts in a fresh and promising fashion. He distinguishes sharply between capital and wages. Instruments and materials are "all that can be correctly included in the idea of capital. It is true that wages are in general included in that idea"; but this is an error, "the idea of the subsistence or consumption of the labourer, for which wages is but another name, is included in the idea of the labour."Elements, pp. 17, 18. Here we have a distinction which anticipates some very modern discussion. Mill presently adds that the laborer's subsistence or wages, "being advanced by the capitalist out of those funds which would otherwise have constituted capital in the distinctive sense of the word, and being considered as yielding the same advantages, it is uniformly spoken of under the name of capital, and a confusion of ideas is the consequence."
If this first step had been followed up, we might have had with James Mill a new and important stage in the development of the theory of capital and wages. But he never got beyond this first step, and seems to have forgotten that he ever took it. When he has completed the introductory chapter on capital and labor, from which the passages just quoted are taken, and proceeds to the separate treatment of distribution and wages, he has nothing more to say of the confusion of ideas in regard to capital and labor. He slides easily and quickly into the familiar statement that wages depend on capital. It is true that he begins by saying that both laborers and capitalists get their reward from the commodity they produce, "or the value of it"; and that "to suit the convenience of the labourers," they receive their share of the commodity in advance, in the shape of wages. But he passes at once to the proof that "the rate of wages depends on the proportion between Population and Employment, in other words, Capital," — this being the italicized summary of the section in which the rate of wages is examined. Apparently "capital" here means not only tools and materials, but subsistence also. For the supposition is made that the number of laborers increases, while the amount of "food, tools, and materials" remains the same: then wages must fall. The point of view is shifted within a page, within a paragraph, from a treatment which contemplates a sharing of product between laborers and capitalists, to a consideration of the ratio between the number of laborers and the total "means of employment" or "requisites of production," — both phrases being used. Thereafter we hear simply of a ratio between capital and population: the familiar formula emerges. "Universally, then, we may affirm, other things remaining the same, that if the ratio which capital and population bear to one another remains the same, wages will remain the same; if the ratio which capital bears to population increases, wages will rise; if the ratio which population bears to capital increases, wages will fall."Elements, p. 44.
The use made of this formula is characteristic of the drift of the discussion of wages among English economists for the next half-century. Mill proceeds at once, after giving but a page or two to the universal proposition, to the corollary which, to his mind and that of his contemporaries, made it mainly important. Population had a "natural tendency" to increase faster than capital: hence are wages low, and the condition of the great body of the people poor and miserable. Their condition can improve only if the tendency of population to increase is checked by prudence. This was the point, however speciously it was concealed at the outset, at which the whole reasoning was aimed. And for this, it was not material whether the thing to which population bore a ratio was entitled "capital" or "subsistence" or "commodity" or "wealth," so long as it was made to appear that population had the "natural tendency" to increase at the more rapid rate. James Mill accepted the familiar phrase "capital" to describe the resources which could not be expected to grow as fast as population, even though he had expressly defined capital in a manner which might have led him to consider afresh the precise grounds on which his predecessors had laid it down that laborers were paid or supported from capital. But he had no great interest in such an inquiry, absorbed as he was, in common with his brother economists, in questions of production and exchange. So far as wages were concerned, the Malthusian doctrine and the pressure of population were the main things to be considered: the details by which wages might be shown to depend on capital at any given time, called for no special attention.
A much less important personage than James Mill, and a much less familiar name to economic students, is Mrs. Jane H. Marcet, who seems to have been the pioneer in the many endeavors made in this eager century to popularize political economy. Mrs. Marcet published in 1816 her Conversations on Political Economy, a series of imaginary conversations between "Caroline," an ingenuous maiden, and "Mrs. B.," a wise old lady, who naturally does most of the talking. The book had so little vogue in its day, going through four editions between 1816 and 1821; and it gives interesting indications of the shape in which economic doctrines then were interpreted by a person of good intelligence who did not affect to have any theories of her own making.
In the conversation on capital, the difference between rich and poor is first referred to; then the circumstance that the rich, to maintain and employ their capital, must advance it to the poor; the perpetual consumption and reproduction of capital; profit arising from the fact that laborers produce more than is advanced to them, — all this is neatly expounded, with a characteristic comment that it is "one of the most beneficent ordinations of Providence that the employment of the poor should be a necessary step to the increase of the wealth of the rich."Conversations, p. 98. Those who are disposed to judge the classic writers by their fruits may not unnaturally be roused to wrath by such as teleology. When it comes to wages, the inquiring Caroline is informed first that they depend on the habits of the poor and the degree of prudence they practice in multiplying, — the exposition resting faithfully on Malthus. Shortly after, it is laid down in terms that wages depend on the ratio of capital to laborers. Plenty of capital may indeed coexist with low wages, if the laborers also are numerous, — thus in China; while capital, though absolutely scarce, may yet be plentiful relatively to the number of laborers, — thus in America. The primary proposition that wages depend on capital is proved, after the fashion of the time, by analyzing a simple case: a shipwrecked crew is supposed to land, stripped and forlorn, on an island where, obviously enough, they must depend on the original settlers" for maintenance and employment."Conversations, pp. 122, 124, 136, 143. The illustrations from China and America are obviously taken from the Wealth of Nations, Book I, ch. viii, p. 32.
The reader conversant with the economic literature of England during the first half of the present century, need not be told how familiar a ring all this has, or how faithfully it reflects the expositions long current of the theory of wages. The reason for singling out for mention this particular bit of popularizing literature is the early date at which it appeared, and the evidence it supplies of the source whence the whole train of thought was derived. Mrs. Marcet first published her Conversations in 1816, at a time when Ricardo was known almost exclusively by his pamphlets on monetary subjects, and when the writers to whom the maker of a tract would look for guidance were mainly Adam Smith and his immediate successors.Ricardo's Essay on the Influence of a Low Price of Corn was published in 1815, and the essence of all his characteristic doctrines can be found in this compact tract; but they are presented in a manner to reach the understanding of only a very small circle of readers. Ricardo is mentioned in the preface, and evidently is followed by Mrs. Marcet in the exposition of money, coinage, and prices. But on value, Adam Smith's analysis of cost of production into its constituent parts, — wages, profits, and rent, — is faithfully followed. On foreign trade there is similarly no trace of Ricardo's unmistakable doctrines; indeed, Adam Smith is followed in a doctrine which no follower of Ricardo would fail to reject, — his eulogy on the home trade as yielding more “encouragement to industry" than the foreign trade. Clearly, the wages fund, essentially in the form in which it was retained for the next generation, is here found in a writer who derived her knowledge and inspiration from economic literature as it stood before Ricardo's peculiar doctrines had been incorporated into it. The dependence of wages on capital, the ratio of capital to population, the standard of living and the "habits" of the population as the important determining factors, — these are the doctrines which the popularizer gathered from the political economy of the day. They are evidently derived, in the main, from Adam Smith and Malthus. Ricardo soon put his stamp on them; but before his day the essentials could easily be put together.
Next among those who represent the views current in their day, comes a writer who would have been highly indignant at finding himself ranked in any way with so modest a personage as Mrs. Marcet, — John Ramsay M'Culloch, member of the Institute of France, editor of the works of Adam Smith and Ricardo, author of a widely accepted exposition of the Principles of Political Economy and of many other works of repute, ever a welcome contributor to the reviews and the cyclopædias, honored witness before Parliamentary commissions, — in fact, the most prominent figure in the economic world in the period from 1820 to 1850. The fate of M'Culloch is a warning to those who bask in the sunshine of general favor. Once the authoritative expounder of the economic gospel, he is now, in the minds of those who would be in the van of thought, the representative of all that is bad in classic political economy. In fact, M'Culloch has been made somewhat of a scapegoat. He was an honest and an able man, who did good service in his day in spreading knowledge and in contributing helpfully to the understanding of many concrete questions. Having a great faith in the completeness and accuracy of his own knowledge, and a great willingness to apply the formulas of the day to any and every problem that might appear, he naturally stated the doctrines current in his time in their most unqualified form, and became a ready butt for those of a later day who had shaken loose from them. However great his pretensions as a man of science, M'Culloch was but a popularizer of the doctrines of Adam Smith, Malthus, and Ricardo, and stood for no views that were his own except by a process of absorption from others.
M'Culloch has been sometimes spoken of as the author of the wages fund doctrine;Thus Mr. John Rae remarks (Contemporary Socialism, 2d edition, p. 360) that M'Culloch was "more than merely the expositor of that ['orthodox'] system; he is really one of its founders, the author of one of its famous dogmas, at least in its current form, the now exploded doctrine of the wages fund." And Mr. James Bonar (Malthus and his Work, p. 155, American edition) tells us that "the theory of a wages fund was formed from the facts of a perfectly exceptional time, and on the strength of two truths misapplied, the doctrine of Malthus (on Population) in its most unripe form, and of Ricardo (on Value) in its most abstract. J. R. M'Culloch seems to have been the first who put the two together." but there is an a priori improbability that he really originated any independent doctrine whatever, and no indication that he did more in this case than to restate and put into more definite form what had been worked out by others. M'Culloch first set forth his views on distribution and on wages in the article on Political Economy which he contributed to the supplement to the Encyclopædia Britannica, and which he expanded into his Principles of Political Economy in 1825. That book went through five editions in his lifetime, the last being published in 1864. Meanwhile he printed in 1826 an Essay on Wages, which in 1854 was revised and enlarged as a Treatise on Wages. In all these writings, not to mention others, the conclusions and the form of statement, even the very words, are repeated with exemplary and monotonous consistency.
To quote the words of the first edition of the Political Economy:
"The capacity of a country to support and employ labourers is in no degree dependent on advantageousness of situation, richness of soil, or extent of territory . … It is obviously not on these circumstances, but on the actual amount of the accumulated produce of previous labour, or of capital, devoted to the payment of wages, in the possession of a country, at a given period, that its power of supporting or employing labour must wholly depend. A fertile soil affords the means of rapidly accumulating capital: but that is all. Before this soil can be cultivated, capital must be provided for the support of the labourers employed upon it, just as it must be provided for the support of those engaged in manufactures, or in any other department of industry."M’Culloch’s Political Economy, 1st edition, p. 327.
This is all that M'Culloch has to say as to the basis of the doctrine that wages depend on the capital available for paying them. The same language, substantially, is used in all the editions of the Political Economy, and in the two versions of the Essay on Wages. Elsewhere, in discussing capital as a means of increasing the productiveness of labor, he follows Adam Smith in saying that the accumulation of capital must precede the division of labor;Ibid., p. 95. beyond this, there is no further consideration of the why and how of the dependence of wages on capital. M'Culloch was an ardent and faithful follower of Adam Smith and Ricardo, and his writing has the easy flow of the former with yet the angular and unqualified doctrines of the latter. His exposition differs from theirs mainly In emphasis. In the note on wages which he appended to his edition of the Wealth of Nations (1828), he put the doctrine of wages and capital, as it stood with Ricardo's stamp on it, with characteristic vehemence: "No other fund [than capital] is in existence from which the labourers, as such, can draw a single shilling."Wealth of Nations, M’Culloch’s edition, p. 470.
This much seemed to M'Culloch, as to a long series of writers of his generation, so simple and self-evident that, to be proved, it needed but to be stated. He passed at once to the phase of the wages question which did seem to need all possible proof and illustration: to the relative growth of population and capital, and the pressure of population on subsistence. Thus he reached, in the phrase which forms the caption of a section in the Essay on Wages, the topic of "natural or necessary wages, different in different countries and periods; dependent on the quality and species of the articles required for the subsistence of the labourer." When he thus proceeded to the discussion of the relative growth of population and capital, he evidently meant by "capital" simply food, and used the proposition that market wages depended on the ratio of population to capital, chiefly as an easy introduction to the Malthusian doctrine. It was with more or less conscious thought of the ratio of food to population that he laid it down in sweeping terms that "the rate of wages in all countries and at all periods depends on the ratio between the portion of their capital allotted to paying wages, and the number of their labourers."Treatise on Wages (1854), p. 7. — In this tract the reader will find also some remarks (at pp. 49, 50) about the advantages of high wages to the capitalists, because they bring "security and tranquility" and are "incomparably the best defence of the estates and mansions of the rich." That M'Culloch could insert such remarks in a tract designed primarily for laborers' reading, shows bow hopelessly be lacked any saving sense of humor.
There is little indication that M'Culloch ever got beyond this stage in the wages fund doctrine. It remains, in all his many disquisitions, simply an introduction to the Malthusian discussion. It is true that in the Political Economy, he inserted, in later editions, a paragraph or two which went a trifle farther. He drew the corollary that the interests of laborers and capitalists are identical, because "a capitalist can not increase his own stock without at the same time, and to the same extent, increasing the wealth, or the means of subsistence of the working classes," — a comforting doctrine very like that of Mrs. Marcet, just referred to. He insisted, too, on the practical certainty that "all the capital, through the higgling of the market, will be equitably distributed among all the labourers"; hence "it is idle to suppose that the efforts of capitalists to cheapen labour can have the smallest influence on its medium price."These passages are quoted from the fourth edition of the Political Economy (1849), pp. 399–400, I have not seen the second or third editions, but suspect that this new matter may have been inserted as early as the second edition (1830). This has something of the ring of a wages fund doctrine with rigid lines, sufficient for the explanation of any and all questions concerning wages. M'Culloch, in another passage inserted in his later editions, mentioned the possibility of an inquiry whether "an increase of capital is synonymous with an increase of the means of employing labour."Fourth edition, p. 401. He disposes of the inquiry summarily by referring to his previous discussion of the effects of machinery on wages, where he conceived that he had shown that "the introduction of machinery uniformly increases the aggregate demand of society for labour and wages." These additions to his first statements show that M'Culloch did come to have some glimpse of the fact that there were some questions on the relations of capital to wages which did not connect themselves once for all with the theory of population. But he never followed them out, or discussed them: briefly touched on them, still retaining his exposition in essentials as he had first given it to the public when a young man barely in his majority. It is significant that when he touched on combinations of laborers and the concrete questions of wages which arise regarding them, he said not a word of a limitation of wages by capital, or of any light thrown from this point of view on the possible effects of trade unions. We shall have occasion presently to consider his attitude, as well as that of other writers, on combinations and trade unions. For the present it suffices to note that he virtually did not cite the wages fund at all on this aspect of the problem: a further bit of evidence as to the use of the doctrine, by the writers of this period, as a means primarily of proving the need of restraint in the growth of population.
One or two other writers who illustrate still further the manner in which wages were usually set forth by the group to which M'Culloch belonged, may receive brief mention. Like M'Culloch, they assume once for all the determination of wages in the first instance by the ratio between capital and population, and then proceed without further ado to the consideration of other less simple matters. Torrens, in his Essay on the Production of Wealth (1821), tried to take a middle ground between Ricardo and Malthus in regard to the mooted questions of value; but on wages he assumed as a matter of course that they depend on the advance of subsistence by capitalists to laborers, and then pushes this line of thought no farther. On one point only does he even stop to consider the relation between wages and capital; influenced perhaps by a suggestion of James Mill's, referred to a moment ago. It occurs to him to inquire whether subsistence should after all be classed as capital; but he concludes that this is not "a forced or unwarrantable extension of the meaning of the term, capital," since the capitalist advances wages, as he provides materials and tools, "for the express purpose of obtaining a reproductive return."* Thirteen years later, when the doctrines of the classic school had been much more frequently worked over, and had gained much wider acceptance, Torrens wrote on Wages and Combinations (1834). Here we have a discussion at large of the theory of wages, by an able hand, and might expect some detailed inquiry into the meaning and grounds of the proposition that wages are determined by the amount of capital. But no such inquiry is undertaken. It is assumed without question or argument that wages are paid from capital; capital is conceived in terms of food, — so many quarters of wheat; and the upshot of the whole book is that wages can be little influenced by combinations, but can be effectively raised through a check to the growth of numbers and through free trade in grain. It is significant that Torrens, while reasoning that wages are paid from capital, evidently does not see herein any ground for alleging that combinations of laborers can not affect wages. On the contrary, he argues that a universal combination might conceivably raise all wages, until they reached the point where the curtailment of profits would check accumulation and reinvestment. All this goes to show that the payment of wages from capital did not present itself to Torrens as a hard-and-fast barrier to efforts on the part of the laborers to better their lot; while, on the other hand, it did not appear to him to be of crucial importance, as compared with the other forces that affected wages.Torrens laid it down that there was a minimum of wages, determined by the laborers' necessaries; and a maximum of wages, determined by the product. Between these limits, combinations of masters and of men might affect wages. This reminds one of the mode of expounding the theory of wages which in later times became current among the German economists, and is still much in vogue among them. See the Quarterly Journal of Economics, vol. ix, p. I6 (October, 1894). As to the position of Torrens on trades-unions and the wages fund, see also what is said at the close of the present chapter.
A similar brevity in the treatment of the doctrine appears in De Quincey's Logic of Political Economy (1844), which is confessedly no more than an exposition of Ricardo's doctrines. It is chiefly concerned with value, and juggles with the subtleties of that subject in De Quincey's most elaborately polished style. In the chapter on wages, he proceeds to mention four determining factors: (1) the rate of movement of population, (2) the rate of movement of capital, (3) changes in the price of necessaries, (4) the standard of living. Little is said of capital, and it is simply assumed, in direct acceptance of the usual compact statement, that the ratio of capital to population determines wages. De Quincey's reasoning rather than reasonable mind brought him to the curious conclusion that a rapid and immediate effect on wages could be exercised only by the third of his four factors, — changes in the price of food. The other factors could vary but slowly; hence, by a residual process, he was led to the conclusion that "the daily cost of necessaries alters sometimes largely in a single day, and upon this, therefore, must be charged the main solution of those vicissitudes in wages which are likely to occur within one man's life." For the present subject, De Quincey's discussion deserves notice only as yielding one further piece of evidence as to the general acceptance of the doctrine as to the payment of wages from capital, and the slightness of the emphasis placed on it.
We come now to a writer who at least saw that there was a question here, and stopped to think about it, — Nassau W. Senior. Professor Böhm-Bawerk,Böhm-Bawerk, Capital and Interest, p. 272. in his admirable history of the theories of capital, has pointed out the merit of Senior in appreciating the need of some independent explanation of interest as a share in distribution; and an equally able and certainly no less critical historian, Mr. Cannan, has similarly given him credit for perceiving the inadequacy of what his predecessors had said on interest and profit.Cannan, History of the Theories of Production and Distribution, p. 214. Praise of the same sort can be given to Senior's treatment of wages also. He did not on the whole advance the discussion of wages as much as that of interest; but he faced it squarely, and showed himself awake to the inadequacy of the simple phrases and generalizations which had been current since the days of Adam Smith and Ricardo. Senior, in fact, was the most acute critic of his day. Intellectual indolence prevented him from pushing his work beyond the stage of criticism. He began his contributions to economic literature with a burst of promising activity: lecturing at Oxford on value, on wages, on population, on international trade. Ricardo's peculiar doctrines and phraseology were subjected to criticism which was severe, but in the main just; and Malthus's excessive emphasis on the pressure of population led to a correspondence in which Malthus virtually accepted Senior's version of his own views. Perhaps the most successful constructive part of his work was in the lectures on international trade and the movement of the precious metals, where Ricardo's general reasoning on those subjects was carried to new and important corollaries. On wages he published in 1830 Three Lectures on the Rate of Wages, which contain almost everything that he ever said on that subject. The matter of these lectures, as well as that of the lectures on other topics, was later incorporated in the general essay on political economy, amounting to a small book, which Senior prepared in 1836, in the form of an article for the Encyclopædia Metropolitana. With this article, — written presumably to order and with no great deliberation, — his contributions to economic theory unfortunately came to an end. Other matters of public and private interest engrossed his attention, and he published nothing more on economic theory. His work was thus never carried beyond its first stage of promise, and his results were never maturely developed.
For our purposes, it will suffice to consider the presentation of the theory of wages in the encyclopædia article on Political Economy, in which, as was just remarked, Senior incorporated substantially everything he said on this subject in the earlier essays. He begins by laying it down that wages depend proximately on the commodities appropriated to laborers as compared with the number of laborers; "or, to speak more concisely, on the extent of the fund for the maintenance of labourers, compared with the number of labourers to be maintained." So much is "nearly self-evident." But various current opinions are inconsistent with it, and Senior proceeds to examine at length seven propositions which are thus inconsistent and therefore unsound. Among the doctrines dissected in this prolonged introduction are some that do not touch the present subject, and others that have no longer a living interest; such as the effects of absentee-landlordism, of the importation of foreign commodities, of the luxurious expenditure of the rich. But two of the rejected propositions were those most widely accepted of the time. One, the most familiar of all, was that wages depended on the ratio between capital and the number of laborers: which Senior rejects because "we know of no definition of that term [capital] which would not include many things that are not used by the labouring classes, and, if our proposition be correct, no increase or diminution of these things can directly affect wages." The other important doctrine set aside by Senior was probably mentioned by him because it was attributable, with some show of reason, to Adam Smith, and (as will presently be seen) to Malthus. It was that wages depended on the proportion between the number of laborers and the whole revenue of society. Neither Adam Smith nor Malthus, so far as they held any such opinion, seem to have had anything more in mind than that wages tended to go up or down in sympathy with the general movement of the whole income of the community. In any case, Senior has no difficulty in showing that this is no precise statement of the specific causes determining wages at any one time.
It is clear that Senior set out with the intention of examining in detail the causes determining the real "fund for the maintenance of labourers," and with a strong sense of the vagueness and inadequacy of the current generalizations about the proportion of capital to population. Doubtless he was led thus to inquire more searchingly how wages at any time were exactly fixed, by his comparative freedom from the Malthusian tinge of his contemporaries. But, as he digressed needlessly in his introductory examination of the opinions he rejects, so he wandered from his subject when he came to the statement of his own views; and before he came to the end, was so weary of the task, or uncertain of his ground, that he ended with little more than that simple statement of the problem with which he had begun.
After the introduction, Senior returns to his main subject, and points out that the fund for maintaining laborers depends on two things: the general productiveness of the laborers of the community on the one hand, and the proportion of those laborers, on the other hand, who are engaged in producing goods for the use of laborers. This is simple, but none the less good because it is simple. While only another statement of the problem, it is a statement and a beginning from a promising point of view. It brings out the fundamental fact that all production comes from labor, and brushes away any notion of an independent "productiveness" of land or capital. It brings out another important side of the same fundamental fact, namely, that income from capital and land means simply that some laborers are working to satisfy the wants or caprices of the owners of these instruments, and that the share of the laborers in distribution depends primarily on how many of them are working for the satisfaction of the wants of their whole number. The right statement of a problem is a good step toward its solution; and a modern writer could do worse than to follow Senior in this mode of approaching the subject.
Fairly started, Senior digresses again. He stops to discuss the first of the two factors he has mentioned, — the general productiveness of labor. The intelligence and skill of the laborers; the quality of the natural agents; the aid given "by abstinence, or to use a more familiar expression, by the use of capital"; the interference or non-interference of government, — are successively examined. These are clearly questions of production, and not of distribution; they distract the reader's attention from the main inquiry, and one may suspect that Senior lingered over these comparatively simple matters because of an instinctive hesitation in grappling with the more involved problem of distribution proper. When at last he reaches this, he sets aside at once, as presenting no difficulties, rent and taxes. Rent means that some laborers produce commodities for the use of landlords, and "such labourers may be considered as existing only in consequence of the existence of natural agents of extraordinary productiveness."Senior considered rent no deduction from wages, and no burden on the laborers, because rent was the consequence of the unusual productiveness of certain land. "The labourers who are employed for the benefit of the owners of natural agents may be in general considered a separate class, not withdrawn from the general body, but added to it by the existence of those natural agents." It is a natural corollary from the classic theory of rent to say, as Senior here does, that the laborers who work for the landowners do not diminish real wages; but might not they add to real wages, by working to supply the needs of other laborers, instead of working to supply the landlords? Both as to rent and taxes, Senior failed to follow the line of reasoning which he had marked out at the beginning. Taxes mean that some laborers work "for the supply of the consumption of the government ": and here again Senior digresses to discuss some evils of taxation, holding off for a while longer from the crucial question. At last, rent and taxes are left behind, somewhat after the residual method which has come so much into vogue in our own time. He reaches profits, ·and "the extent to which wages may be affected by the employment of labour to produce, instead of wages, things for the use of capitalists."
Unfortunately, at this important stage, the exposition becomes obscure, and difficult to follow or to state. What the capitalists get, — i. e., how many laborers work to supply their wants, — is said to depend on the rate of profits and the length of time over which the advance of capital is spread. But the rate of profits is surely the consequence rather than the cause of the share of the capitalist in the result of production; or rather it is the same phenomenon defined in different terms. Senior seems to fall into a vicious circle, and to get no farther than to state his problem in another way. He illustrates his principle by supposititious figures, in which the shares of the capitalists and the laborers are stated in terms of the product of so many days' labor. But, in fine, we get nothing that clears away the real difficulties. "The rate of profit depends on the previous conduct of the labourers and capitalists of the country,"— which probably expresses an intuition that at any given time distribution, and especially wages, must be predetermined by forces that have operated mainly in the past. But exactly how the previous conduct either of laborers or of capitalists affects the situation, is not lucidly set forth. We might expect to find here some reference to the mode in which capitalists have been induced to "abstain," and to the manner in which their reward for "abstinence,"— so much discussed by Senior in earlier passages of this same essay, — is worked out; but we hear nothing of it. Almost imperceptibly, Senior drifts back into the familiar mode of approaching the question. Capital is stated in terms of so much food; and the income of the laborers is made to depend at any given time on the quantity of food as compared with the number of the laborers. He forgets, apparently, what he said at the outset, of wages not depending on the ratio between capital and population. It is true that he professes to examine only the simplest state of society, in which all capital may be food; but he examines no other; and he does not introduce at the close those qualifications which appear in a complicated society and which he clearly had in mind when he began.
It may be suspected that if Senior, after writing this statement of the theory of distribution, had laid it aside, and re-examined it after the lapse of two or three years, he would not have given it to the public in its present form. How far a riper consideration would have affected his views, it is idle to speculate. Senior had good sense, a clear and independent head, the easy style of a man of letters: a more mature and deliberate piece of work from his hand might have profoundly affected the subsequent course of thought. As it was, his discussion of wages served on the whole to keep the traditional statement where it was. When he came at close quarters with the subject, he followed Ricardo in analyzing capital into advances to laborers, or food; he laid stress on the proximate dependence of wages on the "fund for the maintenance of labourers" as compared with the number of laborers; and, while he criticised Malthus, he did little to distract the attention of economists from the standard of living as the one great factor to be insisted on in the presentation of the wages question.
We may turn now to some of the writers who dissented more or less from the general theories of the reigning school. On the wages fund doctrine, in the form in which it was then commonly stated, we shall find their dissent neither important in substance nor strong in emphasis.
Malthus's attitude in the Essay on Population has been already described: he had shown some disposition to differ with Adam Smith, and had attempted to give his own analysis of "the funds for the maintenance of labour." In the books and pamphlets which he published in later years, after Ricardo had turned economic thought so largely into new channels, he attempted a modification of the doctrine that the demand for labor came from capital, which followed substantially the lines of his first modest difference with Adam Smith.
Malthus's opposition to Ricardo and his followers centered about his insistence on demand and supply as the primary forces determining exchange and distribution. Hence, in regard to wages, he laid stress on the importance of the proximate demand for labor, and protested against the emphasis on a "natural" rate of wages determined by the habitual subsistence of the laborer. Malthus himself was mainly responsible for the almost exclusive attention which the Ricardian school gave to "natural" wages; and it is part of the irony of fate that he found it necessary to protest against doctrines which were largely of his own making. He insisted on the importance of supply and demand, as they worked at any given time, in the determination of profits, protesting against Ricardo's teaching that profits depended on the price of food; and similarly he insisted on the importance of the proximate demand for labor in determining wages.
As to the nature of this direct demand, however, and the causes which made it large or small at any given time, Malthus after all had not much to say. In the first edition of the Principles of Political Economy (1820) he begins by saying that wages depend primarily on demand and supply, and that "what may be called cost of production of labour only influences wages as it regulates the supply of labour."Political Economy, ch. iv, section i. Demand, thereafter, he speaks of in terms that vary much: sometimes as coming from the "capital" of the community, sometimes from the "capital and revenue," sometimes from the "resources," sometimes from the "general value of the produce." Apparently he did not at this time think it of much moment to consider and define the demand for labor with any painstaking accuracy. In the second edition (1836), he changed his general introductory statement in a manner indicating that he had given more specific attention to this part of the theory of distribution. It may be guessed that Senior's discussion led him to stop to think more carefully about it; beyond question, the steady controversy which he had carried on, since the appearance of the first edition, with Ricardo and his followers, led him to define his views more sharply in this second edition. The most important passage in the later edition may be quoted in full:
"It has been generally considered that the demand for labour is proportioned only to the circulating, not to the fixed capital of a country. But in reality the demand for labour is not proportioned to the increase of capital in any shape; nor even, as I once thought, to the increase of the exchangeable value of the whole annual produce. It is proportioned only, as above stated, to the increase in the quantity and value of the funds which are actually employed in the maintenance of labour.
"These funds consist in the necessaries of life, or the means of commanding the food, clothing, lodging, and firing of the labouring classes of society,"—Political Economy, 2d edition, p. 234.
and then Malthus goes on to point out that a large expenditure of "neat surplus" in hiring "menial servants, soldiers, and sailors" will add to the demand for labor without an increase of capital. Evidently he was here on very much the same ground that he had taken in the Essay on Population: we must consider "the increase in the funds specifically destined for the maintenance of labor, instead either of the increase of wealth, or the increase of capital, or the increase of the exchangeable value of the whole produce."This is the summary given at p. 260 of the second edition of the Political Economy, at the close of the chapter on Wages.
Yet Malthus never got even as far as Senior did in the inquiry what precise relation these funds bore to the capital, or the wealth, or the exchangeable produce of the country. More than this: when discussing other related subjects, and more particularly the closely related one of profits, he fell into the traditional way of speaking of capital simply as constituting the demand for labor, and of the relative advance of capital and population as determining profits.In the discussion of profits in the first edition occurs this passage, which indicates sufficiently how far his reflections had carried him in 1820: "I have stated in a former chapter that the demand for labour does not depend on capital alone, but on revenue and capital taken together, or the value of the whole produce; but to illustrate the present supposition [the italics are Malthus's: the supposition is that capital is abundant] it is only necessary to consider capital and labour." — Ch. v, section ii (p. 234, note, in the American reprint of 1821). So in the second edition (p. 277): "As capital and produce increased faster than labour, the profits of capital would fall"; and so on. His insistence on the "funds" rather than ”capital" as making and measuring the demand for labor arose, in fact, from a desire to influence other parts of economic theory than those connected with the wages fund doctrine proper. He meant to protest against the notion that "natural" wages, determined by cost of production, told virtually the whole story. Further, he had in mind the question how far a market for an increasing supply of commodities could be found among laborers, as capital accumulated and profits tended to decline. All of Malthus's speculations in later years were colored by his adherence to the theory of gluts, or general over-investment and over-production. His views on gluts never gained acceptance, and on the whole did not deserve to; and this aided to prevent his attempt at a re-statement of the immediate demand for labor from making much impression. In any case, Malthus never questioned that commodities turned over to laborers by employers engaged in production were capital; on the contrary, one of the many points on which he quarrelled with M'Culloch was in insisting that food became capital simply by virtue of being in fact turned over to laborers.See Malthus’s Definitions in Political Economy (1827), p. 85. This fundamental part of the current doctrine being accepted, it was natural that corrections in the precise statement of the total demand for wages, applied as they were chiefly in connection with unpopular doctrines like that on gluts, should have failed to affect in any visible way writers of that day or of later days.
Another writer may here be briefly mentioned: Thomas Chalmers, who joined with Malthus in asserting that something like a general glut was possible, and so dissented from the dominant school on at least one fundamental doctrine. Unlike Malthus, Chalmers, in his Political Economy ( 1832 ), always speaks of "capital" simply as the source whence wages are paid. Capital, in Ricardo's fashion, is treated as resolvable ultimately into a succession of advances to laborers: the point on which Chalmers dissented being the possibility of indefinitely increasing those advances without annihilating profits. In his reasoning on the ultimate consequence of investment, and the ultimate source whence capitalists were recouped, Chalmers suggested, though very briefly, a doctrine which later was made much of by German economists, — that ultimately wages were derived from what was paid for the product by consumers and so from the "replacing power in the hands of consumers."Political Economy, vol. I, p. 98. Of this turn in the development of the theory of wages more will be said in a later chapter. In the main Chalmers, even more than Malthus, retained and even reinforced the current doctrines as to the immediate determination of wages by capital, and made no impression on the course of thought on wages and the wages fund.
A much more vigorous protest than came from either Senior or Malthus or Chalmers, against the general doctrines in vogue, was made by Richard Jones. Jones was an able and scholarly thinker, with views broadened by a wide knowledge of history and an appreciation of the lessons of history. His attitude on the wages fund doctrine, as the doctrine stood at that date, is significant. He admitted that it was true hic et nunc, but insisted that in the sweep of history it had but very limited application. His views on our subject appear in the Literary Remains, consisting of Lectures and Tracts on Political Economy, published in 1859, after his death. At what date these fragments were composed does not appear; but from passages in his Essay on Rent, published in 1831, it is clear that he had matured his opinions in all essentials as early as that date.See p. xxvi of the Preface to the Essay on Rent, where there is a clear intimation of the distinctions amplified in the later volume. See also his Introductory Lecture on Political Economy, and Syllabus of a Course of Lectures on Wages (1833), where the same distinctions are summarily stated, pp. 45–52.
Jones laid stress on the fact that, taking the world over, only a small proportion of laborers were paid out of capital. He divided laborers into three classes: (1) unhired laborers tilling the ground as peasant proprietors or serfs; (2) laborers paid directly out of "revenue" by those employing them, such as servants in modern times and retainers in the Middle Ages; (.1) laborers hired by capitalists and paid by advances from them. He maintained that the great bulk of laborers in the world belonged to the first class, and were not paid out of capital. The commodities on which they lived were a fund for "immediate consumption, constituting part of the revenue of the country." The second class were also paid out of "revenue," and not out of capital. In a society like that of the Middle Ages, this class would include not only the great numbers of feudal retainers, but many artificers engaged directly by those wanting their services. As to the third class, England was the only country in which the bulk of the laborers belonged to it; and even in the England of the author's day, the members of the second class were "a body not unimportant."
Here we have on the one hand an echo of Adam Smith's distinction between capital and revenue, on the other hand a large-minded view of the great variations in the machinery of production and distribution among different communities and in different times. The differences which he pointed out between modern advanced communities, and older communities having a fundamentally different organization of industry, deserved much more attention than they received. The English economists of that time had a singularly insular horizon. They regarded only the phenomena that were before their eyes in their own country, and generalized from them with a strange disregard of the absence elsewhere of the conditions on which their generalizations rested. Jones's protests against the undiscriminating rashness with which they applied their doctrines were not heeded; yet they deserve, as they have received, high praise for the historic sense which they evince.Dr. Ingram, In his History of Political Economy, pp. 142–145, has justly pointed out Jones's merit, and the important place he should have among the early thinkers who used a really historical and comparative method.
Nevertheless, as to the third class of laborers, and so as to the conditions of modern societies, Jones does not question the doctrines of the day. Such laborers are paid out of capital, and their wages depend on the amount of capital. "The whole fund from which they are paid is a fund which has to be saved, which goes through a process of accumulation with a view to profit." As their numbers increase, "it is necessary for their continuous prosperity that the community should save and accumulate capital at least as fast as they are multiplying their numbers."Literary Remains, p. 173. Cf. also p. 460. The wages of such laborers depend on the relative growth of capital and population. This is laid down in unquestioning acceptance, as to modern advanced societies, of the doctrine then current.
Jones gave little space to his third class of laborers, hired by capital. In the fragments, attention is given chiefly to the other two classes, which his contemporaries had so completely left out of sight. He thus questions rather the scope of the classic doctrine, than its validity where the assumed conditions are to be found. He maintains, indeed, that the organization of industry by which laborers are hired by capitalists, represents an advance in the methods of production. The laborers work more continuously and efficiently: the capitalists plan and develop inventions and improvements. In fact, there is a tinge of optimism, unexpected in a writer of his stamp, in the reasoning as to the advantages of the capitalist system for the laborer. It brings greater competition for his services, and "nothing can prevent the whole sum paid as wages being dictated by the wants and demands of the whole body of capitalists made more pressing and eager by each successive accumulation of capital. This competition is the workman’s real safeguard, — he interferes with it, ordinarily, much to his disadvantage."Ibid., p. 459. —In another passage (p. 453), Jones touched on the doctrine, which Chalmers had also suggested, that the "real source of the workmen's subsistence" was in the "revenues of the surrounding customers." We have here another hint (no more than a hint) of that teaching as to the bearing of consumers' income on wages and capital which the German economists later developed so fully.
In all the discussions of this period, the mode in which capital served to reward labor was treated in general terms and with a loose touch. Hence it is not often that we find any intimation on a point which in a later period became of prime importance, — the rigidity of the funds "destined" for the maintenance of labor. The point, in fact, was hardly ever raised in terms. Such opinions as were entertained in regard to it are to be gathered from what was said on other aspects oi the question, and more particularly on the possible effects of combinations and strikes among laborers. No aspect of the proposition that wages are paid from capital has caused it to be treated with greater contumely than the corollary, supposed to flow from it, that trades-unions and combinations can not secure any rise in wages. What was said on this topic by the writers of the generation here considered is in itself of interest, and at the same time gives some clue to their views on the fixity or elasticity of the wages fund.
It has already been seenSee above pp. 194–195. that one of the prominent members of the Ricardian school, Colonel Torrens, writing specifically On Wages and Combinations, gives no intimation of any rigid barrier mocking the efforts of laborers to secure better terms. In that essay, the soldier-scholar admits that a universal combination of laborers might secure an immediate general rise of wages, provided that profits were not at the minimum; and he does not conceive profits as necessarily at the minimum, even though he agrees that high profits will stimulate accumulation, and so raise wages eventually at the expense of profits. In reasoning of this sort, wages are assumed as a matter of course to depend on capital: but capital does not appear as a fund unalterable at any given time, predetermining wages once for. all. Similarly, the reviewer of Torrens in the journal in which the classic writers had full sway, the Edinburgh Review,Vol. lix (July, 1834), pp. 341, 342, 348. evinces indeed a spirit sufficiently out of sympathy with workmen and their unions; but at all events does not fling the wages fund at their heads. The familiar remarks about the certain failure of strikes, the committees who spend the union funds on liquor, the slack trade and diminished employment which must neutralize any temporary success, — these appear in characteristic form. But no law of political economy in the way of an unalterable wages fund is propounded for the confusion of the unionists.
Much the same may be said of M'Culloch. That arch-sinner among the classic writers has something to say of trade-unions and combinations in the two editions of his Essay on Wages; and the spirit of it is by no means of that intolerant sort which the traditions as to the tenets of his school would lead us to expect. In the first edition, of 1825, he defends unhesitatingly the repeal, in the year preceding, of the act prohibiting combinations. While scolding laborers freely for every individual strike he mentions, he yet admits that combinations may sometimes raise the wages of some workmen to their "proper" rate. Of any difficulties in the way of a general rise in wages he has nothing to say.Essay on Wages, 1st edition, pp. 186, 188. — There is virtually nothing on combinations and strikes in the various editions of M’Culloch’s Political Economy. That question is taken up more specifically in the second edition of the essay (1854), — an edition given to the public immediately after the great strikes of 1853, and largely with the purpose of spreading among workmen themselves the economic views which the author thought pertinent to the events of the day. Here the case of a general combination and strike is considered. M'Culloch predicts the failure of any such move; not, however, because it is inherently doomed by economic law, but because the masters are likely to outlast the men. He concludes that strikes to force up wages are likely to restart in the emigration of capital to foreign parts: an effect which presupposes that there was at least a temporary success in bringing wages up.Essays on Wages, 2d edition, pp. 84, 86. All this, to repeat, suggests nothing rigid or inflexible in the capital from which alone M'Culloch and his fellows maintained that wages could be paid, and shows once more how vague were their views as to the precise meaning and limits of the wages fund.
The explanation of this general vagueness of statement and unexpected silence on crucial points in the application of the doctrine, has already been indicated. The main interest of the writers of the period was in other subjects. They believed that the chief means of bettering the condition of mankind was on the one hand by the maintenance of a high standard of living, on the other hand by improvements in the machinery of production, more especially by the relaxation of all restrictions on domestic trade, still more of those on foreign trade. Given unfettered play to self-interest and competition (the mainsprings of individual and national prosperity) and economic difficulties would disappear. The only serious danger under such conditions lay in the possibility, — in the minds of many of these men a probability, — that population would increase so fast as to swallow up all gain from increased production. Hence the ready statement of the causes on which wages depended in a form which made it easy to pass at once to the all-important aspect of the question: the necessity of restraint on the advance of population.
The main results of this account of the stage which the wages fund doctrine reached between 1815 and 1848 may now be summarized. The writers of the period have been considered at length, perhaps at wearisome length, because it is the period during which the doctrine was most widely accepted and might be expected to be most explicitly stated. In fact, however, we find it to be stated usually in the vaguest terms, and with little emphasis. Wages are paid from capital, and depend on the amount of capital compared with the number of laborers: so much is laid down in general terms, and then, as a rule, the writers pass at once to other subjects. The reasons which Adam Smith and his immediate successors gave, to explain and prove the dependence of laborers on capital, are not thought to need attention. Ricardo had set the example of assuming, as one of the things settled by Adam Smith, that wages of "productive" laborers are paid from capital. The same tacit assumption was made by most of his successors. Some writers, indeed, like Senior and Malthus, paused to analyze more in detail the nature of the demand for labor; but neither they, nor other writers who might dissent from the current doctrines, denied that capital constituted a demand for labor; and not only a demand, but the most important, even if not the sole, constituent part of the total demand. Jones, the most radical among the critics of the reigning school, denied that wages depended on capital universally; but that the dependence existed in modern advanced communities, he assumed as unhesitatingly as M'Culloch.
While the general doctrine was thus accepted almost without qualification, it was also stated in terms not likely to provoke opposition. The sting of the doctrine, as it was attacked and reprobated in later days, was in the supposed predetermination and rigidity of the wages fund: in the obstacles which it was supposed to present against efforts at immediate improvement in the condition of laborers. Whatever may have been the case in later years, there is no evidence that fixity or rigidity in the wages fund was prominent in the minds of the writers of the period considered in the present chapter. Such evidence as we get on this point, derived mainly from their discussion of combinations and strikes, is in the negative. The wages fund is there certainly not described as rigid, and by inference is treated as elastic.
With the younger Mill's Principles of Political Economy we may advantageously begin a fresh chapter. Not that the book can be said by itself to have made any substantial change in the discussion of the wages fund. On this topic, as on most others of economic theory in its narrower sense, Mill hardly did more than to set forth and codify the accepted views of his time. But his exposition dominated economic thought for near a generation, and, moreover, gave the impetus both to the first bold attack on the wages fund doctrine and to the first deliberate attempt at its rehabilitation. As an indication of the stage at which the doctrine stood for many years, and as the point of departure for the later movement, Mill's position then deserves an attentive examination. For the present, it will be convenient to limit the examination to Mill's views as they were formed at the time when he published the Principles of Political Economy; leaving for later consideration, in connection with the next stage in the discussion, his recantation of the doctrine.
What Mill's views were, and how he reached them and presented them, is to be gathered from various passages in the Political Economy: not only from the chapters dealing directly with wages, but from those on the place of labor in production, on capital, on changes in distribution under the influence of progress, and on other related topics. These passages are not always consistent. They give unmistakable evidence of Mill's failure to revise his book in cool blood, and so to give coherence to the scattered discussions of the same subject as it was approached from different points of view. The two large volumes were composed in a surprisingly short space of time, — less than two years.The Political Economy was commenced in the autumn of 1845, and was ready for the press before the end of 1847. In this period of little more than two years there was an interval of six months, during which the work was laid aside, while I was writing articles in the Morning Chronicle urging the formation of peasant properties on the waste lands of Ireland.” — Mill’s Autobiography, p. 235. Dr. Ingram remarks with justice in his History of Political Economy (p. 150) that Mill never succeeded in fusing his economic theories with his social and philosophic views. It is equally true that he never succeeded in entirely welding together his strictly economic views. In that regard they constitute a remarkable intellectual feat; but they suffered from the hasty composition. It is true that Mill's mind had been busy with economic topics almost from childhood, and that on some subjects he had written out in early manhood much that he incorporated in the Principles. Yet he had never attempted an exposition of the subject at large; and when he came to dash it off in the evenings of two busy years, he could not bring the whole into consistent unity.
It might be expected that the dependence of wages on capital would be set forth by a writer like Mill, deliberately engaged on an exposition of economic doctrine at large, in connection with the element of time in production. The fact that the operations of production are spread over a long stretch of time, though it underlies the whole classic theory of the relation of wages to capital, had rarely received, since the days of Adam Smith, more than passing attention. Mill is not much more explicit than his predecessors. In one place and another, he presents the fundamental point with sufficient clearness; but usually as an incident to the discussion of other matters. At the very outset, in describing labor as an agent in production, he remarks that the labor "employed in producing subsistence, to maintain the labourers while they are engaged in production, requires particular notice. This previous employment of labour is an indispensable condition to every productive operation, on any other than the very smallest scale. ... Productive operations require to be continued a certain time, before their fruits are obtained."Book i, ch. ii, § 2. Here Mill takes the first important step in the analysis of the functions of capital in production; but almost at once he moves off in another direction, by proceeding to consider the nature of the return secured by the persons possessing that subsistence, produced by previous labor, which is needful for present labor. By thus passing at once to the “remuneration for abstinence," he anticipates, probably to the confusion of readers fresh to the subject, the discussion of profits and interest; while he fails to describe with clearness the mode in which different steps in production, of necessity succeeding each other and so spread over some length of time, result finally in the finished and enjoyable commodity. The simple and fundamental fact is but obscurely presented; the more complicated corollary, though its discussion occupies some pages, is yet insufficiently explained.
This failure to develop simple and fundamental truths, while emphasizing abstruse doctrines of uncertain sound, appears throughout the treatment, in the earlier chapters, of capital in relation to wages. "What capital does for production," says Mill at the outset, "is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process."Book I, ch. iv, § I. Thence he proceeds at once to another and much more complicated proposition, — that the distinction between wealth which is capital and wealth which is not, depends solely on the intention of the owner. Little space is given to that function of capital which is all-important for Mill's later reasoning on wages, — the furnishing of food and maintenance for laborers. Only as an afterthought, at the close of another section of the same chapter, does Mill bethink himself to touch again on this simple but essential matter. "It will be observed," he says, "that I have assumed that the labourers are always subsisted from capital; and this is obviously the fact, though the capital need not necessarily be furnished by a person called a capitalist,"Ibid., §2, at the end. — after which there is no further reference to a fact so obvious.
It may serve still further to show in what manner Mill handled this part of his subject, if we follow some of the reasoning which rested on it. The deduction on which most stress is laid in the earlier part of his book, and which he probably had most at heart in the earlier part of his career, was that the luxurious expenditure of the rich did not benefit the poor. It was to dispose of this notion that he endeavored at such length to show that capital could find indefinite employment in advances to labor, or in his own words, that "the portion [of capital] which is destined to the maintenance of labourers may be indefinitely increased without creating an impossibility of finding the employment." The same motive led him to the elaborate proof that demand for commodities is not demand for labor.In § 9 of chapter iv, Book I. This much-maligned proposition is a simple corollary from the axiom (such to Mill's mind it seemed) that laborers are supported by the product of previous labor, dubbed capital. There is much more to say than is found in Mill's pages of the part which luxurious expenditure and demand for commodities play in the working machinery of modern society. The economist of our own day would be likely to connect the discussion of demand for commodities with the general law of demand, with final utility, with non-competing groups among laborers, and with the general interaction of exchange and distribution. And, so far as expenditure by the rich is concerned, he would not think it necessary to linger long, in the earlier stages of his exposition, on the notion that luxurious expenditure, which is the concrete result of unequal distribution, can be of essential advantage to those whose share in distribution is small. But Mill not only lingered over this topic: he pushed the reasoning in another direction, and to topics of the greatest difficulty and complexity. From the statement that the real demand for labor was to be found once for all in the commodities turned over to the laborers for their use, he proceeded to the doctrine that capitalists could turn over an indefinitely large quantity of commodities to laborers, without encountering any obstacle or embarrassment. This was the point at which the whole discussion was aimed. What he meant was that "a market" for such goods could be found without difficulty in supplying all possible wants and whims of the laborers. He failed to consider, — failed at least in this discussion, — that a stage might be reached where it no longer was profitable to increase the advances.
We have here one illustration, — a multitude such might be found, — of Mill's tendency, partly the result of early training, in part doubtless inborn, to follow to its last conclusion one single line of reasoning, regardless of the mode in which other considerations must be taken into account, if we would have, not merely an irrefragable train of argument, but a sufficient explanation of real phenomena. In this particular case, the steady advance of an increasing quantity of commodities to laborers would not continue unless they produced something over and above what was handed to them; and in the end the possibility of steadily enlarging the advances, must depend on a steady increase in productive powers among the laborers, either by an increase in numbers or a gain in efficiency. This ultimate regulation of wages (i.e., of advances from capitalists to laborers) by what the laborers produce, is touched by Mill in later chapters; but it is hardly more than touched. At all events, in his first presentation of the relation of wages to capital, he never hinted at any bearing of product on wages or profits. He confined himself to the axiom that saving means the making of advances to laborers, and to the deduction that laborers would consume any quantity of goods if they had the chance. Thus the discussion, like so much of the deductive reasoning of the classic school, has an unreal tone and a paradoxical end; and even taken at its best, is but a haIf treatment of a subject which particularly needs full and complete treatment.
This digression from our main subject may serve to make clear how Mill, in his first grappling with the relation of capital to wages, gave much more prominence to other questions than the immediate forces at work. He simply took it for granted that wages were paid from capital. We may proceed now to consider in what way he used this proposition when he came to the specific treatment of wages; and more especially whether he gave it more precise and definite form than his predecessors and contemporaries.
Mill's brief statement of the causes on which wages depend, familiar as it is, may be quoted once again: not only because it is significant in itself, but because we shall have occasion to refer to it when considering the writers who came after Mill. After a preliminary statement that competition, not custom, must be regarded in the present state of society as the principal regulator of wages, he proceeds thus:
"Wages, then, depend mainly upon the demand and supply of labour; or, as it is often expressed, on the proportion between population and capital. By population is here meant the number only of the labouring class, or rather of those who work for hire; and by capital, only circulating capital, and not even the whole of that, but the part which is expended in the direct purchase of labour. To this, however, must be added all funds which, without forming a part of capital, are paid in exchange for labour, such as the wages of soldiers, domestic servants, and all other unproductive labourers. There is unfortunately no mode of expressing by one familiar term, the aggregate of what may be called the wages fund of a country; and as the wages of productive labour form nearly the whole of that fund, it is usual to overlook the smaller and less important part, and to say that wages depend on population and capital. It will be convenient to employ this expression, remembering, however, to consider it as elliptical, and not as a literal statement of the whole truth.
" With these limitations of the terms, wages not only depend on the relative amount of capital and population, but cannot, under the rule of competition, be affected by anything else. Wages (meaning, of course, the general rate) cannot rise, but by an increase of the aggregate funds employed in hiring labourers, or a diminution in the number of competitors for hire; nor fall, except either by a diminution of the funds devoted to paying labour, or by an increase in the number of labourers to be paid."Political Economy, Book II, ch. xi, § I.
Here we have some promise of an analysis, more detailed than was common among previous writers, of the "funds" which make up the demand for labor. Only a part of circulating capital is to be considered; and all funds with which "unproductive" laborers are paid are also to be taken into account. Both of these qualifications of the usual statement had been mentioned by other writers. Ricardo had spoken of "circulating" capital as alone belonging to the demand for wages; Adam Smith, Malthus, Senior still more, had referred, in one way or another, to the unproductive laborers. So far Mill was on much-trodden ground.
Mill did not go beyond this familiar stage. The sentences just quoted contain all that he ever said directly and explicitly on the theory of the wages fund. He passes at once from this simple statement, of which no part evidently seemed to him to need proof or explanation, to the dissection of certain notions inconsistent with it. This was Senior's method; in fact, the whole modus operandi appears so far to be copied from Senior. After brushing aside the inconsistent doctrines, which are again disposed of with reasoning unimpeachable as far as it goes and inconclusive because not going far enough, he proceeds to the point which he conceived really to need proof and emphasis and all possible illustration, — the principle of population and the standard of living. For three long chapters every phase of this topic is discussed and re-discussed. The persistence with which it is hammered at, compared with the light and rapid touch on the constitution of the wages fund, indicates that Mill thought the fund a matter of little moment for the really important problems of wages. For most of his reasoning, as for that of almost all writers after the time of Malthus and Ricardo, the details of the process by which an increase in numbers lowered wages were not of much moment. It made little difference whether wages were said to depend proximately on capital, or subsistence, or wealth, or product. The main moral deduced from the dependence of wages on the funds for paying them was that the growth of population must be restrained and the standard of living raised.Professor Nicholson remarks (in his Principles of Political Economy, vol. i, p. 341): “It follows, then, according to this view (the wages fund doctrine] that wages can only rise either owing to an increase of capital or a diminution of population, and this accounts for the exaggerated importance attached by Mill to the Malthusian theory of population." The converse seems to me nearer the truth: it was the exaggerated importance attached to the Malthusian theory which accounts for the stress laid on the wages fund doctrine.
Thereafter, through the greater part of the Principles, the simple and familiar formula is applied. As Mill summarizes it in the first chapter of the series in which wages are treated: "Wages depend, then, on the proportion between the number of the labouring population, and the capital or other funds devoted to the purchase of labour; we will say, for shortness, the capital."Book II, ch. xi, § 3. Like Ricardo, Malthus, and Senior, not to mention lesser lights, Mill began by using " capital " consciously as an "elliptical expression." Before long, he used it, more or less unconsciously, as a complete and sufficient statement of what constituted the demand for labor.
When Mill came to use and apply, in other directions, the proposition that capital was, once for all, the source of immediate demand for labor, he followed, in the main, the lines on which Ricardo had reasoned. In the third chapter of the fourth Book, on the "Influence of the Progress of Industry and Population on Rents, Profits, and Wages," the proximate cause determining wages is conceived to be simply the relative growth of capital and population.'' Let us first suppose that population increases, capital and the arts of production remaining stationary. One of the effects of this change of circumstances is sufficiently obvious: wages will fall." This chapter is an elaboration, with no essential additions, of Ricardo's Essay on the Influence of a Low Price of Corn; and Mill, in following up Ricardo's conclusions, accepted the practice which his master had adopted even in this early essay, of dismissing "market" wages summarily as determined by capital and population. Unlike Ricardo, Mill had keen social interests and sympathies. But he had been inured from boyhood to Ricardo's rigid and quasi-mathematical reasoning; and his own intellectual bent was in the same direction. In his discussion of distribution, he was absorbed, as his exemplar had been, in deducing certain consequences as to profits and rent which rested on the assumption that real wages were fixed at a stationary point by ingrained habits of the laborers. The wider views to which he was led by his social sympathies were never brought into direct connection with this comparatively narrow reasoning. At all events, they did not serve to bring his attention more closely to the problem of the immediate and direct determination of wages.
There is, however, another aspect of Mill's teaching on capital, which deserves notice: his conception of the relation between the general advance of capital to all laborers on the one hand, and the payment of wages by individual employers on the other; and, in connection with this, his conception of the rigidity or predetermination of the funds for hiring laborers.
Reference has already been made to Mill's distinction between capital and non-capital, as resting solely on the intention of the owner. This mode of defining capital he inherited, like other doctrines, chiefly from Ricardo, who had defined capital briefly as "that part of the wealth of a country which is employed in production." M’Culloch had tried an independent flight by propounding the doctrine that anything which might conceivably be used for further production was capital; Malthus had brought him to earth by answering that only that wealth was capital which was in fact used for production. Whatever these varieties in the tradition of the day, Mill followed its main trend in insisting on the intention of the owner as the decisive element in determining whether a particular quantum of wealth was or was not capital.
It has already been explained, in the first part of this volume,See Part I, Chapter III, pp. 61–62, 67–68. how far Mill and his contemporaries were right, how far wrong. They were wrong in supposing that, at any given moment, the intention of the owner settles whether a particular item of wealth is or is not capital. Under any possible definition, plant and materials can be nothing but capital. It has indeed been sometimes suggested that the owner of a machine may sell it, and squander the proceeds: thus it would cease to be capital simply by his change of intention. Obviously, however, such a process would be a mere shifting of the ownership of the capital from one hand to another: the machine still remains inchoate wealth and capital. The real and important truth which underlies this part of the classic doctrine appears only when it is brought into connection with another part, — the proposition that all wealth is perpetually produced and consumed. That proposition, originating with the Physiocrats and Adam Smith,See Cannan, History of Theories of Production and Distribution, p. 15, and Wealth of Nations, Book II, ch. iii, p. 149. Compare Mill’s Principles, Book I, ch. v, § 6. was set forth by Mill in lucid terms; yet, curiously enough, he failed to apply it to that other proposition, on the determination of capital by intention, which, standing by itself, could be so misleading. In the long run only, and in view of the steady waste and steady reproduction of all wealth, is it true that the intention settles what shall be capital and what shall not be. On this topic, as on others, Mill followed Ricardo's example of sliding rapidly over the concrete details by which the truth of his propositions appeared in real life: with results sometimes confusing to himself, and certainly confusing to later students of his writings.
The cause of confusion in this case was that Mill's vague doctrine as to capital and intention prevented him from making any clear distinction between the advance of money wages by employers, and the advance of real wages from the flow of the community's consumable goods. We have seen that he did not linger long on those causes which, in the nature of complex production, make necessary the support of laborers from past product. It was natural, therefore, that he should fail to separate sharply the real provision of consumable goods which maintains laborers during the prolonged period of production, from the immediate advance of funds by the individual employer to the laborer directly hired by him. Usually he simplifies the matter after Ricardo's method, by getting far away from the facts of concrete industry, and supposing the capitalist to possess so many quarters of wheat which he advances to laborers. This is the plan which he followes in the discussion of the effects of the conversion of circulating capital into fixed, — "circulating" capital there meaning wages fund. But in presenting and illustrating the doctrine that intention determines whether wealth shall or shall not be capital, he considers the case in more realistic fashion.
"A manufacturer, for example, has one part of his capital in the form of buildings. Another part he has in the form of machinery. A third consists, if he be a spinner, of raw cotton, flax, or wool: if a weaver, of flaxen, woollen, silk, or cotton, thread: and the like, according to the nature of the manufacture. Food and clothing for his operatives, it is not the custom of the present age that he should directly provide. … Instead of this, each capitalist has money, which he pays to his work people, and so enables them to supply themselves: he has also finished goods in his warehouse, by the sale of which he obtains more money, to employ in the same manner, as well as to replenish his stock of materials, to keep his buildings and machinery in repair, and to replace them when worn out. His money and finished goods, however, are not wholly capital, for he does not wholly devote them to these purposes: he employs a part of the one, and of the proceeds of the other, in supplying his personal consumption and that of his family, or in hiring grooms and valets, or maintaining hunters and hounds, or in educating his children, or in paying taxes, or in charity. What then is his capital? Precisely that part of his possessions, whatever it be, which he designs to employ in carrying on fresh production. It is of no consequence that a part, or even the whole of it, is in a form in which it cannot directly supply the wants of labourers."Book I, iv, § I.
Here the capital of the community is analyzed in a manner that implies that it is all in the hands of the employers who directly hire laborers, or under their control: the money and the proceeds of the finished goods being the sources from which wages are paid. In the next paragraph Mill illustrates his reasoning by supposing the case of a hardware manufacturer whose
"stock in trade, over and above his machinery, consists at present wholly in iron goods. Iron goods cannot feed labourers. Nevertheless, by a mere change of the destination of the iron goods, he can cause labourers to be fed."
The attentive reader of the passages that follow this statement will see that Mill did not fall into the error of supposing that laborers could be fed without the wherewithal to feed them. If there is no additional food in the country,
" it must be imported, if possible; if not possible, the labourers will remain for a season on their short allowance; but the consequence of this change in the demand for commodities, occasioned by the change in the expenditure for capitalists from unproductive to productive, is that next year more food will be produced, and less plate and jewels."
Here we have a sufficiently explicit hint that it may take home for the intention of the capitalists to work out its effects on the form which the community's possession shall have; and it is surprising that Mill did not come back to this point when in the next chapter he dilated on the perpetual consumption and reproduction of capital. As it was, his language might be easily interpreted to mean that the sources from which wages came were the funds or proceeds in the hands of the immediate employer: an interpretation freely made by later writers, and, as we shall see, the source of a long and unprofitable controversy.In the earlier Essays on Some Unsettled Questions of Political Economy written in 1829 and 1830, though not published till 1844, there is a passage which deserves to be read in connection with those quoted in the text. In the second of the essays, the question of gluts is taken up, and, as part of it, the effect of a "brisk demand" on production. Mill presented, in the main, the orthodox view, but conceded something to Malthus, by admitting that a brisk demand might serve virtually to increase the community's capital. Capital he defines, as he did later in the Political Economy, by intention: it is "all wealth which the individual or nation has in possession for the purpose of reproduction. ... All unsold goods, therefore, constitute a part of the national capital, and of the capital of the producer or dealer to whom they belong. … If, after having sold the goods, I hire labourers with the money, and set them to work, I am surely employing capital, though the corn, which in the form of bread those labourers may buy with the money may be now in the warehouse at Dantzig, or perhaps not yet above the ground." This is dubious doctrine; and the consequences which Mill draws from it show how he confounded the advantages from a rapid succession of the different stages in production, with a real increase in the community's productive apparatus. "An additional customer, to most dealers, is equivalent to an increase of their productive capital. He enables them to convert a portion of their capital which was lying idle (and which never could have become productive in their hands until a customer was found) into wages and instruments of production: and if we suppose that the commodity, unless bought by him, would not have found a purchaser for a year after, then all which a capital of that value [note this phrase] can enable men to produce during a year is clear gain, — gain to the dealer or producer, and to the labourers whom he will employ, and thus (if no one sustains corresponding loss) gain to the nation." — Essays, p. 54. From this sort of reasoning as to capital, it would clearly follow that the circulating capital whence wages are paid, so far from being a rigid quantity, is a very flexible and expansible one. Although Mill published the essay in 1844, he did not incorporate the matter of it, as he did that of others, in the Political Economy, printed in 1849. Indeed, the chapter on excess of supply (Bk. III, ch. xiv) does not mention the effects of brisk demand among the things that might palliate Malthus's errors. Perhaps, on maturer consideration, the reasoning of the essay struck him as unsatisfactory.
The same lack of precise statement as to the way in which capital performs its function of supporting laborers, appears in other parts of these earlier chapters on capital. Such terms as "funds," "sums," "capital paid out," are used, in a manner that, not unfairly construed, connotes money; and the reader is led to think of money available for paying wages as the important thing for the welfare of laborers. When a great loan is raised for war purposes, "it must have been wholly drawn from the portion employed in paying labourers"; and "if they produce as much as usual, having been paid less by so many millions sterling, these millions are gained by their employers."Book I, ch. v, § 8. The attentive reader will here again read between the lines, — and indeed in places within the lines, — that Mill was really intent on the consumption for military purposes of food and other consumable goods that would otherwise have gone to productive laborers; the breach in the capital of the country coming from the "unproductive" consumption of these commodities. Even from this point of view, it would need to be explained that the unproductive consumption is a matter of no consequence to the mass of the laborers at the outset; during the first year, or the first cycle of production, it makes no difference to them whether they get their food in exchange for the work of tilling the ground or of destroying human life. Only in the next stage, when no food has been created in place of that destroyed, will the final effects of the wastefulness of war be felt. But Mill's language is of capital in millions sterling, and of funds borrowed and spent. Whether his own thought was confused, or — as is more likely — he was so intent on other parts of the reasoning that he half-unconsciously adopted a convenient short cut at this stage, he certainly bred confusion in the minds of his later expounders and critics.
So, in discussing the conversion of circulating capital into fixed, Mill does indeed often describe this circulating capital in terms of so many quarters of corn; but he refers to the possibility that the fixed capital may be created, "not by withdrawing capital from actual circulation, but by the employment of the annual increase."Book I, ch. v, § 10. As a matter of fact, the mode in which the steady growth of savings supplies the resources for increasing real capital without entailing even a temporary diminution of the commodities constituting "circulating capital," is very complicated, and can be understood only by analyzing the operations of production over a considerable period. But Mill here again made a short cut for himself and his readers by considering both the circulating capital and the fresh accumulations in terms of money. The same thing is implied in the passage in which Mill refutes those who maintained that an income tax, while apparently falling on the rich alone, really takes from them what they would otherwise have spent among the poor.* Mill makes a distinction: "So far, indeed, as what is taken from the rich in taxes, would, if not so taken, have been saved and converted into capital, ... to that extent the demand for labour is no doubt diminished. ... But even here the question arises, whether the government, after receiving the amount, will not lay out as great a portion of it in the direct purchase of labour, as the tax-payers would have done." This looks again to the money in the hands of one or another set of spenders as the thing whose volume and movement should be considered, if we would ascertain whether the laborers' wages will be raised or lowered.
In a paragraph immediately succeeding that last quoted, Mill remarks that "error is produced by not looking directly at the realities of the phenomena, and attending only to the outward mechanism of paying and spending." Unfortunately, that outward mechanism was all too prominent in his own exposition; especially in discussions of the effects of any specific measure which involved an incidental consideration of the mechanism of payment, as to laborers and their welfare. On the relation between the money funds or proceeds held by the immediate employer, and the food, clothes, and enjoyments, constituting the community's real "circulating capital," he gave ambiguous and unsatisfactory statements, from which only a sympathetic interpreter could patch up a consistent and tenable doctrine.A characteristic passage, illustrative of the uncertain tone with which Mill spoke, is the following, taken from the chapter on the Consequences of the Tendency of Profits to a Minimum. I have italicized some significant words. "What is laid out in the bona fide construction of the railway itself is lost and gone: when once expended, it is incapable of ever being paid in wages or applied to the maintenance of labourers again; as a matter of account, the result is that so much food and clothing and tools have been consumed, and the country has got a railway instead. But what I would urge is that sums so applied are mostly a mere appropriation of the annual overflowing which would otherwise have gone abroad,” and so on. — Political Economy, Book IV, chapter v, § 2.
Some further light on the form which the wages fund doctrine assumed in Mill's hands, may be had, finally, by considering one question more, — his views on that rigidity or predetermination of the fund which was so hotly discussed by later writers.
In the chapter specifically devoted to wages, the passages quoted above show no stress on the rigidity of the fund, and indeed hardly give an indication one way or the other as to Mill's opinion. Like his contemporaries, he did not stop to consider the point. He passed so quickly from "market'' wages to normal or "natural" wages, that he was not led to ask deliberately whether market wages at a given period were or were not predetermined. We have just seen how often, in other passages than those which were expressly concerned with wages, he discussed the relations between capitalists and laborers as if the essential thing were the advance of money funds or proceeds by the individual employers. On this basis, he could hardly have entertained the notion of any rigid source of wages; for he had set forth that these funds would shrink or swell with the capitalist's change of intention, and had implied that they varied with his control over immediate money funds. In the main there is thus little direct indication in the body of the Political Economy of any iron-clad doctrine, and certain proof that such a doctrine, if entertained at all, was far from prominent in Mill's own thinking.
There do not lack intimations, however, that underneath, and without much emphasis on the matter in his own mind, Mill held to a doctrine of the iron-clad sort. In the very discussion of the effect of the owner's intention on the increase or decrease of capital, he suggests that it will take time to alter the existing supply of food; the food being treated, in Ricardian fashion, as the one essential constituent of real wages. The implication is that in any one season, this "circulating capital" is so much and can be no more. The same uncompromising view appears more explicitly in the chapter in the fifth Book which treats of combinations among laborers. There it is reasoned that even if a general combination of all laborers could be effected,
" they might doubtless succeed in diminishing the hours of labour, and obtaining the same wages for less work. But if they aimed at obtaining actually higher wages than the rate fixed by demand and supply — the rate which distributed the whole circulating capital of the country among the entire working population — this could only he accomplished by keeping a part of their number permanently out of employment. As support from public charity would of course be refused to those who could get work and would not accept it, they would be thrown for support upon the trades union of which they were members; and the work-people collectively would be no better off than before, having to support the same numbers out of the same aggregate wages. In this way, however, the class would have its attention forcibly drawn to the fact of a superfluity of numbers, and to the necessity, if they would have higher wages, of proportioning the supply of labour to the demand."Book V, ch. x, § 5.
Here we have something like the stern and ominous wages fund which rouses the ire of the friend of the working-man. The succeeding paragraphs of the same section show with equal plainness that, sometimes at least, Mill had clearly in mind the doctrine that for the time being the total demand for labor was fixed unalterably. He argues that a partial rise in wages — i.e., a rise in the wages of a particular group of laborers — may indeed be secured without corresponding loss to other laborers; but only in the end, not for the moment. It is only after the lapse of some time that this happy result can be secured.
"It may appear, indeed, at first sight, that the high wages of type-founders (for example) are obtained at the general cost of the labouring class. This high remuneration either causes fewer persons to find employment in the trade, or, if not, must lead to the investment of more capital in it, at the expense of other trades: in the first case, it throws an additional number of labourers on the general market; in the second, it withdraws from that market a portion of the demand; effects, both of which are injurious to the working classes. Such, indeed, would really be the result of a successful combination in a particular trade or trades, for some time after its formation; but when it is a permanent thing, the principles so often insisted on in this treatise, show that it can have no such effect. The habitual earnings of the working classes at large can be affected by nothing but the habitual requirements of the labouring people: these, indeed, may be altered, but while they remain the same, wages never fall permanently below the standard of these requirements, and do not long remain above that standard."
In other words, general wages are fixed definitively at any one period by the wages fund. Only after a lapse of time can any other factor enter; and then the factor which is important is that which all the thinkers of this generation held to be promptly decisive: the standard of living.
In Mill's case, as in Ricardo's, it would be unfair to lay too much stress on brief passages of this sort, interjected into a discussion of the policy which the legislature ought to pursue in regard to labor unions. But they show clearly how natural to Mill was the Ricardian way of unrelenting reasoning from an assumed premise: and one premise was that in any given season there was so much “circulating capital” in the community, and could be no more. They show, too, how Mill, like Ricardo, lingered but for a moment on this phase of the wages question, touching it so briefly that we can not be sure how rigorously he would have maintained his doctrines if pressed to a more explicit and emphatic statement. Like Ricardo again, he passed at once to that other phase of the wages question which seemed to him of pressing importance: the "habitual requirements of the labouring people," which constituted the one force to be made prominent in the statement of the laws governing general wages.
So much for the theory as Mill left it. The wages fund doctrine is stated briefly and boldly; its foundation in the nature of civilized production is hardly noticed; its teaching is aimed chiefly at the need of repressing numbers. Its application in other directions is cumbered and confused by references to funds and capital in terms of money, which obscure the essential truths of the doctrine, and became the source of the memorable but fruitless controversy which resulted in Mill's recantation.
Before proceeding to the next chapter, in which that controversy is to be taken up, we may glance for a moment at Mill's more immediate followers. Little is to be learned for our purposes from an examination of the popularizers who belong to this period of placid content with the perfect completeness of economic teaching. In the main, they repeated what Mill had said, with slight individual variations. A very few words as to one or two typical expounders of what was then supposed to be established truth, will suffice to indicate the stage at which the wages fund doctrine stood in England for near twenty years.
Charles Morrison published in 1856 An Essay on the Relations between Labour and Capital which reflects faithfully the attitude likely to be taken by one trained in the economics of the day and not possessed of the will or capacity to follow the current doctrines to their roots. Wages are regulated by the ratio between capital and labor. The fund for paying wages is "that part of the active or productive capital of the nation which is not required for some other employment necessary to the business of production" [i.e., not for plant and materials]. The division is determined by" the nature of things"; hence the wages fund is" a definite proportion of the entire active capital." So much the employers, it is implied, must pay away to laborers. Even if they were "universally misers," and were trying to get "the greatest possible profit," this would "not diminish the sum expended in labour; and consequently would not lower the rate of wages."Essays, pp. 19, 20.
As to combinations and strikes, Morrison argues that they are only harmful. True, some employers might be forced to pay higher than "competitive" wages; but "according to the laws which govern wages," such a result could not be permanent. Yet it is noted that "the existing generation of manufacturers might be ruined before the last results of the process were worked out": which seems to admit that for a while at least, and perhaps a good while, the conditions determining wages might not be so absolutely rigid after all.Ibid., p. 99. There is an admission of a similar sort, again made without any glimpse of the consequences to which it might lead, in a curious bit of reasoning as to the possible effects of confidence and credit in swelling the wages fund. During a period of universal confidence a given fund would be turned over quickly by each capitalist. Thus a wages capital of £10,–000 would be turned over perhaps five times in an active year, three times in a dull one; the virtual wages fund would be £50, 000 in the first case, £30,000 in the second. Hence the source of wages is defined, in a later summary, as "the funds available for their [the laborers'] payment, multiplied by the average rapidity with which those funds are turned over." Morrison considered this an important addition to the laws regulating wages: its innuendo as to the evil effects of strikes and disturbances is obvious enough.See chapters xvii and xviii of Morrison’s Essay. His doctrine here is virtually the same as that which Mill set forth in his Essays in Political Economy, but did not see fit to retain in the Political Economy. See the note to p. 229, above. Clearly it conceives the wages fund in terms of money or funds in the hands of the capitalist. But from this point of view, it is also clear that the wages fund might be flexible, not merely because of variations in confidence and commercial activity, but from pressure from the trades-union or any one of a dozen imaginable causes. That no turn of this sort in the reasoning occurred to Morrison, a man of candid intelligence and real public spirit, shows how rare after all is the capacity for even comparatively simple steps in independent thinking.
Of a different type, and worth noting because of the prominent place which he long held as an authoritative text-book writer, is Henry Fawcett. His Manual of Political Economy, first published in 1863,I have read the third edition, published in 1867. The passages referred to are in Book II, chapters iv, v, ix. was for near a generation an accepted text-book for those not able to undertake Mill's larger and more abstruse volumes; and its dilution of the strength of the original has caused it to be described, not unfairly, as "Mill and water." Here capital is defined as the fund from which labor is remunerated; it follows at once that "wages in the aggregate depend on a ratio between capital and population." This is not qualified or explained, as it was by Mill, as an "elliptical expression": it simply serves to introduce, without delay, the Malthusian proposition. On the other hand, practically nothing is made of the wages fund when Fawcett comes to the question of trade-unions and their effect on wages, — questions which absorbed public attention when he wrote, and led him to more pointed writing than was possible in the simple process of condensing Mill. In the discussion of these living questions, Fawcett's views, so far as they bear on the wages fund, are certainly not excessively orthodox. The slow and imperfect working of competition is explained, and the greater tactical strength which laborers get from combination is fully set forth. On the other hand, as to strikes and their success, the wages fund simply does not appear at all.
Much the same is the case in Fawcett's volume on the Economic Position of the British Labourer, published in I865. Here again we find at the outset the old and wearisome phrase as to the ratio between population and circulating capital; and with it an equally wearisome phrase to the effect that "the laws regulating wages are as certain in their effects as those which control physical nature." But in the chapter on Trade-Unions, the wages fund and the natural laws fade away into nothingness. ''Natural" wages, it is explained, do not result at once or even quickly from mere competition. Combinations have their effects, among masters as well as among men. The tendency of profits to a minimum, and the check to accumulation from a fall in profits, — these, rather than the wages fund, are the obstacles in the way of deep-reaching effects from combinations and strikes. Of profits and their minimum and the accumulation of capital we shall hear more in due time: what the classic writers and their expounders had to say on this topic was stated better and more fully by Cairnes, whose position we shall consider in the next chapter. It is significant, as to Fawcett, that we find in him little of the disposition to fling the wages fund at the head of the laborers which is so much associated with the orthodox doctrines. We have seen that writers of the previous generation, — Torrens, M'Culloch, and their fellows, — made little use of it in this direction. Like them, and like his master, Mill, Fawcett thought of it but little in connection with disputes about wages, and used it chiefly as a means of inculcating the need of that prudence in multiplication which seemed to all of these men the main instrument of social salvation.
The results reached in the preceding chapters, while different in important respects from those usually associated with the wages fund doctrine, have yet been largely conservative. It has appeared that all wages are paid from the products of past labor, and that the supply of products of past labor exists mainly in the form of real capital. It has appeared, too, that the class of hired laborers not only derive their wages from capital in this sense, but that they are dependent, for their share of the real income into which capital steadily ripens, on the funds which the employing class find it advantageous to turn over to them. It remains now to consider another aspect of the old doctrine, — whether the capital from which wages come is rigid, or elastic; predetermined, or easily adjusted to present demands. This question may be considered as to both sides of the doctrine: as to the sources of the real income going to all laborers, and those of the money income going to manual laborers, and more especially to hired manual laborers.
It will be convenient to begin by inverting the former order, and to consider first the case of the hired laborers. Are the money funds which employers can turn over to them limited? Are they so determined by previous happenings that a given sum must go to laborers, and no more can go? Or are they elastic, swelling easily when employers are led by competition among themselves or by pressure from their workmen to advance wages, and shrinking promptly when their niggardliness or ill fortune leads them to retrench?
One part of the answer has already been given.See pages 62–64. As to the direct employer, considered by himself, it is clear that there is no rigidity or predetermination. He sells and borrows, adjusts his payments and receipts, and nurses his bank account. Within limits that are certainly not narrow, he can make his available funds fit new conditions and new demands. In the language of Thornton, who was among the first to face squarely this phase of the problem, it sounds like mockery or childishness to ask if the funds which he can apply to wages are limited or predetermined.Sec what is said of Thornton below, at pages 246–255.
Consider, however, the whole employing class, as it was described in the last chapter. For the hired laborers as a whole, the money wages of a season came from the large body of active capitalists: from the merchants who buy goods or make advances on them, from the bankers who discount and lend, as well as from the immediate employers. Is the total of funds which they can pay in wages limited?
No doubt there are some limitations here. There is a general limit of some sort, in the total of money means which the sale of output or product brings into the hands of the managing class. There are more specific limits within this general one. Contracts of long standing and duration compel the payment of certain sums to investors, in the way of interest or rent. Further, the funds directed to production must be apportioned with regard to existing methods and existing supplies. That workmen may be employed, machinery and buildings must be on hand, and materials must be provided. In other words, a large part of the gross money income of the season must go to purchases which may indeed in the last analysis be resolvable into a succession of advances to laborers, but which involve no present payments to laborers. This was what one of the last defenders of the old doctrine had in mind when he divided capital into the three constituent parts of plant, materials, and wages fund, and pointed out that only the wages-fund part was available for paying laborers.Cairnes, Leading Principles, Book II, ch. i. Compare what is said below at page 257. Cairnes apparently had in mind, when making this division, the money funds of the direct employers, which go to the one destination or the other; not the division of the actual possession of the community into finished and enjoyable goods on the one hand and inchoate wealth on the other. While the individual employer, supported as he is by the multiform apparatus of credit and connection, is not compelled to make any hard-and-fast apportionment of his directly available means between these different uses, the body of employers must divide their purchases and advances in a manner which is determined in its main lines by the state of the arts and the succession of the productive operations.
But, with all this admitted, it still remains clear that nothing in the nature of a predetermined and rigid wages fund can be found. While the payments due to outside investors for interest and rent may be fixed for the moment, the sums which the active capitalists can set aside for their own enjoyment are flexible. The apportionment of those sums, again, which go to the maintenance of the settled course of production can not be said to be rigorously predetermined for the different channels of advances to labor on the one hand, the purchases of tools and materials on the other. The limits are elastic. Even the total money income at the disposal of the capitalist class can not be described as a fixed thing. It has been spoken of as the total price of the output; and such it is. But that total price depends on the relation of the circulating medium to the whole volume of things sold. The modern machinery of credit as a substitute for money makes prices and total money payments for commodities vary under very short-lived influences Banks of deposit and issue, which form so important an element in the whole body of the active managers of industry, can swell their loans, and so can add effectively to the total of money funds received in exchange for the industrial output and available for fresh operations. In almost every direction the causes which determine the advance by the active capitalists of a part of their funds to laborers, operate in the rough, and with no machinelike precision.
If therefore we put the case of a general trades union embracing all the hired laborers, and a general strike by them for higher wages, — a case which, improbable and unreal as it may be, has rightly been made to play a prominent part in the theoretic controversy, — the answer must be that nothing in the proximate conditions of industry stands in the way of their success. Success, that is, in the sense which alone is here under consideration: an advance in money wages. A larger share of the total inflowing receipts of the active capitalists might be diverted into the hands of the hired laborers. Possibly those total receipts would be simply swelled by an increase of the bank credit part of the circulating medium. Possibly the employers might be compelled to submit to a reduction of their net profits. Possibly a diminution of the funds applied to the purchase of materials and plant might shift the shrinkage of profits more particularly to those who happened at the time to be in largest part the holders of these forms of inchoate wealth. The outside investor, though usually shielded by the length of his contract from the contingencies of the season, might yet feel in some degree the effects of the general pressure; here and there he would encounter defaults, reorganizations, new and harder terms on old loans falling due and on fresh funds seeking investment. At all events, there are no cast-iron obstacles to the attainment of the immediate end of the universal strike: higher money wages.
As to the eventual outcome, the situation doubtless might be different. The forces which permanently determine distribution would come into play. To follow their working is not within the scope of the present inquiry, and is called for the less because economists are here much more nearly in agreement than they are on the machinery by which the result is brought about. The general rise in money wages (which may be assumed not to be offset by any corresponding change in general prices) would bring down the returns of the capitalist class. How the loss would be divided among the different members of this class, temporarily and even permanently, would be hard to foresee. Among the active capitalists, some would be at first hit harder than others; and the distribution of the loss among them, through the transfer of capital and the working of competition, would be no simple or certain matter. As between active capitalists and lending investors, in the course of the recurrent renewal of their loans and contracts, there would again be a tendency to distribution of the loss, whose outcome could not be clearly foreseen. At bottom, the mode in which these two classes would act in face of the loss would depend on whether the business men had been getting, before it set in, just enough to induce them to undergo the labor and risk of production; and whether the investors, in their turn had been receiving just enough to induce them to forego immediate expenditure and enjoyment
On these limits the last word has perhaps not been said. The minimum which the two classes of capitalists, under a real dilemma between cessation of operations and submission to a smaller income, would accept, probably goes lower than is suggested in the usual expositions of this part of economic theory. But wider questions are here touched than those connected directly with the proximate sources of money wages, and it is not necessary to attempt to go further in their consideration. Some aspects of them will be touched again in the next chapter; and, at all events, enough has been said to indicate that they carry us far from the wages fund controversy proper.
From this digression we may return to the main subject, and summarize the results of the investigation up to this point. Briefly stated, the main conclusion so far has been, that for a season the resources immediately available for capitalists in their employment of laborers, while obviously not indefinitely extensible, are not limited or predetermined, and that the money-wages fund which goes to hired laborers is not a rigid one.
Next comes the question as to the source of real wages — the important and essential question as to the welfare of laborers. An increase of money wages is of no advantage unless there are more commodities to be bought. Are the commodities available at any given time predetermined in amount?
As to the source of real wages, it will be recalled, no distinction can be made between different classes of laborers or between different classes of the community. All alike, whatever the channel through which their money incomes are derived, get their real reward from the finished and enjoyable commodities which appear at the end of the lengthened processes of production. To this general proposition there is, indeed, an exception of some interest and importance. When savings are made, purchases for immediate enjoyment do not take place. The proximate source of real income is then not found in the flow of consumable commodities. The consideration of this case, however, may be postponed. Let it be assumed that the whole of money income is devoted to the purchase of presently enjoyable things. On the elasticity or predetermination of the real income thus available for the community at large two sets of questions may be raised: one, as to the limits of the total available for all; the other, as to the limits of the share which can go to wages.
First, as to the total real income of the community. That this is at least in large degree predetermined, is obvious from a consideration of the form in which at any moment it exists and the mode in which it recurrently appears. The form in which that part exists which is most immediately available, is in the stocks of the retail dealers. It is here, in the great mass of cases, that money income is converted into real income. The stocks which the dealers possess are a given quantity. The reserves of things ready for sale which are held by the wholesale dealers and the manufacturers are again so much, and no more. New supplies can be got only by working up more materials; and the materials on hand, as well as the tools and machinery for working them up, are for the time being unchangeable. Machinery can indeed be made to work more or less quickly, and this suggests at once an elastic rather than a rigid limit. But materials, such as wool, cotton, hides, grain, timber, are usually dependent for the variation of production on the return of the seasons; and some considerable time must elapse before the existing supplies can be substantially changed. What is now available, and what will be available for a year or two to come, has been determined once for all. If all the active members of the community work harder or more effectively, they may secure more enjoyable things after a space; but present income depends on the manner and the extent to which the earlier preparatory stages of production have been carried on.
Not only are the present available supplies so predetermined, but the tendency must be to arrange them in such manner as simply to meet the habitual rate of consumption, and leave no great margin or reserve. It may be suggested that in the stocks of: merchants and producers there is a reserve fund which can be drawn on more or less rapidly, and which can be replenished from further reserves of half-finished goods and materials. Unquestionably such a reserve exists. The whole series of goods, from those barely begun to those almost finished, constitutes the stock from which the necessaries and comforts of the period must come; but the tendency of every individual holder of the stock is to have no more than is needed to meet the usual demands from consumers, or from the producers who stand next in the order of transmission to consumers. Every dealer keeps enough in stock to meet current demands, and tries to keep no more. It is to his advantage to diminish his holdings to the minimum consistent with satisfying his customers. For every business manager, whether merchant or manufacturer, a needlessly large stock similarly means a needlessly large committal of his funds. The nature of the trade and the accident of individual choice and judgment must affect the extent of the holdings in the different storehouses which contain the community's varied fund for more or less immediate enjoyment and subsistence; but the drift in all must be to accommodate the supplies to habitual and expected demands, and to keep no excess. If, therefore, a very rapid increase of consumption were suddenly to take place, a corresponding deficit would ere long appear. An increase in the productive power of the community can issue in a real increase of the sources of satisfaction only by giving the lengthened methods of production time to work out the result. It can not be anticipated by making immediate larger drafts on the existing supplies, for these are adapted only to meet the usual rate of consumption.
So much is in general true; but it is equally true that we can speak here only of tendencies and drifts, of limitations that hold good against great and rapid changes, but are not of a rigid and unalterable sort. The habitual stocks of dealers may be purchased by consumers a bit faster or a bit slower. Commodities on the way to completion may be hurried forward somewhat. Materials on hand may be drawn on more rapidly, and a period of scanty holdings may be tided over by some straining and ingenuity until fresh supplies can be made to appear. An increased satisfaction to consumers may be yielded by more elaborate manipulation of the materials already on hand. In various ways of this sort some stretching of the existing store of available goods is possible. That it has unmistakable limits, and not very distant limits, is not inconsistent with its being elastic within those limits. How great the degree of elasticity is, can not be stated in exact terms or measured by any conceivably practicable mode of statistical investigation.
On this topic, then, as on so many others in economics, we must be content with conclusions stated in general terms. The real income of the community for any season depends mainly on forces which have operated in the past. It is settled and predetermined, in the sense that it can be no greater than is made possible by the past labor given to machinery, to materials, to all the earlier stages of production. It is not made elastic by any great stocks kept in reserve beyond what the usual rate of consumption makes necessary. Yet it is not rigidly predetermined. It may become in some degree larger or smaller under the influence of forces coming into operation to-day; it is elastic within limits which, if not great, are not so small as to be safely set aside as of no practical import.
The second and narrower part of this question, as to the elasticity of that portion of the real income of the community which goes to wages, has been largely answered in what has been said on the broader topic. Real wages are limited and predetermined in general as much as other sources of income, and no more Any force which is to bring about a substantial advance in the real remuneration which laborers shall get must bring about its effects through the slow-working machinery of production. Like other classes, they may get some immediate increase of real enjoyment by a defter use, a better combination, the temporary bridging over of gaps, in the existing resources; but a considerable advance must begin at the beginning, and go through the orderly stages of the successive steps which lead to the final attainment of a consumable commodity.
In this regard it is immaterial what is the form of the remuneration of the laborer: whether he gets his wages from an employer once for all, or earns an independent income which is substantially all of it return for present exertion, or gets a mixed income which is in good part resolvable into interest or rent. Whatever the channel through which his income in money first comes, it is spent on an elastic but by no means indeterminate mass of finished commodities.
Still a further question presents itself: Is the share of real income which the laborers can get, as compared with the total available for all classes, more flexible than this total itself? It is conceivable that though the whole income of the community were predetermined within narrow limits, the part of it which some members got might be very flexible, swelling or diminishing according to forces of immediate operation. Something may be said as to the situation of the laborers in this aspect of the case.
The first step in such a changed division of the total income must be an advance in money wages. This we may suppose to have been effected, as to hired laborers, within the limits already set forth as to the possible money advances which they can secure from their immediate employers; as to others, within the limits made possible by the conditions of demand for the things they have to dispose of. The money wages, in whatever manner obtained, go to the purchase of commodities the whole mass of which is not susceptible of rapid enlargement. If, now, among the mass, the commodities which they can buy and will buy are of a particular kind, of different materials, and of different fashioning from those sought by other classes, their share is as much predetermined as the whole supply. If, on the other hand, they buy very much the same sorts of things that their employers and other supposed betters buy, they can get a larger slice of real income at once.
Evidently a great existing inequality of wealth, and a great disparity of tastes and habits, would make the substantial change more slow and difficult of accomplishment. More democratic conditions would make it more rapid and easy. As between the great mass of manual labor and the well-to-do, the disparity of tastes and habits is in most communities considerable, and a great shift of the real sources of satisfaction from the one to the other could not easily take place. There is, to be sure, a large constituency among the well-to-do whose members do work for their living and get a return which, while euphemistically termed salary or income, is as clearly wages as is the pay of the day laborer. As between these and the prosperous receivers of interest and rent there can be nothing in the way of a predetermined separation of the real sources of income. Even as between the manual laborers with whom the word wages is usually associated, and the well-to-do classes who are separated from them by habits of greater ease and usually higher culture, the line of cleavage as to commodities bought is not unmistakable. There is some margin of interchangeable things, broader or narrower according to the more or less democratic character of the society. The staples of food are alike for nearly all the members pf the advanced communities of our day, and many materials forming a large part of the available supplies of a season can be worked up in one fashion or another to meet at short notice the tastes of the eventual consumers.
Thus we find again limits that are elastic, not rigid. The total real income of the community, while predetermined in the rough, has some degree of elasticity. The share of real income which shall go to wages in general, or to wages of the great mass of manual laborers, is to a certain extent predetermined by the character of the commodities on hand or in the making. But in no small degree it is indistinguishable and inseparable, forming part of a mass of things that may be diverted to one set of persons or another according to their command of money income for the time being.
The question has sometimes been raised, in the course of the controversy over the wages fund, whether laborers can get an immediate or early benefit from the results of improvements made at the time when their wages are earned. On the one hand, it has been maintained that a general increase in the productiveness of labor, due to advance in the arts or to greater strenuousness or intelligence among the workmen, inures to their advantage at once. On the other hand, it has been denied that they can secure an immediate gain. In essentials, the reasoning of the preceding pages clearly supports the negative answer. The solid effects of greater efficiency in production can appear only after the interval made inevitable by the complex and slow-working machinery of production. Improvements now made do not inure to the benefit of present real wages: always subject to what has been said as to the degree of elasticity which does exist in the sources of real income. But this holds good of wages, simply because it holds good of all real income. It is the total volume of ripening real income which is determined by the causes of the past. Advances in the arts increase the total more or less rapidly, according to the point at which they take effect in the successive stages of production and the extent to which they require a larger supply of supplementary tools or materials for their full fruition. It would be a rare case in which a considerable interval must not elapse before a sensible effect on the flow of consumable commodities could appear. If the extreme case of a sudden doubling of all productive efficiency be supposed, it may be said with confidence that laborers and others would not receive at once, or for some little time to come, a double portion of real income.
There is another possibility, and a significant one, of more practical importance in regard to other forms of income than those usually called wages, but not without its importance for wages also. It has been assumed hitherto that money income is spent as soon as received, and goes at once to the purchase of consumable commodities. But purchases may be postponed and savings made: modification in the assumed conditions which we may now proceed to consider.
The simplest form of saving is hoarding; and it is an easy matter to trace the modifications which would ensue from hoarding. The real income for labor comes when the money income is spent. If it is spent a year after the work is done, the consumable commodities then existing are the source of real income. In the meanwhile, some of these commodities may have become more abundant and cheaper; in which case wages, as to the part postponed, are subject to the conditions of supply of the later date, not to those existing at the time when the work was done. So far as the conversion of money wages into real wages is put off, the laborers thus have a clear field for participation in the results of improvements going on while they work, or in those of greater strenuousness of their own labor.
But the usual form of saving in modern communities is investment, not hoarding. Investment means, not a postponement of all purchases, but only a postponement of direct purchases for immediate enjoyment. Through one or another of the many channels which modern society offers, the funds saved are turned over to the active managers of industry: through the savings bank of the poor, or the purchase of securities by the well-to-do, or the operations of life-insurance societies. By the active capitalists who thus get control of the funds, they are used for the purchase of materials, plant, labor, as their judgment suggests. They are additions to the funds that would in any case be turned in these directions for the maintenance of existing capital. They go in part to wages; and in so far they are not abstracted from the money income which goes for the season to the purchase of finished commodities, but simply shifted from hand to hand. In the long run, indeed, not the part only, but the sum total of the invested savings, goes to wages, by a succession of advances to labor; but this holds good only of the operations of a lengthened cycle. For any one season, the process of investment means, in large part, the purchase of inchoate wealth, or real capital. Such inchoate wealth is usually on hand to meet the new demand. Not only is enough being produced to make good the waste of existing capital as it wears away or becomes useless, but additional supplies of real capital are constantly being made in our modern communities, in anticipation of the fresh accumulation of individual capital. New investment, as well as reinvestment, takes place so regularly that the concrete change in the community's possessions has usually taken place before the decisive committal of his means to accumulation has been made by the individual investor. Saving thus usually means a transfer of purchasing power from the immediate receiver of money income to other hands. Partly it means a transfer to the laborers whom the managing capitalists may employ with the additional funds, and thus a simple shift in the demand for consumable goods; partly it means the buying of tools and materials, and so a real postponement, for the time being at least, of any purchase of enjoyable things at all.
As to the individual saver, the postponement is usually permanent. He does not ordinarily avail himself of the recurrent opportunity for spending which comes as the loans made to the active managers fall due. He reinvests, repeating the decision to save. He spends only the money income handed over to him as interest on his accumulations. With this he becomes each year (assuming that he does not again save out of income) a purchaser of real income, and a sharer in the inflowing supplies of consumable goods. The quantity and quality of these supplies may vary from year to year, and the possibilities of his real income may thus vary. But so far as the reward for his labor is concerned, he is independent of those present limitations on real income which we have found to exist for such as spend their whole money income at once for the satisfaction of immediate wants.
How great is the importance of this additional element of elasticity in the real reward of labor must depend on the extent to which savings are in fact made from money wages. As to the great mass of hired laborers, and even the great mass of those independent workmen, in agriculture and in the crafts, to whom also we commonly apply the term wages, the savings are probably very small as compared with their total earnings. More especially is this the case with hired laborers. It is true, the accumulations in the savings banks of the more advanced countries form an imposing mass; but they are to be compared with the much more imposing mass of the total earnings of the laborers. They come only in part from savings by receivers of wages; and in any case they are small as compared with the whole sum which is paid in wages. It can not be far from the truth to say that virtually the whole of the wages of hired manual laborers is spent at once on consumable commodities, and therefore is subject to the causes by which the supply of consumable commodities is so largely predetermined.
The class in society as to whom the fact of saving is of most importance is that of the successful managing capitalists or business men. It is from them that the largest habitual accumulations of capital are derived. Hired laborers may save a bit from their wages; independent laborers, when prosperous, may save a bit more. The investor, again, getting his fixed income from a capital which is expected to remain intact, is likely to put aside only a small part of his receipts. The professional classes of lawyers, physicians, and the like, do indeed usually save some considerable proportion of their income. But the active managers of industry, more than any other set of men, find the main object of their ambition and the one test of their success in" making money"; in acquiring larger money rights than they spend; in accumulating, and in adding to their possessions. The prosperous business man sets aside for the enlargement of his wealth a greater proportion of his income than any other member of society; and of the total accumulations of fresh capital for the community, the greatest part probably comes from the eagerness of this class to acquire permanent wealth. While he is still in harness, the possessions of the active capitalist usually consist in large part of inchoate wealth directly owned, and of claims against fellow business men, offset more or less by cross-claims; the whole having an uncertain value, depending on the outcome of the operations still in progress. Each one, as he reaches the point (if ever he reaches it) where he thinks he has a competency, begins to wind up his enterprises, converts his possessions mainly into obligations due him by those who are still active in business, and retires to the position of a dependent investor. If he does not retire himself, his children are likely to do so. The existing generation of active capitalists gives way to a new generation, equally intent on large gains and large accumulations.
The fact of saving and postponed enjoyment thus leads to qualifications of our main conclusions chiefly in regard to the well-to-do classes, and, among those, most strikingly in regard to the successful business man. Those who save are pro tanto free from the conditions of present supply which, within greater or smaller limits, cause the available real income of all classes in society to be in some degree predetermined. The largest savers and the largest accumulators of capital are the successful men of affairs. These, then, may be said in a sense to have the most elastic, the least predetermined, real reward for their labor.
It need not be remarked that, in speaking of a predetermination of any sort, as to wages or any form of income, reference is made to wages in the mass, or other income in the mass. To say that the real wages of any particular set of laborers are predetermined, would be an entirely different proposition. The whole wages fund discussion, — the whole discussion of the relation of capital to wages or other forms of income, — applies to the general phenomenon, not to the particular. But of this qualification or explanation more will be said in the next and concluding chapter, whose object it will be to make clear, in other respects also, the scope and significance of the conclusions that have been reached.
Next in order, for the development of the wages fund doctrine, as for economic theory at large, comes Ricardo. In regard to the direct relation of capital to wages, he reflected faithfully the views of his own generation; while the mode in which he stated that relation, and connected it with other parts of economic theory, served to impress these views strongly on the generation that followed.
Ricardo was a brief writer, and sometimes an awkward one. Moreover, he was concerned, especially in his writings on value and distribution, with permanent causes and permanent results. He was convinced of the fundamental validity of certain premises, such as the effective working of competition, the equality of profits, the adjustment of money wages to the price of food, the law of diminishing returns from land; and the bent of his mind was to follow out these premises to their conclusions by quasi-mathematical reasoning. Ricardo was perfectly conscious — when he stopped to think about it — that his conclusions could be true only in the rough, in the long run, "hypothetically": but he was so intent on working them out that he usually spoke and reasoned as if they were absolutely and unqualifiedly true. In any case, it was the conclusions reached in this manner as to eventual results, that he habitually looked to; saying little or nothing of the phenomena which, rightly or wrongly, he regarded as temporary and comparatively unimportant.
Another cause served to add to Ricardo's habitual brevity of statement, so far as the immediate relations of capital to wages were concerned. Neither Ricardo nor his contemporaries were much concerned with the questions of distribution as they appeal to us. Wages, profits, rent, did not interest them from the social point of view, or because great inequalities in the means of enjoyment might be explained, and either justified or not justified, by analyzing them. They were interested mainly in the ways and means of increasing the production of wealth. Ricardo himself, as he went further in economic study, gave more and more attention to questions of distribution, which gradually assumed greater theoretical and practical importance in his mind.See the instructive essay on The Interpretation of Ricardo, by Professor S. N. Patten, in the Quarterly Journal of Economics, April, 1893, vol. vii, p. 322). But in the main, they did not strongly appeal to him; they were attractive largely because they presented complex problems for logical solution. It was natural, therefore, that he should concern himself little with the causes which might directly determine the welfare of the laborers.
Hence we find in Ricardo's writings no such detailed discussion of the relation of capital to wages, as we find of value, rent, changes in wages with the price of food, the causes and effects of international trade. The questions involved in the wages fund doctrine, bearing as they do on the phenomena of the moment, are precisely such as Ricardo was in the habit of passing by. We must make out his views partly from brief statements and incidental remarks, still more from suppositions and premises which, though tacitly assumed rather than expressly stated, are yet of the essence of his reasoning. While his opinions were thus briefly stated, they were none the less clear and explicit. Precision and accuracy of thought are in everything that he wrote; and his chief contribution to the wages fund doctrine was in the precision with which he stated it, and in the example of unqualified statement which he set for his successors.
The first thing to be noticed in Ricardo's treatment of our subject is the simple assumption that wages as a matter of course are paid from capital. Why this should be, he never thought it necessary to explain. Nothing more clearly shows the hold which Adam Smith had on the economists who followed him, than their unquestioning acceptance of this cardinal proposition. A writer having the wider historical interests of Sismondi might indeed stop to explain why wages must come from capital; but most of Adam Smith's successors simply accepted his doctrine.No doubt the great growth of the capitalist system between 1776 and 1815 had much to do with the exclusive attention which the later writers give to laborers hired by capitalists. Ricardo treated it as he did many other conclusions of Adam Smith's: accepted it as a thing settled, and needing no further discussion. All his reasoning shows that he perceived clearly the fundamental fact on which it rested, — the fact that the operations of production are spread over a considerable period of time. Much of his reasoning, indeed, rests squarely on this fact. But its importance as the foundation of the doctrine of the payment of wages from capital, he never mentioned, and probably did not fairly realize.
Next it may be noticed how the problem is simplified at Ricardo's hands. The laborers whom Adam Smith had described as paid out of "revenue," drop entirely out of his ken. Only laborers who are hired by capitalists aiming to make a profit are considered. This simplification of the problem may be due in part to changing conditions in society, — the more complete disappearance of the feudal practice of large arrays of retainers, and the increase in more modern forms of luxury. Chiefly it is due to Ricardo's mental habits: his tendency to cull out the central problem, and consider that only, and in its fundamental aspects only. The laborer producing commodities under the guidance of a capitalist middleman is the typical figure; the one, too, whose case gives opportunity for the intricate figuring and reasoning in which Ricardo was in his element. Hence not only retainers, but independent workmen producing commodities for direct sale, disappear. Adam Smith had noted that laborers are not necessarily hired by masters, but may sometimes work independently; Sismondi too had remarked that such a situation would present peculiarities. Ricardo never mentions the case. He considers only the laborers hired by capitalists.
The industrial conditions under which he wrote undoubtedly contributed very greatly to this limitation of Ricardo's treatment. In England, during his time and since his time, the bulk of the laboring population has been divorced from the capital and the land. Perhaps a writer of academic training and of larger historical attainments might have been led to consider that this was not a necessary or universal state of things; though the procedure of Ricardo's successors hardly encourages the belief that a wide academic culture would have prevented the narrow point of view. But certainly in a country where many laborers had some land and some capital, it would not have been so easy to treat the agricultural laborer, who was the type of all labor in so many of Ricardo's illustrations, as necessarily hired by a capitalist employer. The unfortunate position of Hodge caused English economists with hardly an exception to do as Ricardo did: accept as a matter of course the dependence of all laborers on capital owned by others.
The problem, thus simplified and reduced to its barest elements, was naturally answered in more precise and unqualified terms. Not only, as Adam Smith put it, are wages paid out of capital, and determined by a bargain in which the demand for labor comes from employers' capital: but the amount of that capital, compared with the number of the laborers, fixes wages definitely. It is one thing to say that wages are paid out of capital; another thing, to say that the amount of capital determines wages once for all. Ricardo's habit of close calculation and unflinching reasoning might be expected to bring forth a more sharply defined statement than Adam Smith's. In fact, he made wages dependent directly on the amount of capital, and put forth a wages fund doctrine as unqualifiedly as any of the later writers with whom that doctrine is usually associated.
We may proceed now to consider more in detail Ricardo's conception of capital, and of the manner in which wages depend on capital. "Capital," he says in the chapter on Wages in the Principles of Political Economy, "is that part of the wealth of a country which is employed in production, and consists of food, clothing, tools, raw material, machinery, etc., necessary to give effect to labor." The last clause was the important one in Ricardo's mind. Capital was needed to give effect to labor: and the essential form in which it gave effect to labor was by supporting it. Capital was ultimately resolvable into food, or into advances to labor.
This proposition became, consciously and unconsciously, a corner stone of the Ricardian structure; it underlies all the reasoning of Ricardo and of his followers on distribution. It can be applied, however, in very different ways. It can be easily translated into the statement that wages at any time depend simply on the proportion of the total capital of the community to the total number of laborers of the community. This simple proposition we shall find commonly laid down by the later writers of the classic school; having its roots partly in Adam Smith's first discussion of the subject, but quite as much in Ricardo's identification of capital with advances to laborers. Ricardo himself, however, used it chiefly in other ways and for other purposes.
The mode in which he drew conclusions directly from the analysis of all capital into advances to labor, appears most clearly in the third, fourth, and fifth sections of the opening chapter of the Principles. The chapter deals with value; and in the sections mentioned he considers how far the employment of capital affects his fundamental doctrine that value depends solely on the quantity of labor necessary to obtain a commodity. Under the simplest conditions, or, as Adam Smith and Ricardo put it, "in that early and rude state of society, which precedes both the accumulation of stock and the appropriation of land" it is clear that, if "competition operates without restraint,"This supposition Ricardo made in terms. Works, p. 10. commodities will exchange in proportion to the labor necessary for producing them. The accumulation and employment of capital do not change the situation; because they simply bring a different mode of applying labor to production.
If we look to a state of society in which greater improvements have been made, and in which arts and commerce flourish, we shall still find that commodities vary in value conformably with this principle: in estimating the exchangeable value of stockings, for example, we shall find that their value comparatively with other things, depends on the total quantity of labour necessary to manufacture them and to bring them to market. First, there is the labour necessary to cultivate the land on which the raw cotton is grown; secondly, the labour of conveying the cotton to the country where it is to be manufactured, which includes a portion of the labour bestowed in building the ship in which it is conveyed, and which is charged in the freight of the goods; thirdly, the labour of the spinner and weaver; fourthly, a portion of the labour of the engineer, smith, and carpenter, who erected the buildings, by the help of which they were made; fifthly, the labour of the retail dealer, and of many others, whom it is unnecessary further to particularize.Ricardo, Works, p. 17.
The modern reader would expect to find this description of the successive division of labor, in a discussion of the sequence of production or of the functions of capital. But Ricardo mentions it and uses it for a different purpose. He proceeds to point out how his principle that value depends on quantity of labor bestowed, is modified according to the mode in which capital is advanced to laborers; applying the reasoning to a consideration of value in a community where all laborers are employed by capitalists. We are not concerned with the details of the proof that value, in such a community, will not depend on quantity of labor alone, and that a general rise or fall in wages will affect the value of commodities made with the aid of much fixed capital, compared with commodities made by the more direct application of tabor, — a proposition which both Ricardo and his followers set forth at wearisome length. The point essential for the present subject is that the reasoning rests simply on the assumption that capital means nothing more than advances to labor. In general, if more labor of one sort or another is needed to make a given commodity, more capital needs to be advanced in the same proportion; the profit to capital is in proportion to the advances to labor, or to the quantity of labor; hence the fact of production under the lead of capitalists, and the appearance of profit, do not per se modify the principle that value depends on labor bestowed. "Fixed capital," in fact, is only "accumulated labour."Works, p. 23, where these two' phrases are used as equivalents.
We have only another phase of the same line of thought when, in the familiar and much-abused proposition, profits are said to depend on wages. Profits are high when wages are low, and are low when wages are high, simply because the investment of capital is ultimately resolvable into advances to laborers. All the advances of the capitalists as a body consist at bottom of payments to laborers; what capitalists get back in return for their advances, is what the laborers produce; profits at large depend on the relation between what is turned over to laborers and what is produced by them. Perhaps Ricardo's meaning is best expressed (Ricardo himself did not so put it, but Senior and other writers of later date did so for him) by saying that profits depend on the proportion between wages and product; profits being high or low, according as the proportion of general wages to general output was small or large. However stated, there is a solid and unquestionable basis to the proposition: it brings into bold relief the essential fact in capitalist operations and the essential cause of profits and of interest. In so far economic science owes a permanent debt to Ricardo, however his own deductions may need correction, and however much his theorem may have been twisted by later interpreters. Ricardo deduced conclusions from it on the assumption that wages fluctuated closely with the price of food, and that the price of food rose regularly, under the law of diminishing returns, with every addition to the supply; assumptions to which the historical facts correspond so little that many of his conclusions have, even in the long run, but a very limited application. On the other hand, the proposition that all capital stands for advances to laborers, when stated in the questionable phrase that capital is "accumulated labor," has been twisted by the optimists into a defence of profit, and so has been, not unfairly, the occasion for plentiful ridicule by the socialists. But the essential truth in it remains incontestable. Without it the phenomena of capital and interest can not be understood.
This, however, is not the wages fund doctrine, nor is it of service in answering the question which that doctrine tried to answer: namely, what are the proximate causes determining wages at any one time. Its bearing is on profits, not on wages. The total advances to labor, represented by the total capital of any one time, have been spread over a long period. Some advances were made years ago, and are represented by tools and machinery still in use. Some were made within the year, and are represented chiefly by wheat on the fields. When all the tools are gone, and all the wheat has become bread, it will appear how much the laborers have produced during the whole prolonged period, in comparison with the total which has been turned over to them. But the demand for labor, in any given season, comes only from the fresh advances then made. For the question of "market" wages, it is necessary to cull out from total capital that part which is effective at the moment in rewarding laborers.
To this special part of the subject, Ricardo never stopped to give much attention. His phraseology is loose and uncertain. Frequently, he used language which would imply that market wages depended simply on the proportion of laborers to capital at large, so giving color to the opinion, not seldom maintained since his time, that the wages fund doctrine is but another version of the doctrine that wages and profits vary inversely. Thus, — to cite but one passage from many of the same tenor, — he says, in so many words, that "profits might increase, because, the population increasing at a more rapid rate than capital, wages might fall." Yet the remainder of the same sentence shows that he conceived of the demand for labor at the moment as identical not with total capital, but with a part of capital: ''instead of the value of 100 quarters of wheat being necessary for the circulating capital, 90 only [out of a total capital of 190] might be required."Essay on the Influence of a Low Price of Corn, Works, pp. 371, 372. Here we have the phrase "circulating capital," used to designate that part of capital which serves directly to yield wages. Ricardo rightly declared the distinction between fixed and circulating capital to be "not essential, and in which the line of demarcation can not be accurately drawn."Works, p. 21, note. Nevertheless he accepted the convenient use of circulating capital as meaning wages-capital. He so used it in the passage just cited; and in another, on the very page which in a note criticises the distinction between circulating capital and other capital, the text says that in in. some trades "very little capital may be employed as circulating capital, that is to say, in the employment of labour." Ricardo was not trained to great nicety in phraseology. Sometimes he used circulating capital to stand for the part of capital which constitutes demand for labor; quite as often, as has just been noted, he used capital alone. He speaks roughly of ''the impulse which an increased capital gives to a new demand for labour"; "in proportion to the increase of capital will be the increase in the demand for labour";Works, p. 51; Principles, ch. v. Both of the passages first quoted are on the same page. "experience teaches that capital and population alternately take the lead, and wages in consequence are liberal and scanty."Works, p. 379; Essay on the Influence of a Low Price of Corn. This was an idea of Malthus's, by whom Ricardo thought the proof from experience had been supplied. The demand for labor is frequently mentioned rather as proportioned to the total amount of capital than as equal to that amount; and such a mode of stating the relation, it may be observed, is more common in the Principles than in the earlier writings. We have thus a considerable variety of phrases, strictly consistent only in that the immediate source of wages was regarded as some part of capital.
That Ricardo was thus careless in his language, arose in part perhaps from lack of literary training,"Like most people who have not had the advantage of a literary education, Ricardo was apt to think that a word ought to have whatever sense he found convenient to put upon it." Cannan, History of the Theories of Production and Distribution, p. 195. There is a good degree of truth in this remark, however ungraciously it is put. but more largely from the fact that his attention was fastened mainly on permanent profits and permanent wages. As to permanent profits it was immaterial whether capital at any one time consisted in large or in small part of "circulating" capital or wages fund. The essential thing was that the whole of capital represented advances to laborers. Whether the advances were made earlier or later, and whether spread over a longer or shorter period, profits depended in the end solely on what the laborers produced over and above what had been turned over to them. Permanent or "natural" wages, on the other hand, depended simply on the price of food. The immediate advance of "capital" or "circulating capital" to laborers determined only market wages, which adjusted themselves to "natural" wages by the process, believed by Ricardo to be comparatively rapid, of a variation in the number of laborers. It thus made no difference, either as to permanent profits or permanent wages, how much of total capital happened to take in any one season the form of fresh advances to laborers.
Up to this point, the conclusions of the present chapter are not of any precise sort; showing indeed that Ricardo emphasized, in one way and another, the proposition that wages are paid from capital, but not showing that he held to the doctrine of an inelastic and predetermined wages fund. It was intimated at the outset of the chapter, however, that he had laid down, even though in brief terms, a doctrine of a more specific and rigid sort. It remains to be seen what further and more detailed views on this part of the subject he can be shown to have entertained.
Ricardo follows Adam Smith in speaking of "the funds destined for the maintenance of labour"; using this phrase quite as often as "capital" or "circulating capital," when he is speaking of the proximate causes determining market wages. What he conceives these funds to be, he says most explicitly, not in his chapter on Wages, where we might expect to find the statement, but in the later chapter which treats of taxes on raw produce and food. Incidentally to the discussion of the incidence of such taxes, we have a deliberate and detailed explanation of the nature and the limitation of the funds for the maintenance of labor.Chapter ix of the Principles, “Taxes on Raw Produce.”
A tax on food will not permanently affect real wages. One of the simplest applications of Ricardo’s doctrine on "natural" wages was that such a tax would raise the price of food; that "wages would inevitably and necessarily rise"; and profits would have to shoulder the tax. The dependence of profits on the price of food, via wages, is the cornerstone of Ricardo's theory of distribution, — and, at the same time, it may be admitted, its weakest part. But it might be objected "that there would be a considerable interval between the rise in the price of corn and the rise of wages, during which much distress would be experienced by the labourer." The objection leads Ricardo to consider how close is the connection between the price of food and money wages, and so to consider the causes which at any one time determine real wages.
"The wages of labour are really regulated by the proportion between the supply and demand of necessaries, and the supply and demand of labour; and money is merely the medium, or measure, in which wages are expressed." This is the sound view, which Adam Smith had stated so emphatically; but Ricardo carries it to consequences which Adam Smith never dreamed of. Anything which decreases the supply of necessaries (the real "funds for maintaining labourers") lowers wages, so long as population is the same; anything which leaves that supply fixed, can not affect them. A bad harvest reduces the quantity of necessaries; and however money wages may be made to rise "through misapplication of the poor laws," real wages must fall. Any attempt to regulate wages in such time by the money price of food "affords no real relief to the labourer, because its effect is to raise still higher the price of food, and at last he must be obliged to limit his consumption in proportion to the limited supply."
The situation is different if a tax is imposed on food. Then the quantity remains unchanged; real wages are not affected even for the moment.
"A tax on com does not necessarily diminish the quantity of com, it only raises its money price; it does not necessarily diminish the demand compared with the supply of labour; why then should it diminish the portion paid to the labourer? Suppose it true that it did diminish the quantity given to the labourer, in other words, that it did not raise his money wages in the same proportion as the tax raised the price of the corn which he consumed; would not the supply of com exceed the demand? — would it not fall in price? and would not the labourer thus obtain his usual portion?"The rest of the passage may be given, though it does not bear directly on the present subject:"In such case, indeed, capital would be withdrawn from agriculture; for if the price were not increased by the whole amount of the tax, agricultural profits would be lower than the general level of profits, and capital would seek a more advantageous employment. In regard, then, to a tax on raw produce, which is the point under discussion, it appears to me that no interval which could bear oppressively on the labourer, would elapse between the rise in the price of raw produce, and the rise in the wages of the labourer; and that therefore no other inconvenience would be suffered by this class, than that which they would suffer from any other mode of taxation, namely, the risk that the tax might infringe on the funds destined for the maintenance of labour, and might therefore check or abate the demand for it." It is not easy to make out by what process Ricardo thought the tax on food would raise its price. His language in this chapter usually implies that the effect would be immediate; and certainly he thinks that, if this happened, money wages also would rise immediately. But it is more in accord with his general mode of reasoning, and with the drift of this, passage, to interpret him as concluding that the price of food would not rise at once. The first incidence of the tax is on agricultural profits; then comes a withdrawal of agricultural capital, a diminution of the supply of food; and so a rise in price. How, after this, "no interval which could bear oppressively on the labourer, would elapse between the rise in the price of raw produce, and the rise in the wages of the labourer," it is difficult to see. Apparently money wages can then rise only in consequence of a decline in population: a process which in fact must bear very oppressively.
The result is the same in any other case in which the price of food is raised, but the quantity of it constituting the demand for labor remains unchanged. Thus, there may be a general rise of prices, and so a rise in the price of food,
"in consequence of an influx of the precious metals from the mines or from the abuse of the privileges of banking. It leaves undisturbed too the number of labourers, as well as the demand for them; for there will be neither an increase nor a diminution of capital. The quantity of necessaries to be allotted to the labourer, depends on the comparative demand and supply of necessaries, with the comparative demand and supply of labour: money being only the medium in which the quantity is expressed; and as neither of these is altered, the real reward of the labourer is not altered."Works, pp. 93–97. I have not followed Ricardo's arrangement of the matter in this summary; but the changes in no way affect the substance of his reasoning.
It would be difficult to find in the writings of the classic economists a more direct statement of a predetermined fund, all of which must go to the laborers. The demand for labor is here treated as that part of capital which exists in the form of necessaries or food. No doubt Ricardo is discussing primarily the effects of a tax on food, not of capital and market wages. But he habitually spoke of wages as consisting of food which the laborers can not dispense with, and, in the very passages cited, identifies the food with their real reward. At any moment, there is just so much food on hand, and all of that the laborers will certainly get. No tax on food, no artificial rise in prices, can prevent them from getting, during the season, what is on hand for the season.
Another question would naturally be asked by one who followed Ricardo so far. If the laborers must get at least so much, does it follow that they can not get more? Ricardo never was led to give a clear intimation of his opinions on this further point. In the course of the same discussion of taxes on food, he remarks that "an accumulation of capital naturally produces an increased competition among the employers of labour, and a consequent rise in its price. The increased wages are not always immediately expended on food, but are first made to contribute to the other enjoyments of the labourer."Works, p. 95. This might perhaps be interpreted to imply an elastic supply of commodities which, though not food, yet constituted part of "the real funds for maintaining labourers." But it is more in accord with Ricardo's general reasoning to interpret him as speaking here of the results of several seasons of higher wages. At first, higher money wages could not bring higher real wages; but after a season or two, the increased money demand for" other enjoyments" by laborers and the consequent higher prices of these "other enjoyments" would lead to a greater production of them. Eventually, the laborers would increase in numbers, and demand more food. The other enjoyments would disappear, food would be more costly from the resort to poorer land, money wages would permanently rise, real wages (in the sense important for the laborers) would return to the point from which they started. Such are the details by which, if this interpretation of his views is sound, Ricardo would have described the changes in wages resulting from a greater demand for labor.One other passage from Ricardo's writings may be cited at this point. In one of his letters to Malthus, written in 1815, he expresses himself thus:"If, instead of 4, 10 measures could be produced by a day's labour no rise would take place in wages, no greater portion of com, cloth, or cotton, would be given to the labourer, unless a portion of the increased produce were employed as capital, and then the rise in wages would be in proportion to the new demand for labour, and not at all in proportion to the increase in the quantity of commodities produced. ... In the case of great improvements in machinery … no demand for additional labour will take place unless the increased production in consequence of the improvements should lead to further accumulation of capital." — Letters of Ricardo to Maltlus, edited by Bonar, pp. 98, 99.This does not throw any further light on the details of Ricardo's thinking as to the wages fund; but it is interesting, because expressing in terms a conclusion which would certainly flow from his general reasoning, and which touches the gist of much recent controversy on the wages fund.
It would be a mistake to infer too much from these passages. They intimate, undoubtedly, a rigid sort of wages fund, — an inflexible predetermination of the wages of the moment. But they are incidental to another topic, and Ricardo probably was not reflecting at all on the question of market wages except in its connection with the price of food. They are important, not so much in the specific content, as because they bring into vivid relief the unflinching manner in which Ricardo carried his reasoning to its last consequences. His habit of mind, and his general doctrines, would have led him easily to maintain the existence of such a fund; but, except in such incidental discussion as has just been noticed, Ricardo never made any careful statement of his views as to a clear-cut and predetermined wages fund.
At all events, it is in the example which he set of rigid reasoning and unqualified statement, that Ricardo exercised greatest influence on the presentation of the wages fund doctrine by later hands. The particular passages just discussed were not referred to, in their bearing on wages, by any of the writers of the next generation. But his modes of reasoning and of statement affected his successors powerfully, and gave economic theory a method and a direction which were retained, in England at least, for half a century. The prominent place which the analysis of capital into advances for laborers held in his writings at large, probably affected the wages fund discussion more than did the comparatively brief passages in which the question of market wages is specifically considered. The operations of capitalists consist in making advances to laborers; market wages depend on the ratio between population and capital, — these two general propositions, combined with the example of rigid deductive reasoning, had most effect on the treatment of the theory of wages by Ricardo's successors and followers.
To summarize. Ricardo developed the theory of capital and wages in two directions. He put forth the doctrine that all capital is resolvable into advances to laborers, and that therefore wages and profits are inverse to each other. Faint germs of the doctrine are to be found m Adam Smith; the conclusion as to the inverse relation of wages and profits is explicitly stated by him; but the ground on which Ricardo reached it was never really touched by the earlier writer. Ricardo himself stated it rather by implication than explicitly; but it runs so plainly under all his reasoning on distribution that no one thereafter could fail to consider it. Next, Ricardo laid it down that" market" wages depended on the demand and supply of labor, and that the demand for labor came from the capital of those who hired laborers for production. Here Adam Smith had done more than to furnish the germs of the doctrine: the doctrine itself is prominent in the Wealth of Nations. But Ricardo gave it sharper outline, and a more universal application. He brushed aside all laborers except those hired by capitalists. If asked whether other laborers existed, he must have replied in the affirmative; and if asked whether their remuneration presented problems to which his theories on wages gave no sufficient answers, he must at least have hesitated, and considered the case further, — with what result every student of Ricardo will make his own guess. But the questions were rarely asked and, if asked, got no attention. The insular horizon of almost all the English economists of that period prevented them from touching other phenomena than those presented in their own country. Ricardo's simple formula as to the proportion of capital to population, reinforced as it was by what Adam Smith and his immediate successors had said, seemed to answer all questions worth the asking about the proximate forces determining wages. And, finally, there is evidence of a distinct opinion on Ricardo's part as to the rigidity of the part of the capital which could go to laborers in any one season; but this bears rather on Ricardo's own conclusions than on the influence which he exerted on the generation of economists who followed him.
We enter now on the second part of the investigation: the history of the wages fund doctrine, and of the mode in which the relation of wages to capital has been treated by writers of the past and present.
The history of some parts of economic thought goes far back into the past. But theoretic inquiry as to the causes which affect distribution under the conditions of modern industry is of very recent date. It does not reach back farther than the second half of the eighteenth century, and virtually begins with Adam Smith. With a single exception, presently to be mentioned, we find in the writers before Adam Smith hardly a trace of the sort of reasoning which has been applied during the last hundred years to wages and the return to capital, and to most of the modern phenomena of distribution.
No branch of knowledge, it is true, is without its link of connection with the past. Adam Smith was not an isolated growth. He began where his predecessors left off, and rested his new work solidly on what they had already accomplished. But in his case, as often happens, the fresh growth was in a different direction from the old, and in some respects was of an entirely novel sort. Of the points of connection between the great Scotchman and his predecessors something more will be said in the next chapter. So far as the subject of this inquiry is concerned, the connection between earlier and later thought happens to be singularly slight. The earlier writers had virtually done no more than to clear some parts of the field, and so make it easier for an acute and original thinker to take a fresh start.
On the direct subject of wages, then, and on capital in its relation to wages, we find practically nothing in the earlier writers. Scattered through the literature of the seventeenth and eighteenth centuries there are casual allusions to wages, usually implying that they are determined by the price of food. Subjects connected with money and international trade mainly occupied the attention of the writers of those times. On the problems of distribution they gave no more than incidental expression to opinions half-consciously formed. Probably as explicit a statement as can be found on the subject of wages is that of Mildmay. "As plenty and scarcity will in general determine the price of provisions, so the price of provisions will, in general, determine the wages of labour, and the price of labour will determine the price of all productions and commodities whatsoever."Sir William Mildmay, The Laws and Policy of England relating to Trade, London, 1765, p. 22. Some such opinion as this seems to have been entertained usually, though not universally, by the writers of Mildmay's period. Petty had indeed intimated a different view. "When corn is extremely plentiful, the Labour of the poor is proportionally dear: and scarce to be had at all (so licentious are they who labour only to eat, or rather to drink)."Petty, Politcal Arithmetic, London, 1691, p. 45. But as great a mind as Locke's had accepted opinions like those of Mildmay,Locke, Some Considerations of the Consequences of the Lowering of Interest, 1691, in his works, vol. v, pp. 23, 24. and most of the mercantile writers did the same. They stated, or implied, that a low price of food made low wages, — a result desirable in that it brought low prices and ready exports. Such remarks, however, as a rule, were simply incidental to the discussion of money and the balance of trade. It is significant that writers like Child, Gee, and Steuart have not a word on the general causes that affect wages, or on capital as connected with wages. To all intents, the discussion of this phase of economics had not begun.
This blank among the earlier writers on the topic which in our own time has become the crucial one in economic theory, is to be explained in two ways. In part, it was due to their narrow point of view. They were concerned chiefly with the power of the sovereign, and the greatness and resources of the country in its dealings with foreign nations. As wars and international relations chiefly engrossed the attention of statesmen in the period from the Reformation to the French Revolution, so the nature and profit of dealings with foreign countries chiefly interested those who thought on economic subjects. The statesman of the nineteenth century is occupied with constitutional and social questions; the economist, similarly, with the problems of distribution.
Another cause of the silence of the earlier writers lies in the economic conditions of their time. The feudal régime and the industrial organization of the middle ages were gone. The modern conditions, while fast developing, had not yet emerged with distinctness. The phenomena which arose as employers and capitalists were unfettered and as labor became free, had not existed long enough to compel specific examination. Consequently even those writers whose point of view was wider and more humane than that of the typical mercantilists, did not strike the modern note. Vauban and Boisguillebert take the social point of view; they consider the causes of the condition of the masses; but of wages in the modern sense they have nothing to say. Even the Physiocrats, important as is the place which they take in the development of modern economic thought, yield nothing on this topic. Quesnay rarely touches on wages, never on the nature and functions of capital or on the relations between capital and wages. English writers, like Hume, Cantillon, and Tucker, joined the Physiocrats in attacking the mercantile ideas on money and international trade, and in directing attention to abundance of commodities and productiveness of labor as the true sources of prosperity. But the problems of social happiness, as connected with internal prosperity, which lead to a discussion of wages, did not attract their notice.
To this general silence on the subject of our inquiry before the time of Adam Smith, there is one noteworthy exception: Turgot, great in everything that he touched, made his mark here also. In the Réflexious sur la Formation et Distribution des Richesses, published in 1767, we have a theory of capital which may justly be called the first modern discussion of the subject.See the Works of Turgot (edition of 1844), vol. I, sections 60–61, 69, 80, 90, of the Réflexions. It is true that Turgot's discussion begins from the old point of view. He is led to a consideration of capital from his discussion of money; the whole treatment of capital is an episode in his examination of money, interest, and the "disposable" class. But the treatment is a long step beyond anything reached before his time. The function of capital is to make the advances which become necessary when a great number of arts "exigent que la même matière soit ouvrée par une foule de mains différentes, et subisse très longtemps de préparations aussi difficiles que variées." The hallmark of the Physiocrats appears in the curious doctrine that in agriculture there was, strictly speaking, no need of an advance; since land always produced a "revenu" or "superftu," which enabled its cultivators to dispense with advances. According to Turgot, it is only when a large part of society no longer cultivated the soil and "n'eut que ses bras pour vivre," that advances became necessary. Materials, implements, buildings, and subsistence must be provided, — say for making leather; "et qui fera vivre jusqu' à la vente des cuirs ce grande nombre d'ouvriers"? The constant advance or consumption of capital, its constant reproduction and return to the hands of the capitalist, the source of capital in "l'epargne," the distinction between money and capital, the absence of connection between the rate of interest and the quantity of money, the futility of attempts to regulate the rate of interest, — these varied subjects are presented with an insight far beyond that of any writer before the time of Turgot, and not less than that of many writers who have had the benefit of a century of further discussion.See the Works of Turgot (edition of 1844), vol. I, sections 60–61, 69, 80, 90, of the Réflexions.
But while Turgot thus took an important step toward beginning the modern analysis of capital, he is silent on that aspect of the subject which bas most prominence in the later discussions of distribution, — on the relations of capital to wages. It is true that he says more than once that capital provides subsistence for laborers, as well as materials, implements, and buildings. Some expressions which show that this function of capital was clearly in his mina have just been quoted. But that there might be here a mode of approaching the problem as to what determined the wages of laborers, never seems to have occurred to him. Turgot's theory of wages is very briefly stated in the first pages of the Réflexions; it is the same as was held, so far as any was held, by all writers of this earlier period. "En tout genre de travail il doit arriver et il arrive en effet que le salaire de l'ouvrier se borne à ce que lui est nécessaire pour lui procurer sa subsistence." There is no hint of any Malthusian ground for the doctrine. It rests on the fact that the employer pays the laborer as little as he can, and has "choix entre grand nombre d'ouvriers."See the Works of Turgot (edition of 1844), vol. I, section 6, Réflexion. Thus it serves chiefly to clear the way for the discussion of net income, of the disposable class, and of the physiocratic conclusions as to taxation and economic reform. In all this the laborers are not thought to need much attention. They get only what serves to subsist them, and have no share in net revenue. In short, they are simply eliminated from the problem.
Directly, therefore,Ganilh, Inquiry into the Various Systems of Political Economy. I quote from the New York edition of 1812, page 162. Compare what is said of Ganilh below, at page 157. Turgot left the subject of wages and capital almost untouched, and so left a clear field for Adam Smith. Doubtless it would be possible to find scattered hints and pregnant sentences in other writers: embryos which never developed, and never would attract notice, had not the full-grown thought appeared elsewhere from another beginning. Doubtless, too, the general speculations of the Physiocrats and of their contemporaries on distribution at large had their share in directing thought into new and better ways, and stimulated inquiry into deeper and more substantial causes of prosperity than had been commonly examined by earlier writers. But, when all is said, it remains substantially true, as one of the great Scotchman's immediate followers said, that "the theory of capital is new, and entirely of Adam Smith's creation": and to the examination of his views we may now proceed.
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015)
ABSTRACT: The paper aims to defend the general validity of the ABCT against the assumption that the theory does not hold if entrepreneurs are able to anticipate correctly the inflationary effects of a fiduciary credit expansion. Hülsmann (1998) raises this critique and puts forward a general theory of error cycles centered on government intervention in the economy in order to overcome the perceived shortcomings of the traditional ABCT. The paper analyzes the main implications of this critique of the ABCT in terms of entrepreneurial foresight and the optimal course of action necessary to prevent a monetary induced business cycle, in particular in the context of fractional reserve banks operating under fiat currency. It concludes that within the general framework of human action, entre-preneurs cannot arbitrage away clusters of errors, and the ABCT remains valid. This paper also questions whether Hülsmann’s essentialist approach can be a viable alternative to the traditional ABCT, and find that, despite its merits, the approach can be refuted as a stand-alone theory.
KEYWORDS: business fluctuations, credit and money multipliers, interest rate, rational expectations, government interventionJEL CLASSIFICATION: E32, E51, E43, E03, P00
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015): 578–583
Based on his doctoral thesis directed by Jörg Guido Hülsmann (who also wrote the foreword to the book), German economist Eduard Braun's Finance Behind the Veil of Money aims to show how money affects our financial decisions. The reader will notice that Braun approaches this goal from a different angle of most Austrian-school economists. Instead of looking at how money and credit affect interest rates and propagate an Austrian business cycle, Braun focuses on the “subsistence fund.” Largely jettisoned from modern Austrian business cycle theory, in a way Finance Behind the Veil of Money picks up where Richard Strigl left off with his Capital and Production (1934).
In expounding an updated theory of the definition and role of the subsistence fund, Braun rewards the reader for the time dedicated to reading the book. This time is not insubstantial. At 342 pages, the book is neither concise nor easy reading. It is heavy, dense, technical and littered with citations. The publisher’s exclusive use of endnotes makes the going tougher yet, as the reader constantly finds himself flipping pages to find out to whom Braun is attributing a concept, to what era the idea belongs or, indeed, since Braun uncovers the changing thoughts of several authors over their lifetimes, to what specific work of an author he is referring.
Dr. Mark Thornton is interviewed on the RT program, "Boom Bust". He discusses malinvestments stimulated by artificially lowered interest rates.
Quotes discussed in the interview:
"The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated." -Ludwig Von Mises in The Austrian Theory of the Trade Cycle and Other Essays, Page 28
"The crisis and the ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared "profitable" in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be 'profitable.'" -Ludwig Von Mises in The Austrian Theory of the Trade Cycle and Other Essays, Page 30
You can find the original interview video here.
This seminal treatise in the history of ideas demonstrates what has come to be known as the Higgs thesis: that government grows in periods of crisis, for example, war and depression. He demonstrates this with a detailed look at twentieth century economic history.
Higgs's thesis is so compelling that it has become the dominant paradigm for understanding the so-called ratchet effect: government grows during crisis and then retrenches afterwards, but not to the same level as before.
This book is absolutely essential for anyone who seeks to understand the dynamics of government growth and the loss of liberty.
In fact, Thomas Woods's book on Catholic social teaching surpasses any other book ever published in this genre. Rather than merely recount what has been said, he subjects the corpus to a relentless examination, highlighting contradictions and missteps, while praising the good. Even for those not particularly interested in Catholic teaching, this book is an outstanding elucidation of economic science in light of moral concerns. He covers wages and labor, money and inflation, trade and the division of labor, entrepreneurship and development, and the meaning of a range of concepts such as price and value.
Of particular interest is Professor Woods's primary target: not so much the social-gospel left but the Catholic right, which argues against free enterprise and laissez-faire with surprising intensity. By taking on these critics of the market, as versus easier leftist targets, he has set for himself the most difficult task of providing a corrective concerning economics to those who are most attached to Catholic teaching on faith and morals and yet are dogmatically attached to various forms of government intervention designed to shore up morals and faith.
He shows that market economics is not contradicted by binding Catholic teaching but rather supported by it.
The world waits to see if next week is finally the week that the groundhogs at the Fed announce their long-anticipated interest rate hike. Can the economy survive whatever small bump the Fed deals out? Perhaps, but any temporary stability doesn’t change the inherent instability of our current monetary regime. Even with today’s technology, central planners can’t predict the future or know the “optimal quantity of money.” Only by returning to true sound money, and a proper appreciation for the market, will true, sustainable prosperity emerge.
In honor of the twenty-fourth anniversary of the collapse of the Soviet Union, we have a special guest on the latest episode of Mises Weekends, Dr. Yuri Maltsev. A Mises Senior Fellow and a Soviet economist during the Gorbachev era, Maltsev shares his thoughts on the West’s enduring love affair with socialism. He and Jeff also discuss its political consequences in regard to Obama, Trump, and the Bernie Sanders phenomenon. This is an interview you won’t want to miss.
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Piketty Is Wrong: Markets Don’t Concentrate Wealth by Louis RouanetWhy Gold-Backed Money Doesn’t Bring Booms and Busts by Frank ShostakEnd the Sugar Tax Now by Gary GallesGovernment Debt Is Not Like Private Debt by Simon WilsonNo, "Big Data" Can’t Predict the Future by Per Bylund"Capitalism" Destroyed Itself? by Matt McCaffreyBlowing Up the Death Star Didn’t Destroy Economy, Building It Did by Tho BishopMan, Economy, and Beer: Rothbard-Themed Gastropub Opens in ConnecticutArticle Submission Guidelines for Mises DailyIndia’s Failing Gold Monetization Scheme: Seizure Imminent? by Paul-Martin FossViva Venezuela ... But Not Yet by Carmen Elena DorobățGun Control Fails: What Happened in England, Ireland, and Canada by Ryan McMakenTranscript: Ask David Gordon AnythingTop Ten Most-Read mises.org Articles in NovemberGerman translation of "PC is Control, Not Etiquette"Thanks, Janet Yellen: Homeownership in US Falls to 25-Year Low by Ryan McMakenWhy the No-Fly-List Gun Ban Is a Terrible Idea by Tho BishopBubble Watch: No-Down-Payment Jumbo Mortgage Makes a Comeback by Paul-Martin Foss
The old Marxist apocalyptical fear of ever-rising inequality in capitalist societies is growing. The capitalist elite, it is said, benefit from a dynamic of infinite accumulation of wealth and will be able soon to buy everything and everybody, including the government. This fear of unlimited accumulation of wealth by a few was the main theme of Thomas Piketty’s Capital in the Twenty-First Century, published in French in 2013. For example, Piketty writes:
It would be a serious mistake to neglect the importance of the scarcity principle for understanding the global distribution of wealth in the twenty-first century. To convince oneself of this, it is enough to replace the price of farmland in Ricardo’s model by the price of urban real estate in major world capitals ...
To be sure, there exists in principle a quite simple economic mechanism that should restore equilibrium to the process: the mechanism of supply and demand. If the supply of any good is insufficient, and its price is too high, then demand for that good should decrease, which should lead to a decline in its price. In other words, if real estate and oil prices rise, then people should move to the country or take to traveling about by bicycle (or both). Never mind that such adjustments might be unpleasant or complicated; they might also take decades, during which landlords and oil well owners might well accumulate claims on the rest of the population so extensive that they could easily come to own everything that can be owned, including rural real estate and bicycles, once and for all. (Piketty 2013)
Let us put aside the fatuous example involving a bike as a market response to scarcity — that is a negative technological shock despite the fact that we are today in a highly innovative world. Piketty actually believes that a single person or entity owning “everything” can be a possible outcome of free-market capitalism. According to him, if r > g (i.e., if the rate of return on capital is superior to economic growth) there will be an “endless inegalitarian spiral.” If Piketty had read Austrian economists and had mastered the economic calculation debate, he would have noticed that the unhampered market cannot lead to a situation of wealth accumulation where there is only a single individual or cartel owning everything. Indeed, a situation with one big cartel or one owner is equivalent to full socialism and therefore, to a situation where no rational allocation of resources would be possible, as Mises showed in Socialism. It is Rothbard who brilliantly pointed out that calculability is an upward limit to the size of the firm. But this argument can equally be applied to individual ownership concentration. As Rothbard points out:
[T]he free market placed definite limits on the size of the firm, i.e., the limits of calculability on the market. In order to calculate the profits and losses of each branch, a firm must be able to refer its internal operations to external markets for each of the various factors and intermediate products. When any of these external markets disappears, because all are absorbed within the province of a single firm, calculability disappears, and there is no way for the firm rationally to allocate factors to that specific area. The more these limits are encroached upon, the greater and greater will be the sphere of irrationality, and the more difficult it will be to avoid losses. One big cartel would not be able rationally to allocate producers’ goods at all and hence could not avoid severe losses. Consequently, it could never really be established, and, if tried, would quickly break asunder.
Thus, contrary to what Piketty and other egalitarians think, unlimited wealth concentration is technically impossible in a market economy. This is the reason why a “one big cartel” controlling all the economy never appeared on the free market, and this is the reason why wealth concentration will always be limited.
The lack of theoretical rigor in Piketty’s book is striking. Whereas he is supposed to study the dynamics of income inequality in capitalist societies, he barely analyzes the role of entrepreneurship, and, when he does, he gives absolutely no definition of what it is. This lack of rigor enables him to lead an ideological battle against the rich that he considers as being “undeserving.” Similarly, whether it is Piketty or Anthony Atkinson, none of these modern egalitarians mentions the role of division of labor in the distribution of wealth.
We know however that division of labor is a necessary feature of the market economy. Indeed, the very existence of rich capitalists is not a matter of inheritance or undeserved ownership but is the result of the law of comparative advantage. A capitalist is someone who has a comparative advantage at allocating capital and therefore is specialized in this task. On the unhampered market, those who tend to be the wealthiest tend also to be the most efficient men at allocating capital. If their ownership ability is poor, the consumers sanction them. If their ownership ability is good, the consumer will reward them.
Frédéric Bastiat, while on his deathbed in Rome, and despite being severely ill, made it very clear to his friend Prosper Paillottet, that economists should focus primarily on the consumer. The consumer, he said, is the primary source of any economic phenomena. The major flaw of Piketty’s book is that he explains inequality not by starting from consumers’ choice but by starting from capital ownership. Owners, Piketty says, benefit from a rate of return and when this rate is higher than economic growth, it intensifies income inequalities. For Piketty, the rate of return on capital is a mythical stream of income which depends not upon ownership abilities but on how much capital you own. But the distribution of wealth is not as arbitrary as Piketty would like to think. The consumer has the final word in the decision of who must own the factors of production. As Mises in Human Action explained, the wealthy “are not free to spend money which the consumers are not prepared to refund to them in paying more for the product.” On the unhampered market, the rich can accumulate more wealth only if he is efficient to the task of allocating capital, for the benefit of all. We must admit that we see nothing morally wrong about that. Quite the contrary, we applaud it.
Because the economic theory underlying Piketty’s thesis is weak, his explanations do not match with empirical evidence. In fact, Piketty (2015) himself had to admit that he does not “view r > g as the only or even the primary tool for considering changes in income and wealth in the twentieth century, or for forecasting the path of inequality in the twenty-first century.” And indeed, r > g is not a useful tool for the discussion of rising inequality of labor income. But surprisingly, Piketty himself admitted the weakness of his model since the rise of top income shares in the United States over the 1980–2010 period is due for the most part to rising inequality of labor earnings.
We should also highlight that 56 percent of Americans are, during at least one moment of their lives, part of the top 10 percent in incomes (a ratio of 5.6), and 12 percent are in the top 1 percent (a ratio of 12). Therefore, we can conclude that the richer you are, the more volatile is your wealth. This is a valid critique we can address to Thomas Piketty, Atkinson, and many other egalitarians.
Indeed, if wealth is that unstable in the 1 percent, we can then conclude that infinite concentration of wealth is a myth and does not happen in a market economy. On the contrary, capitalist societies are more prone to intergenerational mobility, upward and downward. Therefore, if inequality of income at a particular point of time in capitalist societies can be higher than in more socialistic economies, the market economy might very well offer more equality when we consider the lifelong income disparities between individuals.
More than 100 years ago, a French economist published a book about inequality. Like Thomas Piketty’s Capital in the Twenty-First Century, this book was celebrated in the United States. But unlike Thomas Piketty, Paul Leroy Beaulieu tried to explain in his book Essai sur la Répartition des Richesses (1881) why he thought inequality, without being eradicated, would decrease in capitalist societies. The radical difference of tone between those two books is a good illustration of the intellectual bankruptcy of both the United States and France since the Belle époque. From classical liberalism, we succumbed to the illusion of egalitarianism, and from liberal optimism about the free-market order, we went to egalitarian and socialist pessimism. Today, many inequalities are due to government violent intervention in the market order. And we should therefore wonder, after all, if it is not wiser to listen to Paul Leroy Beaulieu rather than to Thomas Piketty.
Quarterly Journal of Austrian Economics 18, no. 3 (Fall 2015)ABSTRACT: Austrian economists since the time of Böhm-Bawerk have argued that lowered interest rates lead, in general, to longer production processes. Recently Hülsmann (2011) and Fillieule (2007) have challenged this argument and demonstrated with mathematical precision that lowered interest rates shorten production processes. This paper argues that it may be misleading to search for a direct causal effect of interest rates on the length of production because another, related factor affects it more directly. We name this factor intertemporal labor intensity, since it has to do with the moment of hiring labor. We discuss the relationship between savings and the interest rate, and modify a textbook depiction of the structure of production by changing interest rates. After explaining the concept of intertemporal labor intensity, the paper discusses a crucial assumption of Hülsmann (2011) and Fillieule (2007) on the ratio of labor to capital.
KEYWORDS: capital theory, interest, production structure, Böhm-BawerkJEL CLASSIFICATION: B13, B53, D24, E43
Includes an introduction by Jeff Deist. Recorded via Skype at the Mises Institute in Auburn, Alabama, on 23 July 2015.
In his article “The Big Meh” Paul Krugman complains that despite all the information technology advances the effect so far has been negligible as far as economic growth is concerned.
Krugman writes “That the whole digital era, spanning more than four decades, is looking like a disappointment. New technologies have yielded great headlines but modest economic results. Why? ... The answer is that I don’t know — but neither does anyone else.”
Indeed if one looks at the real gross domestic product to the potential real gross domestic product ratio the economy does appear to be hovering below potential with the ratio of 0.977 registered in Q1 this year.
Contrary to Krugman, we suggest that economists such as Ludwig von Mises and Murray Rothbard have provided a clear answer to the issue of technology and economic growth.
In Man, Economy, and State, Rothbard says that technology, while important, must always work through the investment of capital in order to generate economic growth.
On this issue, Rothbard recalls Mises and writes,
What is lacking in (underdeveloped counties) is not knowledge of Western technological methods (“know how”); that is learned easily enough. The service of imparting knowledge, in person or in book form, can be paid for readily. What is lacking is the supply of saved capital needed to put the advanced methods into effect.
Most modern theories that emphasize the importance of new ideas and new technologies give the impression that these ideas and technologies have a “life of their own.” Many experts hold that because of the limited amounts of capital and labor, without technological progress, the opportunities for growth will eventually run out.
We Need Funding To Implement New IdeasIdeas, unlike material inputs, are not themselves scarce. Consequently, it is argued, new ideas for more efficient processes and new products can make continuous growth possible.
We suggest that regardless of how many ideas people have, what matters is whether these ideas can be implemented. What always limits the implementation of various new techniques is the availability of funding. While ideas and new techniques can result in a better use of scarce resources, they can however, do very little without the pool of real savings.
So regardless of how clever we are and regardless of various technological ideas, without an adequate pool of funding nothing will emerge. It is through the expansion in the pool of real savings that an increase in the stock of capital goods is possible. And it is the increase in the capital goods per worker that permits economic growth to emerge.
To Get More Funding, We Need SavingsObviously, new ideas and new technology can be introduced during the production of new capital goods (i.e., new technology) and will be imbedded in the capital goods stock. The crux of the matter however, is that capital goods cannot emerge without a prior increase in the pool of funding or pool of real savings.
Take, for instance, a baker John who produced ten loaves of bread. He consumes two loaves of bread whilst the other two loaves — his real savings — he employs to purchase a new part to improve his oven. With a better oven he can now raise the output of bread to twenty loaves. If he still consumes only two loaves, then with a larger savings (now stands at eighteen loaves) he can enhance further his oven by introducing new parts, which will enable the introduction of new technology. Note that all this is made possible on account of real savings.
We suggest that despite new technologies, a major impediment to economic growth has been the relentless central bank tampering with financial markets.
Since 2008 this tampering was made manifest in the extremely loose monetary policy of the Fed that resulted in the massive monetary expansion of the Fed’s balance sheet and the lowering of interest rates to almost nil.
These policies have been responsible for a severe erosion of the pool of real savings and thus a weakening of the process of capital formation. This in turn has undermined real economic growth notwithstanding new information technology.
For Krugman and his followers savings is bad news — it is seen as less demand — hence one shouldn’t be surprised that Krugman is puzzled as to why new ideas haven’t manifested in a more robust economic growth. Contrary to Krugman, boosting so-called aggregate demand whilst undermining the capital formation process, and hence the ability to produce goods and services, cannot strengthen economic growth over time. In fact this way of thinking results in the notion that something can be generated out of nothing.
Volume 18, Number 1 (Spring 2105)ABSTRACT: What Engelhardt calculates in his comment is not the Marginal Efficiency of Capital. Engelhardt incorrectly ranks investment projects by Present Value instead of Net Present Value. Engelhardt does not prove that Keynes has a wealth maximizing theory of investment, so his comment is not a successful defense of Keynes’s theory.
KEYWORDS: John Maynard Keynes, marginal efficiency of capital, net present valueJEL CLASSIFICATION: E12, E22, E52, E58
Volume 18, Number 1 (Spring 2105)ABSTRACT: This is a brief reply to “The Marginal Efficiency of Capital: Rejoinder.” I explain that I never intended to defend Keynes against Fuller’s (2013) criticism. Rather, I intended to highlight that Keynes’s conclusions rest on a key shortcoming in Keynes’s theory: the assumption of sticky factor prices.
KEYWORDS: John Maynard Keynes, marginal efficiency of capital, net present valueJEL CLASSIFICATION: E12, E22, E52, E58
Austrian economists are justifiably proud of the rich heritage handed down by Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, Murray Rothbard, and their contemporaries, and Austrians are keenly interested in the origin and development of their ideas. An appreciation for history has led some modern economists, mistakenly, to see the Austrian tradition as static, rigid, and backward-looking, focused on the achievements of the past rather than discoveries and new developments.
As the contributions to this volume attest, nothing could be further from the truth. Austrian economics is a vibrant, healthy, growing tradition, confident in its core propositions while filled with lively debates and exciting new advances. These authors of the essays collected here build upon, refine, extend, and challenge the contributions of their teachers, just as previous generations have done, all the way back to Menger.
Joseph Salerno’s own work is a vibrant illustration of this pattern. Salerno has made seminal contributions to the development and application of Austrian economics, while remaining within the broad, causal-realist tradition pioneered by Menger and refined by Böhm-Bawerk, Mises, and Rothbard. Salerno’s early work was in monetary economics and the history of economic thought. His doctoral dissertation (Salerno 1980) offered a novel interpretation of the “bullionist controversy” and subsequent developments in British monetary theory and policy. He also published a number of important papers on the largely-neglected French liberal school of Say, Destutt de Tracy, Dunoyer, Bastiat, and Molinari, among others, and their important predecessor (and proto-Austrian) Cantillon (Salerno 1978; 1983; 1988). Along with Rothbard he developed a distinctly Austrian approach to measuring the money supply (Rothbard 1978; Salerno 1987), one consistent with Austrian concepts of the nature and role of money.
It was his work on money that led Salerno to a significant breakthrough in the interpretation of Mises’s economics. It had long been recognized, inside and outside the Austrian school, that Mises’s great accomplishment in his Theory of Money and Credit (1912) was an integration of monetary theory into the general, subjectivist, marginalist understanding of value, prices, and markets shared by the Austrian, Walrasian, and Marshallian schools. Prior to Mises, prices were typically analyzed as exchange ratios between goods, not ratios between goods and a monetary unit. Money was a “veil,” overlaying (or obscuring) underlying economic relationships. Mises showed that economic actors evaluate units of money the same way they evaluate discrete units of other goods and services, namely in terms of marginal utility, and that the general theory of economic value also explains the value of money. In a perceptive Postscript to a reprint of Mises’s 1920 essay on socialist calculation, Salerno (1990a) highlighted the degree to which Mises’s analysis of socialism flowed from his analysis of money. As Salerno (1990a, p. 35) put it:
Mises’s pathbreaking and central insight is that monetary calculation is the indispensable mental tool for choosing the optimum among the vast array of intricately-related production plans that are available for employing the factors of production within the framework of the social division of labor. Without recourse to calculating and comparing the benefits and costs of production using the structure of monetary prices determined at each moment on the market, the human mind is only capable of surveying, evaluating, and directing production processes whose scope is drastically restricted to the compass of the primitive household economy.
In other words, what Mises means by “economic calculation” is monetary calculation. The core problem facing the government planner is not that he lacks the “knowledge of particular circumstances of time and place,” as Hayek (1945) famously put it, but that he lacks the real-world monetary prices needed to weigh alternative benefits and costs, to estimate rates of return on investment, and hence to allocate resources rationally in a complex world.
This insight led to a profound revaluation of Mises’s contributions and the role of Mises’s work in the history of economic thought. By the 1980s Hayek’s profound and influential social theory, which emphasized the challenges of economic organization under dispersed knowledge and limited understanding, and was deeply wary of attempts to reconstruct society according to some “rational” plan, was embraced by most Austrian economists. Even today, Hayek’s pithy line from The Fatal Conceit (1988, p. 76) — “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design” — adorns many an email signature line and blog masthead. But, as Salerno carefully demonstrated, this anti-rationalist, incrementalist, evolutionary, “English” approach to economics, law, and social theory was particular to Hayek, and not at all shared by Mises.
In “Ludwig von Mises as Social Rationalist” (1990b) and “Mises and Hayek De-Homogenized,” (1993), Salerno offered a different interpretation of Mises and Mises’s place within the Austrian tradition. Salerno argued that Menger’s younger colleagues Böhm-Bawerk and Weiser extended Menger’s approach along distinct, sometimes contradictory, paths. What we might call a Wieser-Hayek-Kirzner strand of Austrian economics emphasizes disequilibrium, the informational role of prices, and profit-seeking behavior as an equilibrating force. In contrast, the Böhm-Bawerk-Mises–Rothbard strand emphasizes monetary calculation and the entrepreneur as a purposeful, forward-looking agent. In my own work on the entrepreneur (Klein 2008a; Foss and Klein 2012; Klein and Bylund 2014) I have highlighted two distinct Austrian interpretations of the entrepreneurial role. In Kirzner’s (1973) influential formulation, the entrepreneur is a largely passive “discoverer” of profit opportunities created by disequilibrium “gaps” in the current structure of market prices. As I read Mises — largely influenced by Salerno’s interpretation — the entrepreneur plays a different role in Mises’s system, namely deliberate, active, purposeful action in the face of uncertainty in pursuit of economic gain. In the former approach, the market does the work, and the entrepreneur need not be “rational,” only alert to preexisting opportunities. In the latter, the entrepreneur makes use of monetary calculation to plan and act to bring about an improvement in market conditions. I view my own work here as largely an extension of Salerno’s interpretation of Mises.
While some of Salerno’s contemporaries such as Israel Kirzner and Leland Yeager challenged Salerno’s “two Austrian traditions” thesis (Yeager 1994; Kirzner 1999), Salerno’s intellectual mentor, Murray Rothbard, embraced it. Indeed, Rothbard hailed Salerno’s work on calculation and knowledge as a major advance in the Austrian tradition, and an improvement on his own understanding. Rothbard (1989) described Salerno’s “Social Rationalist” paper as “a wonderful, superb advance and breakthrough, not only in the history of economic thought, but also in economic theory itself. ... In a sense, this sort of breakthrough experience is something like the joy of an intellectual conversion.” Rothbard went on to note that while he had harbored reservations about Hayek’s emphasis on the division of knowledge and coordination of plans, he had never quite been able to articulate why he felt uncomfortable about Hayek’s approach to the calculation problem. “Even though steeped in Mises, I had never really paid enough attention to his society-as-division-of-labor theme, and the crucial rationalism there.” Rothbard also described Salerno’s “Mises and Hayek De-Homogenized” as “a magnificent achievement.”
Most important, Rothbard (1989) saw Salerno’s contributions as exemplifying the general pattern of advance and development within the Austrian school:
Your article also points up an important point for the history of thought generally and for Austrian economics in particular. People have bitterly accused me of resisting all change in Austrian economics and of denouncing any differing opinions. Not true: I welcome change and advances in Austrian theory provided that they are true, i.e., that they work from within the basic Misesian paradigm. So just as I think I have advanced beyond Mises in developing the Misesian paradigm, people like Hans Hoppe and yourself have advanced the paradigm still further, and great!
Like the contributors to the present volume, I hope to make my own incremental advances to the Austrian tradition by building on Salerno’s work, just as Salerno built on Rothbard, Rothbard built on Mises, and so on.
Another of Salerno’s important contributions is his reinterpretation of the rise, decline, and rebirth of the Austrian tradition itself. Most accounts of the Austrian school trace its demise to the 1930s and 1940s, as Austrian capital theory was attacked by Knight and Sraffa and Austrian monetary and business-cycle theory was attacked by Keynes and his followers. The rise of positivism and mathematical formalism rendered the Austrians’ causal, verbal style obsolete anyway. Then — according to the typical account (e.g., Vaughn 1994) — the Austrian school experienced a dramatic revival following the South Royalton conference and Hayek’s Nobel Prize, both of which occurred in 1974.
Salerno offers two important corrections to this story. First, he argues that the core of the Austrian system as it developed in the late nineteenth and early twentieth centuries was not its distinct approach to money and the business cycle, but Menger’s causal, realistic account of price formation (Salerno, 1999). Austrian economics was not — as even some contemporary Austrian economists seem to believe — verbal Walrasian or Marshallian microeconomics plus capital-based macroeconomics (and spontaneous order and plan coordination and the knowledge problem as additional glosses). Instead, Austrian economics was a different kind of microeconomics. As Salerno demonstrated, Mengerian price theory peaked before 1920 following the contributions of Böhm-Bawerk and a few European Mengerians, and the particularly important work of the English economist Philip Wicksteed and the Americans John Bates Clark, Frank Fetter, and Herbert Davenport. Unfortunately, during this time most younger European, British, and American economists were adopting Marshall’s eclectic, mechanistic approach, and interest in Menger faded. More important, the “fourth” generation of the Austrian school, led by Hayek and including Morgenstern, Haberler, and Machlup, were heavily influenced by Schumpeter, who had introduced Walrasian price theory to the German-speaking world. In other words, by 1920 most economists, including the younger Austrian economists, had abandoned the causal, realistic approach to value, prices, and markets offered by Menger and Böhm-Bawerk.
The importance of Mises’s Human Action (1949) is not, in this interpretation, simply that it provided an overview of Mises’s mature thinking on a variety of economic topics — a sort of advanced Austrian textbook. As Salerno (1994; 1999) argues, Mises’s treatise offered no less than a rehabilitation and restatement of Mengerian price theory, one further developed by Rothbard in his Man, Economy, and State (also widely mistaken for a textbook). Salerno is himself a major contributor to this revival of Austrian price theory, in particular by highlighting and developing the various equilibrium constructs used by Mises and Rothbard (e.g., the “plain state of rest,” the “final state of rest,” and the “evenly rotating economy,” and what Salerno (1994, p. 99) calls the “Wicksteedian state of rest,” a concept implicitly, but not explicitly, analyzed by Mises and Rothbard).
Second, Salerno (2002) argues that the Austrian revival should be dated not from 1974, starting with the South Royalton Conference, but from 1962–63, when Rothbard published Man, Economy, and State (1962), America’s Great Depression (1963), and What Has Government Done to Our Money? (1963), the works that sparked the younger South Royalton participants’ interest in Austrian economics. Interestingly, these works all deal with what I have called “mundane Austrian economics” (Klein 2008b) — the analysis of value, prices, markets, money, capital, and government intervention — and not the more esoteric philosophical, methodological, and political topics that interest so many Austrians today. Salerno’s introduction to the 2009 edition of Man, Economy, and State is a major contribution to doctrinal history in its own right, pointing out Rothbard’s many advances beyond Mises, particularly in the areas of capital theory and monopoly theory.
In all these revisionist essays, Salerno demonstrates a keen grasp of the underlying theoretical and doctrinal issues, bringing out nuances and subtleties overlooked by other writers. Indeed, many Austrian writings on the Austrian school paint a somewhat tedious and even maudlin picture in which the major thinkers and writers agree on fundamental issues and are united in a desperate battle against socialists, Keynesians, and interventionists. As Salerno points out, the truth is far more interesting. While the early and later Austrians shared many core constructs, theories, and doctrines, there was a tremendous variety of ideas and approaches within the Austrian school, as there continues to be today. The Austrian tradition from its inception was a living, breathing, and lively intellectual movement, filled with internal as well as external controversy. This variety continues to the present, and it is important to review, analyze, sometimes synthesize, and other times disentangle the different theories and methods. Far from indicating weaknesses within Austrian economics, these controversies demonstrate its strength. Vive les différences!
To summarize, Salerno’s contributions range across a variety of subjects (money, price theory, comparative economic systems, doctrinal history, and more) and employ a variety of methods, while remaining squarely in the causal-realist tradition established by Menger, Böhm-Bawerk, the Anglo-American Austrians, Mises, and Rothbard. He is an exceptionally clear thinker and an excellent writer, witty and erudite as well as thoughtful and informative.
I met Joe Salerno in 1989 at an early edition of the Mises Institute summer instructional conference (later expanded into today’s “Mises University”). He was already a rising star in the Austrian movement, but came across then — as he does now — as a regular guy, a wisecracking, sharp-tongued, unpretentious, rough-hewn fellow from New Jersey. He remains one of the funniest people I’ve ever met, and I can’t recall how many hours I’ve spent laughing with him (and his charming wife Helen). I’ve lectured, along with Joe, at the Mises University for the last twenty years, and he is enormously popular with students, for his humor as well as his knowledge.
Joe took over for Guido Hülsmann as director of the Mises Summer Fellows Program in 2004, and it has been a joy to watch him embrace the role of mentor for dozens of younger scholars, many of whom have contributed to the present volume. Besides having a huge influence on his contemporaries, Joe has become the leader of the Austrian movement to its younger practitioners. Speaking for my fellow Austrians, I can say, with pleasure, that we are all Salernians now.
ReferencesFoss, Nicolai J., and Peter G. Klein. 2012. Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge: Cambridge University Press.
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——. 1988. The Fatal Conceit: The Errors of Socialism. In W. W. Bartley III, ed., The Collected Works of F. A. Hayek. Chicago: University of Chicago Press.
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——. 1999. “Mises and His Understanding of the Capitalist System.” Cato Journal 19: 215–32.
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——. 2008b. “The Mundane Economics of the Austrian School.” Quarterly Journal of Austrian Economics 11: 165–87.
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——. 1989. Letter to Joseph T. Salerno, March 28.
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——. 1980. “The Doctrinal Antecedents of the Monetary Approach to the Balance of Payments.” PhD Dissertation, Department of Economics, Rutgers University.
——. 1983. “The Influence of Cantillon’s Essai on the Methodology of J.B. Say: A Comment on Liggio.” Journal of Libertarian Studies 7: 305–16.
——. 1987. “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the US Economy.” Austrian Economics Newsletter 6: 1–6.
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——. 1990a. “Postscript: Why a Socialist Economy is ‘Impossible.’” In Ludwig von Mises, Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute, 1990, pp. 34–46.
——. 1990b. “Ludwig von Mises as Social Rationalist.” Review of Austrian Economics 4: 26–54.
——. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6: 113–46.
——. 1994. “Ludwig von Mises’s Monetary Theory in the Light of Modern Monetary Thought.” Review of Austrian Economics 8: 71–115.
——. 1999. “The Place of Mises’s Human Action in the Development of Modern Economic Thought.” Quarterly Journal of Austrian Economics 2: 35–65.
——. 2002. “The Rebirth of Austrian Economics — in Light of Austrian Economics.” Quarterly Journal of Austrian Economics 5: 111–28.
——. 2009. “The Ambition of Rothbard’s Treatise.” In Murray N. Rothbard, Man, Economy, and State with Power and Market, Scholar’s Edition. pp. xix–l. Auburn, Ala.: Mises Institute.
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ThroughoutJ. Patrick Rhamey is assistant professor in the Department of International Studies and Political Science at Virginia Military Institute in Lexington, Virginia. I was a summer fellow in 2007 and 2008. During these experiences, under the advice and support of Dr. Salerno, I developed a passion for the field of international conflict. Furthermore, Dr. Salerno instilled in me the importance of thinking strategically regarding interdisciplinary theorizing and the importance of interdisciplinary work to the future of the social sciences. his career, Dr. Salerno has sought to expand the influence of Misesian scholarship, not only through his own research, but also classroom engagement, graduate student mentorship, and the education of the general public. His impressive body of work represents a true educator whose interest is fundamentally the advancement of human knowledge. It is in this spirit that this chapter seeks to provide an initial blueprint for the interdisciplinary expansion of Austrian principles to the political science realm, specifically the subfield of international relations theory. While international relations theory has strong shared origins in classical liberal approaches (Van de Haar 2009), recent theoretical evolution across the dominant paradigms has increased the potential for an expansion of Austrian ideas. Many theories within the subfield of international relations have begun to experience something of an “individualist shift” both methodologically and theoretically.This trend originates in the renewed emphasis on domestic politics as a source of foreign policy behavior and extends to recent research examining the underlying causes of individual decision-making (Putnam 1988) and the relationship between the preferences of individual decision-makers and foreign policy selection (Bueno de Mesquita 1999). For these reasons, if approached correctly, international relations research is a field ripe for future interdisciplinary engagement.
Notably, there does not exist an absence of political science research by Austrians, though these contributions remain beyond mainstream political science discourse. Perhaps the best examples are Murray Rothbard’s Power and Market and the concluding chapter of Man, Economy, and State which explicitly engage the effects of coercion, or politics, on human behavior.Indeed, the clarity of analysis from one volume to the other highlights the artificial and unnecessary division of the two works by the initial publisher. The foundation of the argument focuses primarily on the voluntary interactions of individuals in the absence of violence (economics), and yet concludes by engaging the reality that coercion (politics) is nearly always and everywhere present and “economic analysis must be extended to the nature and consequences of violent actions and interrelations in society” (Rothbard [1962] 2004, p. 875). In essence, the fields of economics and political science are highly complementary if not inherently intertwined. Unfortunately this early clear intersection of the two fields of inquiry did not occur more broadly, as political science, the younger of the two, developed from a combination of European legal and historical approaches (Carr 1939; Morgenthau 1948) and early American behavioralist research (Merriam 1924; Key 1934; Key 1966).While some influence from economics is present in contemporary political science research, it is primarily of the positivist variant, to which there has been a significant backlash in the form of “post-positivist” theoreticians (e.g., Peterson 2004; Tickner 2005). However, unlike economics where certain biases may exist, Austrian ideas surrounding political organization, coercion, and the state are somewhat accepted. For example, James C. Scott’s The Art of Not Being Governed: An Anarchist History of Upland Southeast Asia and Charles Tilly’s “War Making and State Making as Organized Crime” share many commonalities with Rothbardian analysis of the state and are standard reading in undergraduate comparative politics courses.
This chapter proceeds by outlining the evolution of international relations theory over the past two decades with specific attention to the progression of theoretical development toward a greater focus on human action. While most research is heavily positivist in its construction, theoretical development over the course of the past two decades has led, steadily, away from the abstractions of traditional neorealist (Waltz 1979) and liberal institutionalist (Keohane and Martin 1995) paradigms that have dominated international relations research. New theoretical approaches that offer greater recognition to human agency, as well as new methodological challenges in qualitative research, provide an opportunity for Austrian engagement. Following a discussion of these theoretical approaches, I conclude with suggested strategies for continued expansion of Austrian ideas to the social sciences outside economics.
The Current State of the International Relations LiteratureI first introduce through a simple illustration the relative position of the dominant international relations theoretical perspectives in the context of two fundamental criteria in Figure 1. The theories are organized according to their assumptions concerning the effect of anarchy on preferences, and thereby behaviors (y-axis), and the assumed level of analysis determining the type of actor under study (x-axis). Organizing each perspective by their nuanced conceptualizations on these two particular subjects provides an effective means of discussing their unique attributes within the context of their overarching similarities. (See Figure 1 on the following page.Immediately the reader will notice the placement of constructivism. While I do not discuss constructivism at length in this chapter, constructivism is unique given its assumption of an endogenous relationship between levels of analysis. As examples, the key systemic features which frame state’s conceptions of world politics such as state sovereignty (Treaty of Westphalia) and anarchy are not universal truths, but social constructions by the states themselves (Wendt 1992, 1995). It is this endogenous relationship between society, state, and system the graphical portrayal is intended to illustrate.)
Notably, either abstraction presents potential problems for future Austrian interdisciplinary analysis. In particular, the level and corresponding relevant unit of analysis being anything beyond the individual is an inherently hostile assumption, as praxeological analysis recognizes accurately that only individuals are capable of action. For example, neorealists may assume for theoretical purposes that all states are rational unitary actors, but such an assumption is ineffective in generating common sense explanations of real world phenomena, given “there are no such things as ends of or actions by “groups,” “collectives,” or “states,” which do not take place as actions by various specific individuals (Rothbard [1962] 2004, p. 2). However, in the theoretical space that minimizes such abstractions, specifically the liberal and neoclassical realist conceptual spaces, the possibility for the development of an interdisciplinary Austrian discourse is quite plausible. Driving this evolution toward the individual over the past two decades of international relations research is in part the desire of applied research to understand real world outcomes, leading to what J. David Singer (1961) termed “vertical drift” wherein theories built on such abstractions as “state behavior” become applied to explaining foreign policy choices by individuals.
For much of international relations, anarchy defines contextual constraints, where expected behavior follows from the strength of the anarchy assumption (Powell 1994). Implied for many authors, particularly in the realist tradition, is that given anarchy and human depravity, conflict will ensue. Even neoliberal institutionalists acknowledge the anarchy assumption of neorealism, resigning themselves to searching for those conditions in which “cooperation under anarchy” is a possibility (Axelrod and Keohane 1985). If anarchy is as salient a political problem as neorealists suggest, then actors seek nothing more than power, as apart from coercive government their security is impossible to guarantee (hence Waltz’s characterization of the system as “self-help”). However, if anarchy is merely an environmental condition suggesting the absence of a single coercive entity, rather than being a constraint that determines behavior, then gains are not inherently zero-sum and cooperation is not only possible, but likely the dominant strategy within the anarchic context.This distinction between anarchy as a defining characteristic that causes states to behave a certain way, as is the assumption by neorealists, versus anarchy as merely a systemic condition that describes the absence of a single coercive entity, as is the assumption by liberal researchers in international relations, has dramatic consequences for expectations of state behavior. Flowing from the neorealist assumption that anarchy causes behaviors are the assumptions that all states pursue self-help strategies, all gains are relative and mutually exclusive, and thereby this systemic condition leads inevitably to conflict. However, if anarchy is merely a descriptive characterization of the international system as the absence of government, which through liberal logic may be a systemic condition that expands possible behaviors rather than constrains as realists would claim, it cannot be assumed anarchy inherently leads to competition over relative gains and conflict. The “strength” of the anarchy assumption in international relations theory is thereby the degree to which the condition of anarchy forces states to behave in a specific manner.
On the right side of the horizontal axis are the predominantly system-focused explanations of international politics, depicting states as unitary actors. In this context, simplistically, the relationship of anarchy is perceived as either an aspect of the environment (English school) or the prime determinant of state preferences (Neorealism). On the left hand side of the graph reside those theories of international politics which focus on a sub-state unit of analysis, each providing an explanation of state behavior as a determinant of either group or individual action. The “Effect of Anarchy” in this context is parallel to the underlying discussion of the “state of nature” in much of political philosophy.It is worth noting that the conceptions of “anarchy” in international relations theory are not entirely identical in classical realism and neorealism (or lower horizontal pairings) as the graph may suggest, as Morgenthau did not share Waltz’s view that the international system is inherently conflictual due to the effect of anarchy (see Morgenthau 1948, pp. 39–40). However, Morgenthau does share the Hobbesian view of human nature which is an abstraction based upon the Hobbesian view of the state of nature, or anarchy. Morgenthau’s conception of human nature, the basis for his description of statesmen and justification for the primacy of the state, exists as an extension of the idea of man’s nature under conditions of anarchy, even if he does not agree anarchy exists in the reality of international politics. Perhaps a more appropriate title for the y-axis would be “conception of human nature” ranging from good to bad. However, I expect in that case a footnote would be necessary explaining the nuances of the systemic level. The point here, however, is simple: philosophically the effects of anarchy on behaviors and human nature are directly related. Toward the top of the y-axis, anarchy has a powerful effect on human behavior, wherein man cares only for his self-preservation resulting in a Hobbesian existence that can only be described as “nasty, brutish, and short.” Alternatively, toward the bottom of the vertical axis, the state of nature, or anarchy, does not imply chaos. Intrinsic to anarchy in this Lockean conception is the principle of natural law endowed to the individual, wherein everyone is entitled to “life, liberty, and property.” In this context, human nature is not so negatively viewed, as individuals are capable of organizing themselves. Government, thereby, is either only necessary to protect person and property against those occasional individuals who seek to violate the principles of natural law, or alternatively is entirely unnecessary if individuals are capable of interaction absent a monopolizing coercive force (Rothbard 2002a). The vertical axis across both levels of analysis can also be described as the degree to which cooperation is possible in the absence of a centralized government in international politics.
Given the existing landscape of international relations theory, Moravcsik’s (1997) conception of liberalism, designated simply as “liberalism” in the illustration, provides the clearest potential avenue for the application of Austrian ideas. Recognizing the failures of systemic, state focused neorealism to account for domestic sources of state behavior (notably the collapse of the Soviet Union), Moravcsik (1997) presents a reframed variant of liberalism in international relations to fully account for the dynamics of policy formation. As both economists and political scientists are well aware, the term liberalism has been construed to mean a myriad of things, both within and beyond international relations research. Moravcsik’s articulation of a liberal theory of international relations is an attempt at salvaging liberalism’s “self-inflicted” condition. However, as the author makes clear, he is providing a “restatement” of liberal theory built squarely on classical liberal foundations.Notably this restatement is not neoliberal institutionalism, which unfortunately dominated the term liberalism until very recently. In terms of assumptions, neoliberal institutionalism shares the entirety of the neorealist core (including the states as rational actors abstraction) while moderately relaxing the implications of anarchy on state preferences. Given this relation, Keohane’s (1993) statement that neoliberal institutionalism “borrows as much from realism as from liberalism” is disingenuous. Institutionalism borrows entirely from realism, while only moderately co-opting liberalism’s focus on the human progressivity (Zacher and Matthews 1995). To use the example of cooperation, it occurs despite systemic conditions of anarchy because actors determine that by doing so they can improve their condition (e.g., Axelrod and Keohane 1985). The core assumptions regarding states as rational unitary actors and the system organization as anarchic are identical. Neoliberal institutionalism appears to remain ambivalent to the historical emphasis of classical liberalism on the individual and the promotion of human freedom, leaving preferences as exogenously determined. I’ll refrain from delving further into the nuances of neoliberal institutionalism and neorealism, as the neo-neo debate has been thoroughly explored elsewhere (Jervis 2003; Baldwin 1993; Powell 1994). Liberalism as defined by Moravcsik thereby is explicitly a theory of preference formation, and it is in this particular conceptualization of liberalism that the most fruitful possibilities of interdisciplinary theorizing with Austrian researchers lies.
Moravcsik makes a series of core assumptions emphasizing preference formation and the evolution of interests within domestic society. First, the fundamental actor in international relations is the individual. Decisions are made by individuals acting in response to an environment to satisfy subjective goals determined by subjective sets of values. Already, we have dramatically complicated the study of international relations away from systemic theories. Second, and by extension, the state is a subset of individuals in society reacting to the preferences of individuals in the society at large. Actors in government, like actors in domestic society, have their own sets of values and preferences and exist in a particular institutional context, be it democratic or authoritarian. This environmental constraint shapes the availability and perceived values of the policy options available to state actors, but individuals remain the only entity capable of action. Finally, preferences across potential behaviors, and the resulting causal processes in policy choice, are constrained further by the international environment of interacting individual preferences and material capabilities (or opportunity to achieve some end).
Moravcsik (1997) essentially constructs a “bottom-up” view of international politics, tracing the source of state behaviors to the initial development of preferences by individuals within societies. What individuals within states want “is the primary determinant of what they do,” not the nature of the system as anarchic (Moravcsik 1997, p. 521), opening the door to understanding political phenomenon as they actually happen rather than under a predefined set of unrealistic abstractions. However, to employ liberalism to better understand outcomes we must have some means of logically deducing the source of preferences, of which Moravcsik lists three: ideational, commercial, and republican. The ideational components capture particular political, national, and socioeconomic cleavages and are manifest in normative explanations of the democratic peace (Dixon 1994), ethnicity based explanations of foreign policy behaviors (Davis and Moore 1997), and liberal economic preferences (Mousseau 2003). Commercial incentives are driven by motivations for some subjectively defined economic gain. These may take the form of trade and investment behaviors, but also may manifest themselves through preferences for resource access and even coercive seizure (e.g., Snyder 1991). Finally, republican sources of preferences are rooted in the political institution’s method of filtering the preferences articulated by the domestic populace. Likely the best examples are provided by the institutional democratic peace literature, but more specifically selectorate theory (Bueno de Mesquita et al. 1999). Indeed, selectorate theory, may provide the best illustration of the bottom-up preference formation process presented by liberalism while retaining a focus on individual action.
The implication of this articulation of liberal theory is a complete reformulation of how we conduct international relations research to refocus not on states, but upon the individual within society. Neorealism, restricted to the system level and states as actors, fails to independently account for state preferences, and so a focus on human action is the logical transition. However, a focus on individuals does not eliminate the systemic realm, in so far as the system is defined through the behaviors of other individuals engaging in their own series of actions within and between political systems.See the conceptual discussion of interactions in Bueno de Mesquita et al. (1999). Furthermore, given the necessity of such a transition toward the individual and human action, there has been something of a convergence in international relations theory. For example, Jack Snyder’s (1991) work on empires, if one was ignorant of his self-identification as a “realist,” is indistinguishable from the theoretical processes outlined by Moravcsik. Specifically, Snyder discusses the logrolling interests of domestic actors, ideational preferences, and political institutional configurations all contributing to the propensity and rate at which empires historically over-expand — an outcome that is impossible to explain under any framework where states are rational unitary actors.
This international relations shift toward liberalism seems intuitively obvious, occurring quite broadly in mid-range topical analysis (see Oneal 2012): individuals have values for ends and employ means to achieve those ends. However, understanding, operationalizing, and incorporating the preferences of actors, determining their relative importance, and then interacting those aggregate preferences with state structures and the preferences of others individuals outside the state is a daunting task, and attempts to do so do not debunk clearly deduced theory as the burden of properly specifying such empirical analysis is exponentially greater than traditional state-level studies. However, with advancements in technology, the ability to conduct econometric tests of liberal ideas are more accessible and plausible, providing a means to mathematically sort out myriad coinciding human behaviors. In particular, the recent availability of multilevel modeling to political scientists is intuitively appropriate for testing liberal hypotheses, which employ indicators from across arenas of political interaction (e.g., actors both within and between states). Indeed, progress for the field entails “an increasing ability to explain and connect complex phenomenon” both theoretically and methodologically (Dryzek 1986, p. 301).
Liberalism in international relations theory is not the only path that has evolved to grant greater attentiveness toward the inherent basis of social science research in human action. Neoclassical realism possesses many of liberalism’s strengths while attempting to maintain many of classical realism’s fundamental Machiavellian assumptions. Like liberalism, neoclassical realism “explicitly incorporates both external and internal variables.” However, “the scope and ambition of a country’s foreign policy are driven first and foremost by its place in the system and specifically by its relative material power capabilities … the impact of such power capabilities on foreign policy is indirect and complex … translated through intervening variables at the unit level” (Rose 1998, p. 146). Though political preferences are influenced by the actor’s position in the power hierarchy relative to all other actors in the system, human action still is the fundamental phenomenon of interest. Indeed, there are close parallels evident in not only the analysis, but also the conclusions, of neoclassical realists and Austrians on the topic of war and empire. For example, both Snyder (1991) and Salerno (1995) engage in similar discussions of the relationship between inflation and imperial expansion, as well as highlighting it as a catalyst of further international conflict and long run unsustainability.Snyder’s Myths of Empire is both an excellent example of neoclassical realism and source of many parallels with existing Austrian perspectives, including coalition behavior in democracies leading to warlike behaviors, the pervasiveness of certain “myths” of external threat exploited by politicians to justify conflicts, and the inevitable destructive consequences of imperial overexpansion. Another possible example is that of Robert Higgs (1987) “ratchet effect” and the “phoenix factor” discussed by Organski and Kugler (1977). Distinctly, while liberalism is a theory of preferences from the bottom up, neoclassical realism is a theory of preferences from the bottom down. Though liberalism as discussed is perhaps more amenable to Austrian engagement, both approaches, however, attempt to integrate individual behaviors into a general theory of international relations, albeit with different emphases on the relative importance societal influences.
Perhaps neoclassical realism and liberalism constitute different roads leading to the same destination. Both take seriously the need to incorporate greater complexity into our theories to better account for political phenomenon. Encouraging for practitioners of international relations, and the potential for interdisciplinary engagement with the Austrian school, is the drifting of paradigms not further apart, but closer together. These two latest iterations of realism and liberalism are perhaps more theoretically compatible than ever before in the past, constituting, in Lakatosian terms, progress in the field. In conjunction with rising methodological interest in deductive theory development and qualitative analysis (see Goertz 2005), a fruitful cross discipline dialogue incorporating the Austrian school as a next necessary step to this theoretical evolution in international relations is now possible.
Strategies for Future Interdisciplinary EngagementIn order for such a debate to both occur and be fruitful, not only must the theoretical components be compatible and international relations researchers amenable to an Austrian turn, as I argue they now are, but the presentation of the ideas must be done in a thoughtful and effective manner. Just as in the presentation of any argument or position, the negative aspects of the method by which it is presented, or the individual doing the presenting, affect audience receptivity. For this reason, it is necessary for those engaging mainstream IR theory in advocacy of an Austrian perspective to be somewhat strategic, or at least minimally thoughtful, in the method and context of that interaction. While international relations as a field may be ready for interdisciplinary engagement, there are, in my opinion, three broad strategic impediments currently limiting the persuasiveness of the Austrian school to the social sciences (and the general public) that must first be addressed.
Strategy 1: Comprehension Before EngagementOne great pitfall to any interdisciplinary engagement is a failing to fully understand the core theories, methods, and even discipline specific jargon of the field you seek to engage.Perhaps the best example is the term “institution” which possesses numerous definitions dependent upon the field and context within which it is used. Comprehension is a necessary condition to effective engagement, and in its absence, attempts at an intellectual exchange may be dismissed or misunderstood, harming future discourse. As one example, there is a frequent and unfortunately persistent mischaracterization in Austrian circles of democratic peace theory, often inappropriately conflated with neoconservative foreign policy prescriptions. As but one example, a recent discussion by Hans Hoppe (2013) on the democratic peace grossly mischaracterizes the theory as including the claims “In order to create lasting peace, the entire world must be made democratic” and “war must be waged on those states to convert them to democracy and thus create lasting peace.” Such a claim about democratic peace is a complete invention, as there is not a single piece of democratic peace research in international relations that states either. Indeed, the original conceptualization of the democratic peace in modern political science empirical research was labelled the “libertarian peace” and focused on libertarian normative values (Rummel 1983). Such claims are completely absent in both the normative (Dixon 1994) and institutionalist (Bueno de Mesquita et al. 1999) explanations of the empirical finding, which has been described as “the closest thing we have to an empirical law in the study of international relations” (Levy 1989, p. 88). Indeed, the empirical record even suggests that newly created, unstable democracies are the most violent states in the system (see Mansfield and Snyder 2002). Dr. Hoppe appears to confuse the democratic peace, which originates as a deductive theory about domestic influence on the polity by Immanuel Kant ([1795] 1991, p. 113) and/or the rise of capitalist preferences by Joseph Schumpeter (1950; 1955), with neoconservative foreign policy recommendations (e.g., Kagan 2012) and the idealist policy prescriptions of Woodrow Wilson.Notably, Kagan and many neocons operate out of the field of history. There are no significant neoconservative international relations scholars, due both to the absence of any clear logic behind such an approach as well as a dearth of empirical evidence for such policies’ effectiveness. Wilsonian idealism, likewise, is generally absent in contemporary research, and the term exists in the present typically as a pejorative used by neorealists in describing liberal theorists (e.g., Mearsheimer 1995).
While the criticism of such neoconservative policies that follows in Hoppe’s analysis is well crafted and would be predominantly shared by most democratic peace theorists, the failure to properly engage the enormous extant literature and demonstrate a basic knowledge of the theory as it currently exists in international relations fosters and supports divisions between the two social science fields rather than providing interesting political science insights from an Austrian perspective. Research in coercive hierarchical power relationships and the dissemination of democracy (Organski 1968; Rasler and Thompson 1994), the causal development of clear individual preferences within democratic (and non-democratic) institutional frameworks (Mousseau 2003; Peceny and Butler 2004; Gartzke 2007), and the relationship of foreign policy behaviors to institutional coercive strength (Rhamey 2012) all go ignored through this failing to engage international relations scholarship. Such a dialogue between these systemic and liberal approaches with Austrian scholarship has enormous potential for better understanding human action in the political context.For an introduction to the democratic peace in international relations, see Russett et al. (1995).
Strategy 2: Engage and Incorporate MathematicsIf a priori science is a valuable approach, and we cannot knowingly observe the underlying motivations of actors, then generalizable and observable patterns of behavior should no doubt be present throughout a cadre of relevant historical events. While exploration of a single event may require a potentially dangerous divination of motivation in order to sensibly explain an historical episode, as well as any relevance to praxeological theories, econometric large-N analysis possesses the virtue of mathematically organizing possible relationships between events to uncover generally present correlations. A relationship between observable phenomena that are generalizably present in coincidence with an outcome of interest should correspond with any reasonably developed praxeologically deduced theorem, and certain types of statistical analysis may heavily complement Austrian research.Importantly, there is an intuitively plausible potential relationship between the praxeological approach and Bayesian empirical analysis that requires additional future attention by social scientists. Bayesian analysis recognizes the inherent uncertainty underlying observable events, obvious when observing real world phenomenon, as we cannot understand the complexity of motivations inherent in individual decision-making. However, rather than the explicitly inductive process of Bayesian updating, conceivably our priors may be updated instead by the deductive expression of a praxeologically based theory, permitting a more effective and appropriate large-N test. In other words, the logical posterior for an Austrian Bayesian model is the deductively generated theoretical information where probabilistic analysis is conditional on common sense claims. While the idiosyncrasies of a single case may make for difficult historical illustration, laws of human behavior capable of explaining real world occurrences, in a Mengerian sense, should be observably evident in a statistically significant fashion across a relevant population in a properly specified model.“Properly specified model” is simply one that accurately manages the nature of the data (e.g clustering, time series, hierarchical data structure) while also organizing the data to logically fit deduced theoretical priors. Generally, the problem in social sciences is not the models, but poor application and interpretation. While the failure to demonstrate expected empirical relationships that can be deduced from a praxeological approach does not, by definition, disprove the theory, it can serve the quite important purpose of highlighting deficiencies or logical fallacies within a deduced theorem. Theories are not apodictically true simply by labeling themselves a priorist, and a failing to observe generally present historical relationships that should coincide with the theory in a properly constructed econometric model is potentially an indication of a failing in the theory’s initial deductive logic. Furthermore, formal modeling, such as that often employed in applications of selectorate theory (see Bueno de Mesquita et al. 2008), can be a helpful means of organizing information regarding causal processes arrived at through clearly deduced theories.
Austrians often criticize econometric analysis as promulgating poorly developed or even illogical theories through the manipulation of algorithms to provide corroborating mathematical relationships. However, such a cautionary note surrounding statistical analysis is made by any serious approach to the social sciences, even in the most positivist corners, and an emphasis on theory prior to econometric testing is taught in every mainstream graduate research design course.Such criticisms are present in the most frequently used texts for such courses in political science and sociology doctoral programs, such as those by Shively (1974), King et al. (1994), Goertz (2005), and Ragin (2008). This attack on econometrics, then, is something of a straw man caricature of econometric research as such inductive, hyper-positivist work is not the standard in mainstream social science. Instead, the hostility toward mathematics is more likely an indication of mathematical ignorance of underlying statistical algorithms, a confusion regarding statistical claims surrounding causality, or simply an attempt to promulgate a bad, illogical theory when confronted with a lack of, or even contradictory, empirical evidence. While properly developed social science theory is not dependent on empirical “proof,” an absence of such is typically a sound indication that something in the theory’s logic has gone awry. This is not to suggest that historical method of careful logical argumentation on a case by case basis is without merit (e.g., Rothbard 2002b). However, such qualitative approaches, while interesting, may not provide the most effective social science illustrations regarding generalizable theories. Econometric knowledge is neither the foundation nor the end goal of social science research, but if done well, it is an important tool in the arsenal of the social scientist and should be embraced.
Strategy 3: Focus on Academic EngagementThe ideas of the Austrian school have the potential to contribute greatly to the social sciences, but perceptions of those ideas, and thereby their dissemination, may be marred, however unfairly, by an unclear union between the intellectual development of theory building and libertarian political activism. As such, scholars should promote a clear distinction between Austrian research and political activism, not allowing scholarly work to be shrouded by irrelevant, and sometimes counterproductive or contradictory, agendas. This strategic concern is particularly applicable to interdisciplinary expansion to political science and international relations, fields already highly sensitive to the politicizing of social science research. In these fields, new research programs viewed as pandering to particular ideological perspectives or political groups, regardless of whether they are left, right, or libertarian, are likely to be quickly dismissed. For this reason, the community of Austrian scholars should promote a clear distinction between Austrian research and political activism.
In part due to the efforts of scholars such as Dr. Salerno, the Austrian school has grown in prominence and exposure by leaps and bounds in the academic community, both within economics and beyond. However, the growth of the Austrian school as a heterodox approach may also tend to attract elements that seek to exploit rising interest for personal profit, or those attracted to the community not necessarily by its ideas, but its distinctiveness from the existing status quo. Such groups may include racists, fear-mongers, or simply those advocating apophenic views contradictory to empirical reality. Clearly, as an intellectual enterprise that not only values the development of thoughtful theoretical and empirical research, but also one with a deep dedication to principles of human liberty, the scholarly community must act to quickly condemn any such groups that may attempt to associate themselves with the Austrian school for no other reason than its rising popularity. Organizations or individuals whose mission is contrary to that of advancing sound social scientific thought and human liberty central to the Austrian school should be immediately and quickly dismissed. Obviously most Austrian scholars are quick to condemn these types of groups or individuals, but a more active, vocal, and immediate stance is necessary within the scholarly community in opposition to such detrimental associations to prevent negative perceptions by broader academe and to preserve the school’s intellectual integrity. In addition to being clearly opposed to principles of human liberty and Austrian thought, such negative associations would also be highly detrimental to the advancement of interdisciplinary opportunities across the social sciences.
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In this article IPhilipp Bagus is professor of economics in the Department of Applied Economics I at Universidad Rey Juan Carlos, Madrid, Spain. Professor Bagus was a summer research fellow in 2006 and 2009. This chapter is an extension of the theoretical perspective developed in the article “The Quality of Money,” for which the he received very valuable comments by Professor Salerno. The author wishes to thank David Howden for excellent comments on the present article. Joseph T. Salerno has not only been a very important mentor and friend for me. With his humor, positive attitude, and generous support he is a precious asset for Mises Institute summer fellows such as I was for two years. Thank you, Joe. With his articulate, intransigent and courageous support of sound money, he is an invaluable asset for the Austrian school. He not only always stands up to defend the theoretical advances of Mises and Rothbard, he also has added to the corpus of Austrian theory. would like to continue in the tradition of Mises, Rothbard, and Salerno to analyze how sound monetary regimes affect the quality of money. The value of money, as of any other good, depends on its usefulness or quality in the eye of its user. Money’s quality can be defined as “the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit” (Bagus 2009, pp. 22–23). Changes in money’s quality affect the demand for money and, consequently, its purchasing power. The quality of a monetary regime, in turn, may be defined as the capacity of a monetary system to provide an institutional framework for a good medium of exchange, store of wealth, and accounting unit.
While the quality of a monetary system or regime is perceived subjectively by actors, there are several objective characteristics that tend to influence this perception. In a trial and error process actors normally do not base their perceptions of their institutional framework on poor whims, as they suffer the consequences of poor judgment. Guided by the objective qualities of monetary systems, actors tend to benefit as they can hedge against depreciation or gain from appreciation of the currency. They can protect their monetary wealth more efficiently. In this article we will analyze these objective qualities of “good” monetary systems.
Connection Between the Quality of Monetary Regimes and Money’s Purchasing PowerThe quality of monetary systems has been neglected in the literature.Bagus (2009) discusses the quality of money in general. Bagus and Schiml (2009, 2010) and Bagus and Howden (2009a, 2009b) analyze the quality of the currency unit through the central bank’s balance sheet. Bagus and Howden (2011) point out that Iceland’s central bank adopted an explicit lender of last resort function that deteriorated the quality of Iceland’s monetary regime. Comparative analyses of monetary systems from an institutional perspective are rare.The mainstream focuses narrowly on the aspect of central bank independence and mostly neglects all other aspects. Neither do textbooks delve into the qualities of monetary systems, an exception being White (1999). Rather, monetary policies within the setting of our current fiat money systems are analyzed, sometimes enriched by a narrative of the evolution of some historical monetary regimes, yet without providing a comparison of them. The neglect of a comparison might be caused by the belief that we have found the best monetary system. Fiat monetary systems are controlled by a central bank and can be manipulated to provide a supposedly perfect money fulfilling its functions as a medium of exchange, store of value, and unit of account. Moreover, qualities of monetary regimes are hardly measurable or usable in econometric analysis which makes the question unattractive for modern econometric research. Recently, the financial crisis has led to doubts about the set up of the financial system and the monetary system in particular, which makes a comparative analysis of the monetary system timely.
The quality of monetary systems influences the demand for money and, thereby, money’s purchasing power. While much emphasis has been put on the quantity of money and its influences on money’s purchasing power, money’s quality, and the quality of monetary systems are equally important for money’s price, if not more so. In fact, money’s quantity may be interpreted as one of several characteristics that determine money’s quality and the likelihood and capacity of monetary regimes to increase or decrease money’s quantity is one of the important characteristics of the quality of a monetary regime.
Changes in monetary systems may lead to sudden changes in money’s quality and purchasing power. More specifically, a change in the monetary regime may lead to a pronounced change in the valuation of money in relation to other goods. Imagine that actors regard the new monetary system as a worse provider of a medium of exchange, store of wealth, and accounting unit than the preceding system. Actors value money less intensely with respect to other goods. This may be illustrated by an example of an individual’s value scale before and after the regime changes.
Value scale before regime change...20th 5th $10 bill21st Hamburger meal22nd 6th $10 bill23rd cheeseburger24th 7th $10 bill25th Bottle red wine26th Bottle white wine
In our example our person having seven $10 bills in his pocket would not buy wine priced at $10. However, she would give up one $10 bill for a cheeseburger that she values higher than the 7th bill she owns. She would also spend the 6th bill for the hamburger meal valued higher. Let us look at the value scale of the regime change by which the perception of money’s quality falls. The new monetary regime is in the eyes of actors providing a worse medium of exchange, store of value, and unit of account than the preceding regime.
Value scale after regime change...20th Hamburger meal21st Cheeseburger22nd Bottle red win23rd 5th $1024th Bottle white wine 25th6th $1026th 7th $10
We see that goods tend now to be ranked higher on the value scale relative to money units than before.Salerno (2006, p. 52) refers in this context to “the relative rankings of goods and of money among market participants.” This relative ranking is immediately and potentially strongly affected by changes in monetary regimes. After the change, the person would give $10 for a bottle of white wine. She would also buy red wine, cheeseburger, or a hamburger meal with $10. The prices of these good would tend to increase. Without any increase in the quantity of money, money is valued less in comparison to goods due to the qualitative deterioration of the monetary regime. Money’s purchasing power decreases. Brisk changes in purchasing power may be caused by a change in monetary regime. This gives us reason to analyze the quality of different monetary regimes and how changes to them influence their quality.
Qualities of Monetary RegimesMonetary regimes provide a framework within which money fulfills its functions. As the unit of account function is fulfilled by nearly all monetary systems equally well and it is impaired only in extreme situations, we will concentrate of the characteristics of good medium of exchange and store of value.As Röpke states, referring to the German 1922–1923 hyperinflation (1954, p. 121), money’s functions often disappear in a certain order. First, money ceases to be used as storage of wealth, when actors start to think that it continuously will lose value. Second, when the fluctuations of the value of money increase and money loses its value faster, money loses its function as a unit of account. People started to calculate in other units. In 1923, they started to calculate in gold and even the German government calculated its taxes in gold mark. The last function that is lost in a hyperinflation is the function as medium of exchange. People progressively started to use foreign exchange to transact (Bresciani-Turroni 1968, p. 89). In November 1923, the mark was completely abandoned as a medium of exchange.
We will begin with the characteristics of a good medium of exchange and the influence on it by a monetary regime. A good medium of exchange has low storage and transportation costs. Other properties are easy handling, durability, divisibility, resistance to tarnish, homogeneity, and ease in recognition. These properties hardly change today as paper-based fiat standards have eased the physical usability of the monetary unit, as well as the costs to provide it. In commodity standards these qualities may change when society switches from one commodity to the other. For instance, a change from a silver to a gold standard may imply an increase in the quality of money as gold is more durable than silver, which suffers from oxidization. A more relevant property of a medium of exchange is the number of users. More users imply more demand for the medium of exchange. As more people accept it in trade, the medium of exchange is more useful. Changes in monetary systems may increase the number of users and thereby the quality of the money. For instance, at the end of the nineteenth century ever more countries left their silver standards to adopt the gold standard. The increased use of gold as a currency increased its quality as money. Similarly a switch from Germany’s Deutsche mark to the more widely used Euro or from national fiat currencies to a world fiat money increases the quality of money as a medium of exchange. The tendency of an increase in the quality of money as a medium of exchange is, however, counteracted by possible decreases in its functionality as a store of value.
Ironically, maybe the most important characteristic for a medium of exchange is the existence of ample non-monetary demand for the money as either a consumer good or a factor of production. The demand for other, non-monetary purposes assures that there exist unsatisfied wants which are intense and permanent (Menger 1892, p. 5). The non-monetary demand serves as “insurance” for the money holder as it stabilizes its value due the constant demand.The main disadvantage of Bitcoin is that it virtually lacks such an “insurance.” If the money is demonetized, in the worst case scenario, by the government or because people turn to another medium of exchange, it will still retain its use value. A money with a very low or no non-monetary demand loses almost all its value in a demonetization. Its value is totally dependent on the monetary demand for the good and the confidence in it. Its value tends to be more volatile than the value of a money that has a stabilizing non-monetary demand. If the insurance breaks away even without any change or expected change in money’s quantity, its quality is reduced, leading to a tendency for its purchasing power to decrease. This is so, because the risk of demonetization and a complete loss of value for money holders without a non-monetary demand insurance is greater than for a monetary unit with a use value. Without this insurance, the demand for money tends to fall, leading to a fall in purchasing power. Therefore, if there is a switch from a monetary regime with ample non-monetary demand such as a gold standard to a monetary regime without a relevant non-monetary demand such as a fiat money standard, the quality of the money regime is reduced, independent of (expected) quantity changes.
The store of value function is another important function of money. There are several characteristics of a good store of wealth.
One of its most important characteristics is the possibility of increases in its quantity. Different monetary regimes allow for different mechanisms to increase the quantity of money, thereby influencing money’s quality. Thus, monetary systems may set strict and less strict limits for increases in the money supply. A switch from a monetary system that strictly limits the quantity of money and its possible increases to a monetary system that makes increases in the money supply more likely and less predictable implies a deterioration of the quality of money.
For the quality of the monetary regime the stability of the financial system it fosters is also important. There are monetary regimes that are more prone to generate business cycles, over-indebtedness and illiquidity than other regimes. Business cycles, over-indebtedness and illiquidity may provoke interventions and bailouts on part of the government or monetary authorities. In the wake of the bailouts the quantity of money is often increased, or even the quality of the monetary system is diluted. For instance, redemption into specie might be suspended or a new monetary order may emerge (e.g., the introduction of a world fiat money). Consequently, money’s quality is affected negatively by a change toward a more instable monetary system.
The probability of demonetization is a related factor influencing money’s quality. Some monetary systems are more prone to demonetization than others. Systems that come along with an instable financial sector may lead to collapse or public bailouts that endanger the confidence in the monetary unit. Another factor that affects money as a store of value is the potential for general manipulation by the government. Interventions by the government often decrease the quality of money in its own favor by increases in money’s quantity or through a deterioration in the reserves backing it. A government could, for instance, confiscate the gold reserves of its fiat currency to pay for expenditures thereby decreasing the quality of money. Some systems are less prone to government intervention than others where the government has a stronger foothold in the system.Herbener (2002, p. 11) points out that the government is likely to use those footholds to switch to ever more interventionary monetary regimes: Given any foothold in monetary affairs, the state would always move step by step to an inflationary monetary regime, the exercise of which would eventually cripple, if not destroy, the market itself. Given the power to coin gold, the state would come to suppress the coinage of private mints by waiving its mintage fee. Once securely dominant as a money producer, it would make its coins legal tender, leading to the possibility of seigniorage from debasement. Likewise, if the state had the power to issue money substitutes, it would suppress the issue by private banks by waiving the printing or accounting fees. Once securely dominant as a money substitute producer, the state would rescind redemption to capture the revenue from inflating the stock of its, now, fiat paper money. The more independent a monetary regime is from the government, the higher is the quality of the currency. A switch to a monetary system more dependent or open to interventions by a government means a deterioration of money’s quality.
A 100 Percent and Free Gold StandardI will now analyze the quality of money in different monetary regimes.For an analysis of the devolution of monetary systems see also Hoppe’s (1994) analysis. Hoppe shows how money and credit deteriorates as a result of government intervention. Rittershausen (1962, p. 334) and Veit (1969, p. 88) offer classifications of monetary regimes. Rittershausen focuses on the legal tender and emphasizes that systems were beside specie also bank liabilities are legal tender diminish the quality of the currency. His classification is similar to mine. I will start with the highest quality monetary regime and work my way downward to systems of lower quality. In a 100 percent gold standard, only gold (or 100 percent backed gold certificates) is money and banks hold 100 percent reserves for their demand deposits. The following analysis applies mutatis mutandis to other 100 percent commodity standards such as a 100 percent silver standard.Similary, gold and silver may be in use simultaneously. I picked the example of gold out for two reasons: the historic importance of the gold standard and its unique qualities.
A 100 percent and free gold standard offers all the qualities of good money. Gold has a relatively high value in a small size, thus reducing storage and transportation costs. It is easy to handle in exchange and easily divisible. It is homogenous. Its grade is easy recognizable and it is resistant to tarnish. There exists a tremendous non-monetary demand for gold all over the world. Gold is also relatively hoardable as it can be bought and sold in large amounts without losses. Moreover, the production costs of gold are very high, as is the existing gold stock. Anyone can mint coins; the government has no foothold in the monetary system. Gold is, thus, difficult to manipulate by governments. Only by outright coin clipping or by changing the monetary regime itself can the government manipulate gold. Furthermore, these two kinds of gold manipulations can face strong resistance, as they are highly visible when gold is in the hands of the citizenry.
In addition, in a 100 percent gold standard there is unlimited and unconditional redemption. The banking system is per definitionem liquid; it cannot be brought down by a bank run, as there are 100 percent reserves. The economy and the government are less likely to have negative effects on the quality of money than in other regimes. This is so, because a 100 percent gold standard strengthens the economy and puts limits on the spending of government. As there is by definition no credit expansion and no artificial reduction of interest rates, there is no credit created business cycle. And as taxation is unpopular and government debt cannot be monetized but has to be paid out of taxes, government has to be fiscally more responsible. The tendency toward slowly falling prices in such a system when economic growth exceeds increases in gold production makes debts less attractive.For an analysis of growth deflation see Salerno (2003). Overindebtedness is therefore quite unlikely.
In a free 100 percent gold standard there exists also monetary competition. No one imposes gold as money and other monies can compete freely with it. The competition in the production of money ensures the quality of money. Bad money is pushed out of the market by good money (Hayek 1978, pp. 1–3).For the advantages of currency competition see Klein (1974) and Vaubel (1977, 1988). Only the money that best fulfills and keeps fulfilling the function as unit of account, storage of wealth and a medium of exchange prevails under free competition. There is no central bank, no monetary monopoly or legal tender laws. Hence, there will be a discovery process for the best currency. Different issuers in a trial and error process compete in offering currencies to their customers. Inefficient producers of money disappear. Only the efficient producers of money that produce money in a quantity and quality fitting consumers’ wishes best will survive. As money users usually prefer a stable currency, there will be a competitive process toward stable currencies.
Lastly, the monetary system tends to be stable. 100 percent reserves on demand deposits ensure that no bank runs on demand deposits will lead to a banking crisis. Moreover, there are harsh limits to other types of maturity mismatching, i.e., borrowing short and lending long (Bagus 2010; Bagus and Howden 2010). Borrowing short and lending long is a very risky business. Competitors, by assuming short-term debts and not rolling over the debt, might drive banks into bankruptcy. Speculators may also short bank stocks and try to instigate a run on the short-term liabilities of banks. Customers will attend those banks that limit this risky behavior. In short, in a free market maturity mismatching is strictly limited and there is no reason why banks would systematically err about the amount of short-term renewable savings. More importantly, the promoters of excessive maturity mismatching such as government guarantees for banks are limited, or absent, as there is no central bank that could roll over short-term debts nor credit expansion increasing constantly the money supply making a roll-over of short-term debts easier. The financial system in a 100 percent gold standard is, therefore, very stable. The chance that governments will be tempted to bailout the financial system diluting the value of money or the monetary regime is reduced.
Fractional Gold StandardsI will now analyze fractional reserve gold standards with different properties. I will not explore every theoretical possibility but will concentrate on the historical monetary regimes. The first fractional reserve standard is a gold coin standard.Again, the analysis applies mutatis mutandis to other fractional reserve commodity standards. In a gold coin standard banks hold fractional reserves and gold coins are in circulation. A gold coin standard contains the same properties in regard to its functions as a medium of exchange as a 100 percent gold standard. Gold is not perishable, homogeneous, has a great value in a small bulk, etc.
The main difference concerning the quality of the money, though, comes with money’s function as a store of wealth. In a gold coin standard, money is easier to manipulate for governments than in a 100 percent gold standard, as the government typically holds the monopoly of the mint. In addition, banks are allowed to produce fiduciary media, i.e., money substitutes not backed by gold. The banking system does not necessarily have to hold 100 percent reserves, as credit expansion is possible. Credit expansion, by causing business cycles, weakens the economy and helps to monetize government debts. In a recession, there is the danger of government bailouts diluting money’s value. Recessions may also be used as a pretext to increase government’s foothold in the economy, for instance by installing a central bank. If a central bank is installed, the quality of money falls even more, as this agency is a foothold of the government into the monetary system that is likely to reduce the quality of money further.
Moreover, credit expansion serves as a promoter of maturity mismatching, i.e., borrowing short and lending long. In the case of roll over problems of short-term debts, banks may use their own deposits as a substitute for financing. In addition, credit expansion tends to increase the money supply which reduces the risk of maturity mismatching. The financial system becomes more unstable by the tendency for excessive maturity mismatching. This makes a government bailout implying a deterioration of the money standard more likely.
Furthermore, an important difference of a fractional gold standard and a 100 percent gold standard is the effect of increases in the quantity of money on its quality. When in a 100 percent gold standard new gold is mined, this gold naturally is of the same quality as the old money. The quality does not deteriorate. Yet, when in a fractional gold standard, the amount of fiduciary media, i.e., paper money, increases, the quality of the currency decreases, as there are less gold reserves per monetary unit. The reserve ratio shrinks and the average backing of the currency deteriorates.
Gold Bullion StandardThe gold bullion standard tends to emerge from a gold coin standard. When in a gold coin standard, credit expansion creates recurrent banking crisis, and banks tend to press for the installation of a lender of last resort, the central bank. At the same time, banks are interested in a reduction of coins in circulation which is realized in a gold bullion standard, where the government does not mint coins. Typically, the gold reserves are centralized in a central bank. The currency is backed by gold bullion and the reserves centralized in a central bank. The currency can be exchanged against bullion at a fixed rate. Gold coins likely disappear from circulation.
In such a system the quality of money is reduced vis-à-vis a gold coin standard. It is more difficult to hoard gold as only bullion can be exchanged against currency. Due to the difficulties of redeeming and transporting bullion, less currency will be redeemed into gold and gold will practically disappear from day-to-day transactions. Consequently, banks can reduce their gold reserves. This allows for greater credit expansion, which, via business cycles, weakens the economy and helps to monetize government debt. As banks tend to reduce their reserves, they become more illiquid. Greater credit expansion and the introduction of a central bank reduce also the risk of maturity mismatching. Excessive maturity mismatching adds to the instability of the financial system. The higher probability of bailouts and further denigration of the regime deteriorates the quality of the currency.
As there is a lower amount of gold in the hands of the public it is easier for the government to suspend redemption altogether without leading to a double standard and facing the resistance of people to hand over their gold. Thus, the government can manipulate the money and deteriorate the money standard easier.
Gold Exchange StandardThe next step down in the quality of monetary standards is a gold exchange standard. A gold exchange standard is a fixed exchange rate system like the Bretton Woods system. Currencies are pegged at a fixed rate with a main currency that can be redeemed into gold bullion. Only central banks can redeem one currency into gold bullion through the main central bank which was the case during the Bretton Woods era with the Federal Reserve System.
A gold exchange standard leads to a further centralization of gold reserves and allows the banking system outside the main country to expand credit on top of the main currency. The main banking system also is likely to use its privileged position in order to expand credit. The system sows the seeds of its own collapse if the main country expands credit, thus imposing a cost on the rest. The exploitation of this position will then meet the resistance of the other countries who start to demand redemption as happened in the case of Bretton Woods, when the French government demanded payment in gold.
As a consequence of a higher capacity for credit expansion, business cycles will become more volatile, harming the economy. In addition, monetization of debt on a larger scale becomes possible. Maturity mismatching increases and the financial system grows more unstable increasing the chance of diluting bailouts. The tendency toward price inflation also increases, which in turn incentivizes people to take on debts. The population’s day-to-day connection with gold becomes looser and less resistance will be felt when the connection is cut by the government altogether.
It should be pointed out that becoming the main currency in a gold exchange standard may in some sense increase the quality of this main currency. It is very profitable to be an international reserve central bank (Rittershausen 1962, p. 408). Other central banks hold reserves of the main currency at very low interest rates. Other central banks must fear devaluations that would imply losses in their assets. When a currency becomes the main currency it implies therefore an increase in its quality. Other economic agents are more likely to accept and hold this currency.
Within these fractional reserve standards we may distinguish between systems where the unit of account and medium of exchange are separated and those where they coincide. In systems where unit of account and medium of exchange are separated, people calculate in a currency such as gold but pay also with another medium of exchange such as bank notes or deposits. These notes and deposits may have a discount in relation to payments in specie. Therefore, a credit expansion may lead to a higher discount leaving unharmed the integrity of the gold currency. Prices denominated in bank notes increase but not denominated in specie. If, on the other hand, bank notes and deposits have to be accepted at par due to legal tender laws, the quality of the system decreases. Credit expansion in this case cannot lead to a discount anymore but deteriorates the quality of specie as prices denominated in gold increase.
Fiat Paper Money StandardA brisk change in the quality of the monetary regime occurs when redemption is finally suspended altogether leading to a fiat paper currency. In a fiat paper money standard as the world has been on since 1971, not even central banks are able to redeem the currency against bullion. There is no guarantee anymore to receive any specific amount of gold for the currency. Hence, the quality of the money has declined.The fall in the quality of money helps to explain historical price inflations. When the U.S. went off the gold standard in March 1933, wholesale price soared 14 percent over 1933 and 31 percent by 1937. When the U.S. went off the gold reserve standard (the Bretton Woods system) in August 1971, wholesale price increased 4.35 percent during the rest of the year, more than 13 percent between 1972 and 1973, and over 34 percent between 1972 and 1974 (Hazlitt 1978, p. 76).
There is a wide divide between redeemable claims to gold as in the gold standards discussed above and unredeemable paper money. Unredeemable paper money presents a claim on something that is not specified. Fiat paper money fluctuates in value according to the holder’s belief of what the fiat money will be able to purchase. This estimation may fall very low and easily to zero. It is completely dependent on trust. If trust evaporates its value may well fall to zero, without dramatic changes in the money’s quantity.
The capacity of irredeemable paper money to serve as a store of wealth is dominated by this uncertainty. Nothing of this sort happens with a (convertible) money certificate that, for instance, can be exchanged at any moment against gold. As Rist (1966, p. 200) summarizes: “In short, convertibility is not a mere device for limiting quantity; convertibility gives notes legal and economic qualities which paper money does not possess, and which are independent of quantity.” Therefore, when the redemption of bank notes and deposits in a gold standard is suspended, the quality of money, from one second to the next, is reduced (independently from what might happen to money’s quantity).
Once redemption is suspended, there is no safety net for the value of the currency to fall back to. Money is not connected any longer with the industrial demand for gold. The “insurance” of a strong industrial demand for the money holder is gone.One might argue that “de facto” redemption, i.e., interventions of the central bank selling its assets are an insurance. However, there is no legal insurance or security whatsoever that central banks will intervene at the point of time the money holder wants.
Production costs of new paper money are very low, increasing the likelihood of increases in the money supply. Moreover, as redemption is suspended, the last control against government manipulation is gone. The floodgates for governmental manipulation of the money supply are open. Now the only restriction for government is its own will to put a limit on the production of additional money. These limits are typically formalized through the statutes and mandates of the central bank.
As a central bank can print an unlimited amount of money and bail out banks, moral hazard ensues. Maturity mismatching increases and reserve ratios are reduced. Credit expansion leads to more volatile business cycles harming the economy. The monetization of government debts by using the printing press has become easier. The financial system becomes even more fragile than before. Government bailouts become more likely and deteriorate the quality of money. As a consequence, money practically loses its function as a good store of wealth. Price inflation becomes a feature of everyday life. As people become accustomed to increasing prices, they start to incur more debt. Both the indebtedness and fragility of the economy increase. Thus, at the instant the monetary system is deteriorated to fiat paper money system, the quality of money declines sharply.
Switching Monetary Regimes and Money’s Purchasing PowerChanges in the quality of money can be made within a certain monetary regime and by changing the monetary regime. Any move up the qualitative ladder explained above from the bottom to the top, i.e., from a fiat paper money, to a gold exchange standard, to a gold bullion standard, to a gold coin standard to a 100 percent free gold standard implies a substantial improvement in quality. Any move down the qualitative ladder implies a deterioration of the quality of money and a tendency for price inflation. Downward movements have been more common in history. Especially in preparation of or during war efforts, monetary regimes were often changed for the worse (Rittershausen 1962, p. 366).
Improvements in monetary regimes have occurred in history. For instance, resumptions of specie payments, i.e., a change from a fiat paper money to some variant of a gold standard have occurred in history at various times; especially when specie payment was suspended during war and later resumed. Examples are the resumption of specie payment in Great Britain after the Napoleonic Wars and after World War I, as well as the resumption of specie payment after the U.S. Civil War in 1879. When it is expected that specie payment will be resumed, people expect the quality of money to increase and money’s price can rise immediately. This is probably one cause of the price deflation in the U.S. before the resumption of specie payment in 1879 (Bagus 2015). Another example is Peel’s Bank Act of 1844 which prohibited the issue of unbacked bank notes. The failure of Peel’s Bank Act was to not include bank deposits in the provision. The introduction of a 100 percent reserve ratio for demand deposits as well, would have increased the quality of the monetary regime strongly.
In general, however, the evolution has been downward from gold standards of a higher quality to gold standards of a lower quality and finally to fiat money standards. In fact, once we step down from a 100 percent gold standard, the seeds are sown for a progressive deterioration of the money regime. Government gets a foothold in the monetary system. Credit expansion by the central bank lead to excessive maturity mismatching, overindebtedness, and financial instability. In the crisis caused by these monetary regimes, bailouts tend to occur leading to higher government debts which are later monetized. In theses crises the regime is also often denigrated. For instance, redemption of specie payments may be suspended in a banking crisis.
ConclusionBeside money’s quantity also its quality influences its purchasing power. In this paper we have analyzed the quality of monetary regimes which consists in providing an institutional framework for a good medium of exchange, store of value and medium of account. Changes in monetary regimes may lead to substantial changes in money’s quality and thereby affect money’s demand and purchasing power. The highest quality regime contains a 100 percent gold standard. Fractional-reserve gold standards contain the seeds of their own deterioration, leading via credit expansion to economic and banking crisis. Via progressive government intervention and centralization of reserves a gold coin standard deteriorates into a gold bullion standard and a gold exchange standard.
The switch from a gold exchange standard to a fiat paper standard is a watershed. There is no non-monetary demand for the money unit anymore. Its value is solely maintained by trust and confidence while the insurance of an ample non-monetary demand has vanished. Government and central banking control monetary affairs totally. Recurrent recessions and bailouts of the financial system become likely, deteriorating the quality of money. Future research may focus more on the qualities of different monetary regimes and how their switch affects the quality of money and also economic growth. A switch to a higher quality regime of money in a recession may positively affect confidence and economic growth.
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EconomistsDavid Howden is professor of economics and chair of the Department of Business and Economics at St. Louis University, at their Madrid campus, Madrid Spain. beyond a certain age will recall a simple mnemonic when listing money’s main functions: “Money is a matter of functions four, a medium, a measure, a standard, a store.” The four functions of the categorization of money are known today as the, (1) medium of account, (2) measure (or unit) of value, (3) standard of deferred payments, and (4) store of value. The rhyme alludes to the fact that economists thought that money served a somewhat broader role once upon a time than it does today.
The mnemonic also makes clear that money has several well-defined uses, unlike other economic concepts, like “goods” which have innumerable uses subjectively determined by their users, or a “price” which is the unique objective embodiment of these uses. In this way, money is special.
Due to good luck endued in him by his parents, Joe Salerno is of the age necessary to be included in the group of economists who cut their teeth in monetary economics by learning this rhyme. Unfortunately, he may well be old enough to have forgotten it, as well as where he left his glasses, his wife’s birthday, their anniversary, and all sorts of other things important to his life!Amongst other things important to his life, I will take the liberty to include the first time Joe met me. By my “young” mind’s recollection, this was at a dinner at a taco house in Auburn, Alabama, some balmy early June evening in 2008. This was the first of two summers I would spend at the Ludwig von Mises Institute as a summer fellow under the guidance of Joe. Thank you, Joe, for your intellectual encouragement, mentoring and, of course, friendship, over these past six years.
In this chapter I will revisit the use of this simple mnemonic to underscore what money is. I will then use these insights to augment Salerno’s (1987) work on the “true money supply.”
Money is as Money DoesIn an unsettling way, the old adage that “money is as money does” has a ring of truth to it. When defined, as it commonly is in introductory economics textbooks, as “the generally accepted medium of exchange,” money can be a variety of goods, provided they meet three criteria: (1) that the good is used to settle exchanges, (2) that the good is the final means of settlement, i.e., not credit, and (3) that the economic community generally accepts such a good to settle exchanges. Economists then move on to a discussion of whether a “good” is a candidate for inclusion in the definition of the money supply when it satisfies all three of these conditions. The result is any of the common “M” measures of money.
While it is trivially true that money is as money does, there must be a better way to approach the problem. The old trusty mnemonic hints at how we can proceed.
In the common story of the origin and evolution of money, one central aspect is the reduction of transaction costs (i.e., Menger 1871, chap. 8, 1892). In a moneyless world there is a double-coincidence of wants problem, as elaborated by Jevons (1875, p. 3). As the scope of trades is limited and the costs associated with setting an agreeable price once trading partners do meet is high, there is an incentive for traders to use specific goods that are widely demanded to settle their transactions. As more individuals use these few specific goods to settle their exchanges, they gain a value for exchange purposes in addition to the value they possess for direct use. The process ends when one (or very few) goods begin to be traded solely for exchange purposes, and their acceptance is due to the knowledge that they can be easily traded with, and accepted by, another individual. Money is the outcome of this process, and it is also clear that whatever good is functioning as money will also be the generally accepted medium of exchange as a result.
Money’s use during its evolutionary process is clearly for exchange purposes but there is also an additional role of great importance. Mises (1949, pp. 244–51) sheds light on this by way of his equilibrium construct of the “evenly rotating economy” to demonstrate when money is not necessary. Only in a world of full certainty — one where all expenditures are known in advance, both in magnitude and timing — would money not be necessary. The reason comes from a simple opportunity cost analysis.Confusions suffered while interpreting the results of Mises’ evenly rotating economy commonly center on misunderstandings of what role money is embodying within it. Specifically, it is not necessary for money to circulate as a medium of exchange but it is of importance that it exists to denominate prices (Howden 2009, 8 n.8).
Since money functions as the final means of settlement, it is also always and everywhere a present good. Indeed, money functions as the present good par excellence and as such yields no interest payment. Holding money will always force an individual to incur a cost in terms of the yield on whatever other best but foregone option is available to him. Rather than forego an opportunity by holding money, if the individual knew in advance what his monetary demands would be he would either lend his money at interest until it was needed, or would turn to the futures market to settle his future transactions at some discounted value in the present.
Depart from the perfectly certain world, however, and one runs into the intractable problem of how to best meet his future needs. As Mises (1949, pp. 14, 249) shows, money serves as a security hedge to guard against these uncertain situations. The key problem is that “[u]ncertain of what, when, where or the amount of future expenditures, individuals demand to hold an amount of money to safeguard against this uncertain future” (Bagus and Howden 2013, p. 236).
Of course, other highly liquid money substitutes can also serve this role to some degree. Rothbard (1962, p. 713) refers to these as goods as a type of “quasi money,” but to the extent that they are not perfectly liquid assets or the final means of settlement, they cannot function as “money.”
Thus, while a highly liquid very short-term bond may substitute for money in some ways, the fact that it is never the final means of settlement and is itself open to some degree (however small) of default risk forever trap it in the category of quasi moneys and stop it from claiming a monetary status. Chief among these quasi moneys in today’s economy are money market mutual funds (currently amounting to about $2.7 trillion) and liquid assets used as collateral by the shadow banking industry.Notoriously difficult to define or measure, some estimates place the size of the shadow banking system in the United States at $19 trillion as at year-end 2011 (Singh 2012). By way of comparison, the True Money Supply figure, defined in Salerno (1987) and elaborated on below, was substantially smaller at the end of 2011 — $7.3 trillion.
In this brief discussion of the evolution and use of money there are several roles taking place concurrently. The most obvious one is the medium of exchange — a unit to transfer in settlement of pecuniary obligations. There is also the role of money in mitigating our felt uncertainty, however. In order to function accordingly, we must identify what the relevant uncertainties are that the individual will face.
Having already commented on the unknowledge of what, how much or when we will need purchasing power in the future, we can now comment on why money is held as a hedge against these expectations. After all, most individuals can and do hold a variety of liquid non-money financial assets to assist them with their future expenses, e.g., equities, short-term bonds or certificates of deposit. All of these non-money financial assets have a risk inherent in them which the money holder must overcome.
It is useful to think about financial assets in terms of two characteristics — when are they available, and what value they will have at that moment when they are used. The first criterion can be divided into two categories. A good is either a present good, i.e., it can be used at any time, or it is a future good, i.e., its value cannot be realized until some point in the future. The values in question also come in two distinct forms. A financial asset either trades at par or market value, with the latter fluctuating as per supply-demand conditions in the market. All financial assets can be classified according to these characteristics, as in Figure 1.
In the scope of financial assets, money is unique. It is the only good that is available at a moment’s notice and at par value. The par value nature of a financial asset comes from the fact that its payout is defined in terms of itself. One dollar held as currency or on deposit equals one dollar of purchasing power. Likewise, bonds are denominated in terms of money units (e.g., dollars), such that the purchaser receives a set nominal amount of said currency units upon maturity. In contrast, financial assets that trade at market value are purchased in terms of “shares” (or a claim to shares in the case of a future), with each share deriving its value from an underlying asset, whether it exists in the present or the future. When an individual buys a share in a company, the value is defined as a percentage of the company’s future earnings stream, discounted to the present at an appropriate discount rate.
Equities and money are both present goods in the sense that their respective values, or purchasing powers, are unleashed at a moment’s notice. The owner of equity is forever unsure of the value he will receive for the sale of his shares, however, as it is dependent on market conditions at the time of sale. The owner of a bond is assured the value of his asset, but only if he waits until maturity to sell it. (He can, of course, sell at any moment though the value he receives will be dependent on supply-demand conditions at the time, i.e., he will receive the market value at that moment in time, effectively making the bond an equity investment ex post.)
In a superficial sense, money is demanded because it is highly liquid. Yet this cannot be the sole reason money is demanded, as other financial assets such as equities and heavily traded debt securities are also highly liquid. Money is also demanded because its nominal purchasing power is guaranteed, as it is with bonds if we abstract from default risk. Thus, in some ways money exhibits features of equity securities (e.g., high liquidity) and other features more common in debt (e.g., par value redemption).
More to the point, money is demanded because of its uniqueness. Money is the only asset that is able to combine both features — par value and on demand availability — into one package. It is this combination that makes money such an exceptional, and also essential, part of a portfolio of financial assets.
Money as Medium of Exchange and Unit of Account, Present and FutureThus far I have been able to establish some characteristics of money without making reference to its specific functions. Actually, the causality runs the other way ‘round. There are some specific roles needed to be filled in the economy, and money (broadly defined for the moment) is the good that emerges to serve these roles. To understand why, consider two of the common functions of money in our introductory mnemonic. To jog the younger reader’s mind (as well as Joe’s): “Money is a matter of functions four: a medium, a unit, a standard, a store.”
The obvious two functions that correspond to what any introductory economics course teaches us are those of the unit of account and medium of exchange. In one very important way, these two roles share a common link. They both perform their role in the present. Money serving as a numéraire to express prices allows for value comparisons in the here and now, and when we exchange money we settle our transactional obligations instantly. Thus, the unit of account and medium of exchange are both present functions of money.
Although we commonly think of money in terms of these present functions, is it also possible for money to have future functions? Again, returning to our mnemonic we see that the other two roles — the store of value and standard of deferred payments — are important roles that money is expected to perform at some future date. Whether money will prove itself to be a useful store of value will not be known until the future is revealed. Long-dated contracts can be defined in terms different than the common unit of account by the standard of deferred payments.A weight of gold served this purpose for most of history, even when a different currency unit was used in exchange for more short-term oriented pricing. This changed in the United States starting with the Legal Tender Act of 1862 (which, despite a tumultuous start was finally ruled constitutional in the 1884 case of Juilliard v. Greenman, 110 U.S. 421). Despite contracting for settlement in a different good than was commonly used as the medium of exchange, legal tender laws effectively make the standard of deferred payments (as well as the other monetary functions) the same as the preferred money of the state. Since payment must be accepted if rendered in the legal tender, even a pre-agreed alternative cannot be upheld in a court of law.
Each of money’s four roles has a temporal dimension, but they also have a common connection by the general category of use that they are satisfying. Generally speaking money is either used to price a good for sale (if one is the seller) or exchange for the good to complete the transaction (if one is the buyer). Figure 2 shows how money’s four roles dovetail with the two criteria defining their demand. Money, by serving in any of these four functions, is demanded to set prices or exchange for goods, either now or in the future.
As previously alluded to, one monetary good need not serve all of these roles simultaneously. Historically, many goods have served as pricing units without also being exchanged to settle transactions. Although gold and other precious metals have commonly served as pricing units in recent history, accounts abound of other, less common goods, performing the same role. Cigarettes in POW camps (Radford 1945), large circular Rai stones on the South Pacific islands of Palau and Yap (Bryan 2004) and even slave women (cumal) in Early Medieval Ireland (Nolan 1926) are well-known (and well-used) examples provided by economists.
Likewise media of exchange are varied over history, though much less so than with the units of account. The reason for this is straightforward. As per Menger’s theory of the evolution of money, for money to achieve the status of the “generally accepted medium of exchange,” it must be broadly demanded throughout the economy. Together with some of the objective properties of precious metals (e.g., divisibility, durability, difficulty to counterfeit, etc.), metallic goods were used because of the assuredness that the recipient would accept them.
Pricing units need not be chosen mindful of this constraint. Instead they have been selected for criteria that include general knowledge of their value, constancy of value of time (or, at least, a non-volatility of value compared to the values of other goods), and ease of recognition. Divisibility has never been an issue for pricing units, as fractions of any unit can express value as well as any whole number. Fractions of women were used to define fines in ancient Ireland, though these prices were not paid with the aid of a steady-handed surgeon. Instead they were settled with another good functioning as a medium of exchange, at the going exchange rate of that good for women.Although using fractions of women to pay fines could lead to more accurate convictions and judicious verdicts, as with King Solomon’s ruling to “split the baby,” as recounted in 1 Kings 3: 16–28.
Money’s four roles are a direct outgrowth of the fact that what we call “money” is actually the combination of several functions commonly embodied in one good. Denominating the prices of all goods in terms of one good brings great computational ease when comparing the opportunity costs of alternatives. Not only is the calculation provided by money prices “a device for lowering transaction costs relevant to deliberate search,” it is also the embodiment of a social arrangement allowing for spontaneous learners to easily recognize overlooked opportunities (Kirzner 1979, p. 150).
As an example, a simple economy consisting of ten goods to exchange against each other would have 45 “prices” if there was not a single good used to express their value with a common denominator.An economy with n goods will result in (1/2)(n-1)(n) direct exchange ratios. Using one of these ten goods to express all other prices results in only nine prices (with the price of the good in terms of itself, one, making an additional tenth “price”). In the modern economy, the number of goods is many orders of magnitude greater than this example. The average car, to take one small component of the vast number of goods produced in the American economy, has upwards of 15,000 separate parts. If these individual parts were transacted without a common pricing unit, there would be over 112 million separate exchange ratios! Since the automotive industry is less than 2.5 percent of the whole American economy, I leave it to the reader to consider the number of “prices” that could exist across the United States lacking a common denominator through the unit of account. Needless to say it is doubtful that such computational complexity resulting from direct exchange ratios would allow for anything more than a simplistic, nearly autarkic, economy.Confusions around the origin and emergence of money commonly treat the unit and account and medium of exchange interchangeably. David Graeber (2011) is unconvinced by Menger’s evolutionary theory, relying on anthropological data that seems to suggest there was never a time when direct exchange existed, an important first step in the path to a money emerging as a form of indirect exchange. As proof, Graeber points to the lack of pricing boards showing prices expressed in terms of multiple goods. In this criticism, Graeber asks too much and too little. Too much because he extends what is really an example of a lack of multiple units of account as means to express prices to conclude that there was never a time with multiple goods functioning as media of exchange. On the other hand he asks too little by expecting there to be evidence of a primitive society expressing prices in terms of all, or many, other goods. Given the computational problems discussed above for a small economy not using a common unit of account, I would expect that this monetary function was eclipsed by one, or a very small number of, goods in anything more advanced than a very primitive society, thus explaining the lack of anthropological evidence from very early human developments.
Money may be a present good, but the people who use it are always future oriented. Thus there will be a necessary forward-looking perspective on each of money’s two roles, in addition to their demands in the present.
The store of value, being the future extension of the medium of exchange role, is probably the simplest future-oriented function to understand. Money is demanded in the present to settle current debt and transactional obligations. However, due to the uncertainty inherent in the future, there will need to be a medium of exchange demanded today to fulfill requirements in the future. The exact dates and magnitudes of these expenses are as yet unknown, but the money saved today must retain its value, or purchasing power, until that unknown future date.
Thus, the store of value function is the other side of the medium of exchange coin. Economists often couch their discussion of the store of value function as if it was a way to transmit wealth to the future. Such an understanding of the role obfuscates the issue. Money is not demanded to transmit wealth into the future, although it can certainly perform this role. Almost no one holds a sum of money today because he is preserving his “wealth” for the future. After all, there is an opportunity cost to using money for this role given its lack of interest return. In its place, investment vehicles commonly perform this task.
Money serving as a store of value is more correctly thought of as the property whereby money will only be demanded today based on its expected purchasing power in the future. This future purchasing power will be determined by how well the medium of exchange preserves its value, i.e., functions as a store of value. Note that this is quite different from more typical discussions of storing wealth for the future in the general sense, something which is not unique to the monetary asset. We are here concerned with money’s ability to preserve its value to be used in the future for monetary needs, which are, incidentally, the same category of needs that money is demanded for in the present as a medium of exchange.
The standard of deferred payments functions as the reverse side of the unit of account coin. It is the ability of a good to express the value of other goods, but over a longer time horizon than the standard unit of account. As an example of this distinction today, despite having lost 98 percent of its purchasing power over the last 100 years, the U.S. dollar has managed to do so with constancy. Each year prices increase by around 3 percent on average, notwithstanding some outlying periods. On a year-to-year basis the U.S. dollar performs well as a unit of account, and, e.g., a clothing shop, can take comfort in knowing the price tag made in one year will suffice for the following year as well; menu costs are minimal. Over longer periods the dollar has performed terribly and lacking an alternative good to use as the standard of deferred payments, Americans have had to suffer the costs of hedging their bets on long-term contracts denominated in dollars.
When using the term “money,” what economists have in mind is actually any of the four specific roles performed by money. In this way, one reason that monetary economics has become so confused is that the very adjective in its title is ill-defined. Furthermore, with the exception of select works in the now well-aged “New Monetary Economics” literature (Black 1970; Hall 1982a, b; Greenfield and Yeager 1983), very few serious attempts have been made to look at money’s individual roles in isolation of their shared embodiment in a single good. General equilibrium models are at a loss to incorporate money since they have no scope for a medium of exchange. It has been difficult to integrate money into basic utility analysis since money confers no direct utility, unlike other goods. (And since utility analysis forms the bedrock of microeconomics, the economics profession has long grappled unsuccessfully at providing “microfoundations” for monetary economics.) In short, much has been lost by using one word — money — to describe four different functions.
Multiple or a Unique “Monetary” Good?The source of the muddled state of present monetary economics stems, at least in part, from the simple fact that for the better part of a century, one good has served all four monetary roles. This is understandable given that the enforcement of legal tender laws effectively forces one good (i.e., the legal tender) to serve all roles simultaneously. Before the passage of such laws in the mid-nineteenth century, an American could purchase a home with a mortgage denominated in ounces of gold and furnish it with goods priced in U.S. dollars. Neither dollars nor gold would be needed to pay for either transaction, as silver could be exchanged at the market rate. With the advent of legal tender laws, prices could still be struck in any good, but the payer would always be able to use U.S. dollars in settlement. As a result, U.S. dollars became the dominant pricing unit, both for current and long-dated contracts.
Yet there is still another reason why one good would assume all roles concurrently. Consider the origin of the demand for money. Mise’s use of the evenly rotating economy illustrates that it is only the existence of uncertainty that makes money a necessity. Money need not exist as a medium of exchange, not in any abstract sense anyhow, since any contract can be settled with a future if its magnitude and timing are known in advance (or an option if not even the timing is known).
Money is held to mitigate the holder from the uncertainty concerning his future transactions needs. In this way, one may get the impression that money’s key role is the store of value —the ability for it to unleash purchasing power in the future. Such thinking is also erroneous, as there are several assets that can provide more-or-less good stores of value over time. (It is often recollected that one ounce of gold has purchased a good men’s suit for hundreds, if not thousands, of years.)
The way that money insures the holder from uncertainty stems from its unique properties as a financial asset, as in Figure 1. It is the unique good that is redeemable at par value at a moment’s notice. From this simple fact we can derive three important insights about what money is.
The first is that a good only functions as “money” when its two general functions coincide. Specifically, if a good is used as the pricing unit and is also exchanged to settle transactions, it will by necessity trade at par value. At the same time, since money is the generally accepted medium of exchange it will also be available on demand since the timing of future transactions cannot be estimated, evenly probabilistically, in the present. This is important to the extent that we can see why money takes on its specific role in the schema of financial assets, a position attributable to the specific monetary demands by individuals.
The second insight is that we can better explain what is not money. In short, any asset not trading at par value and available on demand cannot be so categorized. The reason is that it would negate the original reason why money is held — to mitigate uncertainty. Holding an asset as “money” even though it is not available on demand (e.g., a future or a bond) entails a degree of risk since there is no guarantee that the purchasing power will be available at that moment when the holder demands it. What good is a 30-year bond to the holder as money if he requires funds in ten years’ time?
On the other hand, holding a good that trades at market value (e.g., equities) will give the holder no assurance that its value will be retained, either in whole or in part, at that moment when the holder needs it. Holding Enron shares may have seemed to satisfy an individual’s demand for money superficially, but when it turned out that his shares were worthless, he moved on to satisfy this monetary role by means of another good.
Thus only goods available on demand and at par value can survive as money, and these two criteria are only fulfilled when a good is used as a pricing unit and as a medium of exchange simultaneously.
Finally, we gain some insight into better defining what the money supply is. Currency obviously fits the bill, but what of bank accounts? To the extent that they are guaranteed to be paid on demand and at par value, demand deposits also comprise an important component of the money supply. Herein lays two important caveats. Fractional-reserve banks do not necessarily come with either of these assurances. As recent events in Cyprus have made clear, fractional-reserve deposits are effectively equity holdings masquerading as money. When bank assets lost sufficient value to render them illiquid, depositors were paid out a corresponding fraction of their account’s value, an event akin to receiving the market value of a number of shares. Alternatively, some fractional-reserve banks honor the par value redemption of their deposits, but only after the depositor incurs a waiting period to receive his funds. Such a condition is imposed in nearly all banking systems on redemption requests above a certain amount.
Historically, a similar condition was used liberally on fractional-reserve deposit accounts under the guise of the “option clause.”Checkland (1975, p. 85) describes the Scottish free-banking period as one of “continuous partial suspension of payments.” This has since been heralded as a stabilizing force of free-banking systems lacking a guarantor such as a central bank to function as a lender of last resort (White 1984, pp. 28–29; Selgin 1988, pp. 161–62; Selgin and White 1994, pp. 17–26). Such advocacy gets the problem of stabilizing the monetary system exactly backwards. Solving the problem of banking instability by removing the on demand criterion, even if for only a short while, removes one-half of the key features making money so unique. It also removes one-half of the reasons why money is demanded.
Thus, deposits held in fractional-reserve bank deposits are a tenuous component of the money supply. Provided that the issuing bank can maintain on demand and par value redemption, there is no significant problem. Changing either of these aspects effectively removes the asset from the upper-left quadrant in Figure 1, and relegates the former “money” to some other financial role.
(Re)defining the Money SupplyDefining the money supply is tricky business. This is so not least because of what criteria define monetary assets, but also because some of those assets are not capable of performing their jobs without serious caveats. I will close with some brief and sundry comments on Salerno’s (1987) definition of the “true money supply.”
In writing this pithy article, Salerno builds from the theoretical framework of Rothbard (1963, pp. 83–86; 1978; 1983, pp. 265–62) used to accurately define the money supply. In doing so Salerno diverges from Rothbard by excluding life insurance net policy reserves, owing to the fact that very few, if anyone, considers them to be part of the money supply. Since the supply in question is concerned with the “generally accepted” medium of exchange, Salerno excludes this component due the lack of perception that it is money on the part of money holders.
While this exclusion is warranted if one is concerned with money as the “generally accepted medium of exchange,” it is unwarranted if one defines “money” under a different set of criteria. As money is demonstrated herein to be defined as “the unique financial asset that is available at par value, on demand,” the inclusion of life insurance policy reserves is not only warranted, but necessary. Indeed, some works, e.g., Nash (2009), Lara and Murphy (2010), point to the use of life insurance policies as a bank account, and thus implicitly include these reserves in the money supply.
Salerno also excludes money market mutual funds (MMMF) because they are not instantly redeemable, nor are they par value claims to cash. While they may look like this at first glance, a MMMF is an equity claim to a managed investment portfolio of short-term, high-grade financial assets. Cases where these funds have “broke the buck,” i.e., the net asset value of the underlying portfolio drops below the value of MMMF claims to the assets, have historically resulted in either the owners receiving less than the par value of their holdings, or a capital infusion from the fund’s sponsors. Likewise, Salerno excludes short-term time deposits on the grounds that they are not available on demand.
More common attempts to define the money supply have suffered from an ad hoc approach, as is the case with the common “M” measures.Alternative measures of the quantity of money run into similar difficulties. The “Divisia” monetary aggregates developed by Barnett (1980) use what are essentially the same types of money and money substitutes as in the more common M measures, though weighted by their expenditure share instead of evenly. Austrian economists have made great strides by realizing that the money supply can be defined by the two main reasons that money is demanded, whether to facilitate payments or to provide an uncertainty hedge. Most notably this approach follows Rothbard (1962, pp. 756–62) in defining the reservation demand to hold money separately from its exchange demand (Howden 2013, p. 21).
Ultimately, definitions of the money supply are tricky because they grapple with four problems at once. These four problems allude to money’s four roles, as listed in the opening mnemonic. I will end this chapter with one approach to measure money, and draw one implication.
In one way, money defines prices that will need to be paid for with the medium of exchange. The stock of exchange media available to settle these prices is one “money supply.” For simplicity I suggest we call this “exchange supply of money,” Mx.
Money as used to price goods comes with one complication. At any given time there is a set of obligations priced in terms of the money unit that require the medium of exchange to settle (e.g., debts coming due). To this set we can include those goods desired (but not obliged) to be purchased, which are priced in the money unit and which the medium of exchange will be required to settle (e.g., consumers and producers goods). The sum of these prices, or units of exchange, comprises what we can call the “pricing supply of money,” Mp. There is also a known amount of units of account that will arise at a future date, due to existing debt contracts yet to be fulfilled. The standard of deferred payments, thus, can also be defined with some degree of certainty in the present and we can call this the “future pricing supply of money,” Mp´.
This approach to defining the money supply gives rise to several distinct quantities, only one of which has any bearing to the more commonly given measures. While the Mx supply is easily understood, both Mp and Mp´ are determined not by any monetary factor, but instead by the demand of individuals to purchase goods and services (whether on the current spot market or on some futures market in the past). Readers will see an affinity between this approach and Salerno (2006), whereby prices are not the result of the demand for money per se (as is commonly extrapolated from the quantity theory of money), but are rather the result of the demands for goods and services which in turn create the pricing money supplies, Mp and Mp´.
One implication of, and benefit from, using several “money” supplies is that it allows for an alternative method to look at how the purchasing power of the medium of exchange fluctuates over time. If, e.g., Mx < Mp, the value of the medium of exchange must rise to clear the market. Since some of the prices that comprise the supply of pricing units of money, Mp, are fixed at a pre-defined value (e.g., those resulting from a previous debt contract), either the prices of goods contained in Mp will fall, or the real value of the supply of the medium of exchange, Mx, will rise. Of course, these implications are just two sides of the same coin.
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After Joey Rothbard’s death, I flew to New York to organize the disposal of Murray and Joey’s goods according to their wills. Books and papers went to the Mises Institute, of course, where they are the center of our library and archives. But my strongest memory, aside from ineffable sadness, was the printed document on the small table next to Murray’s reading chair in the living room. It was Joe Salerno’s doctoral dissertation.
To me, that has always symbolized Murray’s relationship with Joe, whom he praised as a wonderful economist, and — perhaps almost as important in our times — as a brave fighter against error and sellout.
Joe has been a strong intellectual influence on the Mises Institute since our founding. How appropriate that he is also Murray’s successor as our academic vice president.
Joe influences so much. The Mises University, the Austrian Economics Research Conference, and the Summer Fellows Program are all under his aegis, and much the better for it. Not only is Joe an important scholar, he is a teacher of the sort we would all have loved to have had. No one could be more patient, rigorous, detailed, and loving. Forget Mr. Chips. We’ve got Joe Salerno.
The Next Generation of Austrian Economics: Essays in Honor Joseph T. Salerno is a celebratory volume honoring the work of a respected and beloved teacher. It signifies a flourishing career of significant achievement, and also the gratitude and well-wishes of his students.
Dr. Salerno, longtime Professor of Economics at Pace University and Academic Vice President of the Mises Institute, is honored in these pages by the very students whose lives and careers he influenced. His important work in monetary theory and policy, not to mention his great exposition of Austrian school sociology, are addressed here by contributors such as Dr. Philip Bagus, Dr. David Howden, Dr. Per Bylund, Dr. Mateusz Machaj, Dr. Matthew McCaffrey, Dr. Peter Klein, and others.
Salerno stands at the head of what may be termed the “5th generation” of Austrian economists, having been both a friend and close associate of the late Murray Rothbard (not to mention a young attendee at the famed 1974 South Royalton conference). But as this volume illustrates, Joe is also a great friend, mentor, and godfather to an emergent new generation of formidable Austrian economists.
Ten years ago Joe Salerno inherited the Mises Institute’s summer fellowship program from his predecessor, Jörg Guido Hülsmann. Generously funded by Peg Rowley, summer fellows are given time to study Austrian economics firsthand with some of the current masters. Not only is a sense of camaraderie inculcated amongst the participants, but they are also given access to the world’s best Austrian economics library and other resources. Frequent visits by friends of the Institute give these young scholars the ability to ask questions about the theory and history of the movement, and give them an ability to become a part of its ongoing evolution.
Central to this fellowship is the mentorship of Professor Salerno himself. Under his stewardship the program has brought 138 students to the Institute’s facility in Auburn, Alabama, from 2005 to 2013. These students have produced magnificent works central to Austrian economics during their summers in Auburn, and have gone on to take active roles in both the academic community and with private industry.
Perhaps more important than the careers that these young scholars have gone on to live is the enlightenment that they have shared with others through their daily lives. Using their argumentation skills fomented during their stays at the Mises Institute, these scholars have had their reach extended to others in subsequent encounters. We are all the better off for it.
The contributors to the present volume come from the ranks of PhD students, post-doctoral researchers and university professors. They have reached out to others in a bid to have the truth of their studies heard by the widest audience possible. Professor Salerno’s work in fostering debate and encouraging students during their summer in Auburn has no doubt been influential in spurring on this activism.
The present book is divided into three sections: money, policy and what we can refer to as mundane economics, the study of the basic, yet vital topics of the science. Each section represents an important area of Professor Salerno’s own research and his imprint on each chapter should be apparent to the reader. Suffice to say, a brief overview of his contributions will assist the reader in seeing his impact on the development of these young Austrian scholars in particular, and on Austrian economics in general.
Influence on Mundane EconomicsProfessor Salerno is one of the leading contemporary theorists in the Austrian tradition. A former colleague of Murray Rothbard’s, Professor Salerno has made his unfading mark on the theoretical Austrian literature through several influential as well as highly provocative articles. He has also changed the landscape for Austrian theorizing and the self-perception of Austrians.
His perhaps most debated contribution is “Mises and Hayek Dehomogenized” (1993), an article that essentially rewrote the history and sociology of the Austrian school. Professor Salerno here argues that “the Mengerian tradition was developed in very different directions by his brilliant followers, Eugen von Böhm-Bawerk and Friedrich von Wieser, and by their own students and followers” (1993, p. 114). In fact, Professor Salerno argues, these directions constitute “very different paradigms.” The former focuses on monetary calculation and resource allocation using actual market prices and comprises the social rationalism of Mises (Salerno 1990) and the judgmental entrepreneur (Salerno 2008b); one may also add the distinctly Austrian method of praxeology (see e.g., Rothbard 1951a; 1951b). The latter, in contrast, is a “general equilibrium tradition” (Salerno 2002) focused on the problem of coordination due to dispersed and tacit knowledge (see Hayek 1937; 1945) and much more inclined to quantitative analyses.
While only one of many influential contributions, the “dehomogenized” article represents Professor Salerno’s contributions to Austrian theory well. His contributions to “mundane” theory are primarily in the form of integrating existing theories and prospective theoretical perspectives by offering reinterpreting and contextualizing commentary, comparisons, and theoretical extensions. While perhaps not as glamorous as producing thousand-page treatises, this important integrative work is what produces a consistent body of theory that defines and furthers a tradition or school of thought.
Salerno’s work has strengthened the Austrian theoretical tradition and helped identify precursors and “proto-Austrians.” His work stretches beyond publishing in specifically Austrian journals and discussing exclusively Austrian theorists. Much thanks to Professor Salerno’s work, we are able to trace the philosophical origins of Austrian thought centuries if not millennia back in time and can identify kinship with other traditions. To exemplify, Professor Salerno has pursued illuminating commentary on the legacies of Carl Menger (Salerno 2004; 2010a), Eugen von Böhm-Bawerk (Salerno 2008), Ludwig von Mises (Salerno 1995a; 1999; 2012), Murray N. Rothbard (Salerno 2006), as well as of the French Liberal school’s Jean-Baptiste Say and Frédéric Bastiat (Salerno 1978; 1985; 1988; 1998; 2001), and has addressed the theoretical origins and shortcomings of opponents and competing traditions (Salerno 1992). Professor Salerno has also addressed traditions in monetary theory (Salerno 1991), but this work has come to be overshadowed by his important theoretical advances related to macroeconomics and money, especially monetary policy, business cycle theory (Salerno 1989; 2012b), and the calculation problem (Salerno 1990b; 1994b; 1996a).
Money and PolicyBesides his work on the more mundane aspects of economics, Professor Salerno has pushed forward the development of the one topic, besides method, that most separates neoclassical from Austrian economists: business cycle theory. This focus stems from the fact that the
Austrian theory [of the business cycle] embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. (Salerno 1996b)
While this focus on business cycle theory has most recently been summarized in Salerno (2012), the bulk of his work on the topic has fallen into monetary theory and history. (Understandably so, as manipulations to the money supply as the root of economic disturbances remain the bulwark of the Austrian theory.) As the title of his most comprehensive book alludes to (Salerno 2010b), the undercurrent of his life’s work can be summed up in two words: “sound money.” In this agenda, Professor Salerno can be included in a long line of great economists championing a solid currency for the economy to be built upon, starting with the Spanish scholastics in the sixteenth century, expanded upon by David Ricardo and his fellow “bullionists” in the early nineteenth century, and most forcefully and completely argued by Ludwig von Mises in the early twentieth century. According to Mises (1971, pp. 414–16),
the sound money principle has two aspects. It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system. … Sound money meant a metallic standard. … The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit’s purchasing power independent of governments and political parties.
Professor Salerno has made available to his professional colleagues, students and laymen alike the true historical role and functioning of the “gold standard” (in its myriad forms). His work (Salerno 1983) on defining what a true gold standard entails has been instrumental in recognizing red-herring gold standards, imperfectly designed as they were, and which are commonly used to denigrate the usefulness of the “barbarous” monetary relic. His most comprehensive work on the topic (Salerno 1984), shows that the international gold standard is an oft-misunderstood beast because of the aggregative tactic the profession chooses to look at economic phenomena. Taking a more disaggregated approach to monetary and balance-of-payments theory allows one to see the true equilibrating mechanisms promoted by a healthily functioning gold standard.
Nor have these historical insights been merely apparent, allowing one to gain an understanding of a past disconnected from the future. In “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation,” Professor Salerno lays out a theory of war finance, showing that monetary inflation obscures the cost of war and contributes to the capital decumulation and wealth destruction that ultimately ensues. That war-time inflation paves the way to “economic fascism” should be more than apparent to the reader who considers the socialization of large swaths of the American economy that have taken place over the past fifteen years in the wake of the ongoing “War on Terror,” an insidious undertaking with an enormous price tag. With some estimates of the total cost of this war as high as $5.5 trillion (nearly $20,000 per American citizen) the role of inflation in financing this broad-reaching undertaking cannot be overstated (Eisenhower Study Group 2011).
Professor Salerno has been instrumental in demonstrating that Ludwig von Mises’s contributions to the theory of money in the early twentieth century not only predated and were ignored by many mainstream economist, but is also far superior (Salerno 1994a). In light of this, it is to his credit that he has not ignored mainstream monetary theory completely. In Salerno (2006) he gives a “Rothbardian” analysis of the familiar equation of exchange. His insights allow the reader to see clearly and in a way that is not possible via the vacuous quantity theory that
the Quantity Theory of Money as expounded in terms of the Quantity Equation gets matters exactly wrong: it is not the flow of spending that determines the price level, given a level of output that is exogenously determined in some separate and mysterious real process. Rather the money prices and quantities of goods exchanged, which are codetermined in the overall market process, are the causal determinants of the spending flow. (Salerno 2006, p. 51)
Never content to rest on the laurels of his forebears, he has striven to improve upon the great works they have achieved. Salerno (1987) provides a better measure of the “true” money supply. Unsatisfied with the existing “M”s expounded with near unanimity by the rest of the profession, Professor Salerno builds off Rothbard (1963, pp. 83–86; 1978; 1983, pp. 254–62) to provide a better answer to a seemingly simple question: how much money is floating around out there? Not only is the exercise admirable for its clarity, it also shows a dedication to truth seeking and an undogmatic approach to economic analysis. Though clearly following in the footsteps of Rothbard, Professor Salerno does not hesitate to correct the dean of the Austrian school in his previous attempts to define the money supply.
To the Next GenerationThe contributions to economic science discussed above, although formidable, will not be Professor Salerno’s greatest professional achievement. The thirteen contributors to the present volume have all learned from him, and there can be no doubt as to the influence he has had on their intellectual development. Just as Professor Salerno very clearly is influenced by the Menger-Mises-Rothbard tradition of the Austrian school, each of these thirteen authors (as well as the other summer fellows under his tutelage, and the thousands of people who have listened to his lectures and read his works) can be considered an intellectual descendant of his. To introduce the adjective, we are all “Salernians” in some way.
Professor Salerno was not only present for the rebirth and revival of Austrian economics in the mid-1960s, he has been an important focal point of its continual growth over the ensuing decades. With this book, we present to him the evidence that the discipline is in good hands, and that his reach and influence has not only been wide, but also strong, ensuring its promulgation for another generation. It is with this contribution that his most lasting influence has been made, and continues to grow with each passing year. Thanks, Joe.
ReferencesEisenhower Study Group. 2011. “Cost of Iraq, Afghanistan, and Anti-Terrorism Operations.” Watson Institute for International Studies, Brown University. Accessed 27 August 2014.
Hayek, F. A. v. 1937. “Economics and Knowledge.” Economica 4(13): 33–54.
——. 1945. “The Use of Knowledge in Society.” American Economic Review 35(4): 519–30.
Mises, Ludwig von. 1971. The Theory of Money and Credit, 2nd ed. Irvington-on-Hudson, N.Y.: Foundation for Economic Education
Rothbard, Murray N. 1951a. “Mises ‘Human Action’: Comment.” The American Economic Review 41(1): 181–85.
——. 1951b. “Praxeology: Reply to Mr. Schuller.” The American Economic Review 41(5): 943–46.
——. 1963. America´s Great Depression. Princeton, N.J.: Van Nostrand.
——. 1978. “Austrian Definitions of the Supply of Money. In Louis M. Spadaro, ed., New Directions in Austrian Economics, pp. 143–56. Kansas City: Sheed, Andrews and McMeel.
——. 1983. The Mystery of Banking (New York: Richardson and Snyder.
Salerno, J. T. 1978. “Comment on the French Liberal School.” Journal of Libertarian Studies 2(1): 65–68.
——. 1983. “Gold Standards: True and False.” Cato Journal 3 (Spring): 239–67.
——. 1984. “The International Gold Standard: A New Perspective.” Eastern Economic Journal 10 (October/December): 488–98.
——. 1985. “The influence of Cantillon’s Essai on the Methodology of J. B. Say: A Comment on Liggio.” Journal of Libertarian Studies 7(2): 305–16.
——. 1987. “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy.” Austrian Economics Newsletter 6 (Spring): 1–6.
——. 1988. “The neglect of the French liberal school in Anglo-American economics: A critique of received explanations.” Review of Austrian Economics 2(1): 113–56.
——. 1989. “Comment on Tullock’s ‘Why Austrians are wrong about depressions.’” Review of Austrian Economics 3(1): 141–45.
——. 1990. “Ludwig von Mises as social rationalist.” Review of Austrian Economics 4(1): 26–54.
——. 1990b. “Postscript: Why a socialist economy is ‘Impossible’.” Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute.
——. 1991. “Two Traditions in Modern Monetary Theory: John Law and A. R. J. Turgot.” Journal de Economistes et des Etudes Humaines 2(2–3): 337–80.
——. 1992. “The Development of Keynes’s Economics: From Marshall to Millennialism.” Review of Austrian Economics 6(1): 3–64.
——. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6(2): 113–46.
——. 1994a. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” Review of Austrian Economics 8(1): 71–115.
——. 1994b. “Reply to Leland B. Yeager on ‘Mises and Hayek on Calculation and Knowledge.’” Review of Austrian Economics 7(2): 111–25.
——. 1995a. “Ludwig Von Mises on inflation and expectations.” Advances in Austrian Economics 2: 297–325.
——. 1995b. “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation.” Journal des Economistes et des Etudes Humaines 6 (March): 153–73.
——. 1996a. “A final word: Calculation, knowledge, and appraisement.” Review of Austrian Economics 9(1): 141–42.
——. 1996b. “Why we’re winning.” Austrian Economics Newsletter 16(3).
——. 1998. Review of “J.-B. Say, An Economist in Troubled Times.” Journal of the History of Economic Thought 20(4): 524–27.
——. 1999. “The Place of Mises’s Human Action in the Development of Modern Economic Thought.” Quarterly Journal of Austrian Economics 2(1): 35–65.
——. 2001. “The Neglect of Bastiat’s School by English-Speaking Economists: A Puzzle Resolved.” Journal des Economistes et des Etudes Humaines 11(2).
——. 2002. “Friedrich von Wieser and Friedrich A. Hayek: The General Equilibrium Tradition in Austrian Economics.” Journal des Economistes et des Etudes Humaines 12(2).
——. 2004. “Menger’s theory of monopoly price in the years of high theory: the contribution of Vernon A. Mund.” Managerial Finance 30(2): 72–92.
——. 2006. “A Simple Model of the Theory of Money Prices.” Quarterly Journal of Austrian Economics 9(4): 39–55.
——. 2008. “Böhm-Bawerk’s Vision of the Capitalist Economic Process: Intellectual Influences and Conceptual Foundations.” New Perspectives on Political Economy 4(2): 87–112.
——. 2008b. “The Entrepreneur: Real and Imagined.” Quarterly Journal of Austrian Economics 11: 188–207.
——. 2010a. “Menger’s Causal-Realist Analysis in Modern Economics.” Review of Austrian Economics 23: 1–16.
——. 2010b. Money, Sound and Unsound. Auburn, Ala.: Mises Institute.
——. 2012. “Ludwig von Mises as Currency School Free Banker.” Procesos de Mercado: Revista Europea de Economía Política 9(2): 13–49.
——. 2012. “A reformulation of Austrian business cycle theory in light of the financial crisis.” Quarterly Journal of Austrian Economics 15(1): 3–44.
AustrianSimon Bilo is assistant professor of economics at Allegheny College, Meadville, Pennsylvania. This paper is a revised version of selected sections of my 2006 M.A. thesis. I would like to thank Peter Boettke, Per Bylund, Gene Callahan, Jan Havel, Marek Hudík, Juraj Karpiš, Shruti Rajagopalan, Walter Stover, Lawrence White, and participants of the Graduate Student Paper Workshop at GMU for their valuable comments and suggestions during earlier drafts of this paper. A draft of the paper was also presented at the Austrian Scholars Conference in 2009. I gratefully acknowledge the financial help that I received from the Mercatus Center at George Mason University while working on this project. All the usual caveats apply. I have known Joseph Salerno for about ten years. These were ten formative years for me — I was an undergraduate student in Prague back then; now I am teaching economics myself. Salerno played an important role in this journey of mine: he was my adviser in the summer of 2005 at the Mises Institute, he kindly agreed to write letters of recommendation for me when I was applying for graduate school, and we would see each other when the two of us were attending the Colloquium on Market Institutions and Economic Processes at New York University. economists have not ventured into the field of international economics very often and most of the exceptions wrote their work a long time ago. This is the case with the work on money and credit by Mises (1953 [1924], esp. pp. 170–86), Hayek’s discussion of monetary nationalism (1999 [1937], esp. pp. 61–73), Machlup’s (1939, 1940) and Haberler’s (1950) contributions, and Rothbard’s brief discussion in Man, Economy, and State (2004 [1962], esp. pp. 828ff.).
Of the few recent contributions made to this field, two authored by Salerno (1994a; 1994b) highlight the subjectivist perspective that Mises (1953 [1924]) holds about the determinants of the purchasing power of money in geographically separate locations. Physically identical goods in different locations are different economic goods even if we assume away all transportation costs. Because people often value separate economic goods differently, prices of physically identical goods in different locations might vary even in general equilibrium.
The insight that there can be an equilibrium with different prices between physically identical goods in different locations is important from the perspective of the absolute purchasing power parity theory, which is one of the models that tries to explain foreign exchange rates. This theory assumes the law of one price and implies that equilibrium exchange rate must equalize prices of physically identical goods across different currency areas when the prices of the goods are converted into same currency. Currently available data, however, bring this idea of absolute purchasing power parity into question: the general consensus is that in spite of high variability of foreign exchange rates, it takes a number of years at best before the exchange rate adjusts to a deviation from parity (Rogoff 1996; Taylor and Taylor 2004). It is this “purchasing power parity puzzle” (Rogoff 1996) that Mises’s subjectivist view on purchasing power of money can explain: if physically identical goods in different locations are different economic goods, it is not surprising that they have different price tags when the prices are expressed in the same currency and that absolute purchasing power parity does not hold. Yet, at the same time, there can still be a tendency toward equilibrium in the exchange rate between two currencies. The equilibrium exchange rate, however, does not reflect the purchasing power parity condition but rather the subjective valuations of goods in each currency area, given the prices of those goods in their respective domestic currencies.
In what follows, I develop the argument from the previous paragraph. I first review the insights of Mises and Salerno on the subjectivist theory of the purchasing power of money and then look at how these insights apply in the setting of two currency areas with a floating foreign exchange rate. In conclusion, I formulate the underlying subjectivist theory of foreign exchange rates.
Subjective Valuation Differentiates Purchasing Power of Money Across SpaceIn the section on “Alleged Local Differences in the Cost of Living,” Mises (1953, pp. 175–78) stresses the importance of the position of goods in space when considering the valuation of those goods and their relative prices. He illustrates how important the location of goods is by comparing the prices in Karlsbad, a desired spa destination, and prices in other cities. While the same type of good costs more in Karlsbad than in other cities, the price difference is justified because goods in Karlsbad are perceived as different types of goods. In other words, “[i]f [person] has to pay more in Karlsbad for the same quantity of satisfactions, this is due to the fact that by paying for them he is also paying the price of being able to enjoy them in the immediate neighborhood of the medicinal springs” (Mises 1953, pp. 176–77).
To generalize the previous example, one can say that the position of a good in space matters — geographic location is an important characteristic of an economic good that can change one’s perception of this good, and consequently its value and price. Physically identical goods in different locations can then be priced differently even in equilibrium (Mises 1953, pp. 177–78; Salerno 1994b, pp. 251–52).
Arbitrage Does Not Equalize Purchasing Power of Money Across SpaceOne can object that while the demand for goods might differ by location, the difference at least does not apply in the case of tradable goods, which can be easily transported from one place to another. The demand for apples in the city of Meadville in Northwestern Pennsylvania, for example, might be lower than the demand for apples in Manhattan, incentivizing suppliers to distribute apples accordingly and eventually equalize the prices of apples in both places. If the existing relative supply of apples in these two places results in lower relative price of apples in Meadville, this incentivizes entrepreneurs to ship apples from Meadville to Manhattan to equalize the profits from selling apples in the two different places. Assuming perfect competition and zero transportation costs, one might say that profits equalize when the price of apples in Meadville is the same as the price of apples in Manhattan.
However, since tradable goods are usually bundled with non-tradable complements as Rogoff (1996, pp. 649–50) and Taylor and Taylor (2004, pp. 136–37) briefly note, location also affects the prices of tradable goods. Shelf-space, for example, is one such non-tradable complement: returning to the apple parable, a sufficient lack of shelf-space in Manhattan may fail to incentivize shop-keepers to supply enough apples to equalize prices between Meadville and Manhattan. In this case, the opportunity cost of supplying so many apples is too high; Manhattan shop-keepers would rather use the scarce shelf-space to offer other products while keeping the price of apples relatively high.
To generalize the example, one can say that tradable goods often need to be bundled with non-tradable complements when sold in specific geographic locations. Since these complements might be subjectively valued and priced differently across locations, opportunities to arbitrage price differentials across space are limited. This limitation might then lead to price differentials between physically identical goods sold in different geographic locations.
Subjective Valuation Differentiates Purchasing Power of Money also Across Currency AreasThe conclusion that physically identical goods can vary in equilibrium prices between different locations also applies to the case of two separate currency areas. This application suggests that foreign exchange rates do not necessarily correspond to the absolute purchasing power parity of the respective currencies. To illustrate this point, I will use a modified version of the previous section’s apple parable.
Assume that there are only two places in the world: Manhattan and London. Each city has its own independent fiat currency so that people in Manhattan use the dollar ($) and people in London use the pound (₤). Let’s assume an equilibrium where an apple in Manhattan costs $6 and where a physically identical apple located in London sells for ₤2. Assuming away transportation costs, the absolute purchasing power parity theory says that the equilibrium exchange rate between dollars and pounds is $6 per ₤2, i.e., $3/₤1. If the foreign exchange rate was different, the purchasing power parity theory suggests that this would create a state of disequilibrium with associated arbitrage opportunities that buyers and sellers will exploit until the exchange rate $/₤ is equal to the ratio of the price of apple expressed in dollars over the price of apple expressed in pounds.
However, the subjectivist insight proposed by Mises (1953) and emphasized by Salerno (1994a; 1994b) suggests a very different conclusion about the equilibrium exchange rate. Following the example, even if $6 and ₤2 are the equilibrium prices of apple in Manhattan and London respectively, the two prices tell us little about the equilibrium foreign exchange rate between dollars and pounds. The difference in geographic location means that apple in Manhattan and apple in London represent two different economic goods. The difference means that while $6 is the price of an apple in Manhattan, we cannot necessarily infer from this that in equilibrium people are willing to pay the pound equivalent of $6 for an apple in London. People might be paying more or less for an apple in London than its dollar equivalent, depending both on the demand for apples in London and on the prices and subjective values of complementary non-tradable goods necessary to sell apples in London. Assuming that the equilibrium price of an apple in London is ₤2, this implies the exchange rate $/₤ can be below or above the absolute purchasing power parity of $3/₤1.
Purchasing power of money is therefore unequal across currency areas in the same way it is unequal across different geographic locations within the same currency area. Goods with identical physical characteristics but different locations are different economic goods (Salerno 1994a, p. 107). In equilibrium, such goods can have different prices when their respective prices are converted into the same currency unit. As a result, equilibrium foreign exchange rate does not have to equalize the prices of goods across currency areas and therefore does not have to adhere to the absolute purchasing power parity condition.
Foreign Currency is Valued Subjectively as a Means Toward Goods in Its Currency Area/p>If absolute purchasing power parity is not the equilibrium condition for the foreign exchange rate between two currencies, what are the equilibrium conditions? It is important to realize in this regard that people demand money because it is medium of exchange (Mises 1953, pp. 30ff.) — a medium of directly purchasing goods in its corresponding currency area. Assuming that money does not have non-monetary uses, people value different currencies against each other depending on the economic goods they can procure with those respective currencies (Mises 1953, pp. 180–81).
The foreign exchange rate of a currency thus depends on the prices that people expect to pay for goods using the currency. If expected prices increase in one currency, demand for that currency drops at the foreign exchange market and its exchange rate becomes less favorable; if the expected prices decrease, the demand for the currency increases and its exchange rate becomes more favorable. In contrast to the absolute purchasing power parity theory, however, the relationship between the foreign exchange rate between two currencies and the prices of goods that people using each currency can buy is qualitative and does not follow a pre-determined mechanical formula. The numerical imprecision of the law explaining determinants of foreign exchange rates is a necessary consequence of the fact that most of the goods that people buy with each currency are different economic goods that people value subjectively. People’s subjective valuations therefore act as a filter for every price change of a good expressed in that currency: people ultimately decide to what extent the price change has an effect on their demand for the currency in question.
Conclusion: Subjectivism and International EconomicsIn his 1994a and 1994b articles, Salerno restored attention regarding Mises’s subjectivist approach to monetary theory and international economics. This approach helps us to understand why economists have been struggling to empirically confirm the absolute version of the purchasing power parity theory. They have been unsuccessful because the theory assumes the law of one price for goods that have identical physical characteristics but which differ in location. Because the difference in location means that these goods are in reality different economic goods, the law of one price does not have to hold and the absolute purchasing power parity can be violated even in equilibrium. The subjectivist approach to international economics thereby gives us yet another illustration of the importance of subjectivism in economics that was emphasized by Hayek (1952, p. 31).
ReferencesHaberler, Gottfried. 1950. The Theory of International Trade. William Hodge & Company.
Hayek, Friedrich A. von. 1952. The Counter-Revolution of Science. Glencoe, Ill.: Free Press.
——. 1999 [1937]. “Monetary Nationalism and International Stability.” In Stephan Kresge, ed., The Collected Works of F. A. Hayek, Vol. 6: Good Money Part II: The Standard, pp. 37–100. London: University of Chicago Press and Rutledge.
Machlup, Fritz. 1939. “The Theory of Foreign Exchanges.” Economica, n.s. 6(24): 375–97.
Machlup, Fritz. 1940. “The Theory of Foreign Exchanges.” Economica, n.s. 7(25): 23–59.
Mises, Ludwig von. 1953 [1924]. The Theory of Money and Credit. New Haven, Conn.: Yale University Press.
Rogoff, Kenneth. 1996. “The Purchasing Power Parity Puzzle.” Journal of Economic Literature 34(2): 647–68.
Rothbard, Murray N. 2004 [1962]. Man, Economy, and State with Power and Market. Scholar’s Edition. Auburn, Ala.: Mises Institute.
Salerno, Joseph T. 1994a. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” Review of Austrian Economics 8(1): 71–116.
——. 1994b. “International Monetary Theory.” In Peter Boettke, ed., The Elgar Companion to Austrian Economics, pp. 249–57. Aldershot, Hants, England and Brookfield, Vermont: Edward Elgar.
Taylor, Alan M., and Mark P. Taylor. 2004. “The Purchasing Power Parity Debate.” Journal of Economic Perspectives 18(4): 135–58.
TextbookGuillaume Vuillemey is a PhD student in economics at Sciences Po, Department of Economics, Paris, France. I was a summer research fellow at the Mises Institute in 2009, under the guidance of Professor Joseph Salerno. descriptions of financial markets draw a clear and seemingly unambiguous distinction between spot and future transactions. Whereas future transactions are often confined to derivatives markets, everyday trades on stocks, bonds or other assets are said to be spot. Furthermore, common descriptions of spot transactions usually do not distinguish between (i) the time a trade is agreed upon and (ii) the time it is paid for and delivered, as both are assumed, by definition, to take place virtually at the same point in time.
This chapter provides a theoretical investigation of high-frequency trading (HFT), which arises from the lag existing — even for seemingly spot transactions — between steps (i) and (ii). To this end, I shall redefine the dichotomy between spot and future transactions when the settlement of trades does not occur in real time but with a lag, and when this lag can be exploited by algorithms, computerized techniques or human decisions.
High-frequency trading consists of trade exposures opened and closed between settlement dates by market participants ensuring that their net open exposure at the settlement time is zero (implying that none of the trades performed intraday are either paid for or delivered). HFT transactions are not akin, for conceptual understanding, to usual trades that would merely be executed “faster” or to positions being liquidated after a shorter period of time. One distinguishing characteristic of HFT activities is that they can be performed with virtually zero cash or securities’ holdings in the first place, as the trader ensures a zero net position at the settlement date.
This chapter investigates two questions. First, does HFT imply that intraday buy and sell trades are performed using temporarily ex nihilo created fiat money? Second, can the case where securities are agreed-upon but never delivered create multiple (therefore conflicting) but valid property rights on particular assets? The issue at hand resembles those raised by fractional reserve banking. Importantly, this chapter does not comment on the status of high-frequency trading under various legal systems or jurisdictions — this is left for future research — and instead focuses only on the theoretical conditions under which the above-mentioned consequences may occur.
If the above questions are to be given a positive answer, then serious consequences follow as regards intraday liquidity management in payment and settlement systems. An example is that of “failures to deliver” arising from high-frequency trading from naked short selling, whereby a trading institution is not able to deliver at settlement date securities it has been selling during the day.On the extent of failures to deliver in the United States, see SEC Fails-to-Deliver Data. Other consequences may relate to intraday collateral management, for instance in the case where securities are bought and delivered as collateral before the settlement of the initial purchase. Besides economics, ethical and legal issues raised by the potential over-issuance of property rights through high-frequency trading activities are akin to those raised by Mises (1996) or Huerta de Soto (2011) in the case of fractional reserve banking. An overview of Mises’s views on fractional reserve banking and monetary theory can be found in Salerno (1994).
Answering the above questions requires a careful analysis of the consequences of the lag between the time trades are agreed and the time they are paid for and delivered. I will show that, when clearing and settlement do not occur in real time, trades that are usually — theoretically and/or legally — described as spot must be treated as futures if a careful economic analysis is to be conducted. I also provide a criterion to distinguish between spot and future trades. Finally, I show that the over-issuance of property rights arising from HFT exists when transactions which should be treated as futures are legally or factually treated as spot.
The remainder of the chapter is structured as follows. First, high-frequency trading is described and is shown to be merely the exploitation of the lag between the time trades are agreed upon and the time they are settled. Its fundamental difference with other (“usual”) trading activities is also highlighted. Then, the distinction between spot and future transactions is refined. Trades on financial markets where settlement is delayed are shown to be meaningfully understood as futures. Finally, I define the conditions under which certain legal treatments of high-frequency trades as spot or as future transactions may lead to the over-issuance of property rights, thus give rise to liquidity risk in payment and settlement systems.
High-Frequency Trading as the Exploitation of Delayed SettlementI shall start by examining the nature of high-frequency trading and the conditions under which it arises. High-frequency trading on an exchange platform consists of trades usually performed by computer algorithms so as to benefit from private information regarding the order flow or from small price variations over short horizons (ranging from a few milliseconds to a few hours). The major characteristic of high-frequency trading algorithms is that they ensure a virtually zero net open exposure at the end of each trading day, so that no cash or securities have to be physically delivered. High-frequency trading has recently become a sizeable phenomenon on financial markets, as it represents up to 70 percent of all trades on some organized stock exchanges (see Swinburne 2010).
I do not propose an extensive review of the literature (which can be found in Gomber et al., 2011). Most of the academic work revolves around the consequences of high-frequency trading on particular aspects of the price system, typically on the price formation mechanisms (bid-ask spreads, “price discovery” mechanisms, etc.).Another issue regarding high-frequency, which has been less dealt with in the literature, is the extent to which it is akin to insider trading, as some high-frequency traders benefit from their technological superiority to get market information (on incoming buy and sell orders especially) ahead of other market participants. This issue is not addressed in the present chapter. For instance, one oft-mentioned concern relates to the fact that high-frequency trading may amplify price volatility to the extent of triggering “flash crashes.”The most prominent example of so-called “flash crash” occurred on May 6, 2010, when the Dow Jones Industrial Average plunged by about 9 percent before recovering in a few minutes. High-frequency trading algorithms have been shown to play a role in the amplification of the drop (see SEC, 2010). Among the main findings documented in the empirical literature are a reduction in trading costs and bid-ask spreads (see Brogaard 2010; Hasbrouck and Saar 2010) and a decline in short-term volatility (see Jarnecic and Snape 2014 or Brogaard 2011). Contrasting with the existing literature, this chapter focuses on an issue of a completely different order, largely neglected up to now. I do not focus on the empirical or theoretical consequences of high-frequency trading on particular aspects of the price system, but instead provide a theoretical analysis of high-frequency trading as regards property rights on cash and on traded securities. More precisely, do HFT activities lead to the over-issuance of property rights or to the ex nihilo creation of money?
An essential preliminary to be mentioned is a key institutional feature of present-day financial systems, namely the lag that exists on financial markets between the time trades are agreed (prices and quantities are decided upon) and the time payment and delivery actually take place. Whereas trade orders can be executed at any point in time during the trading day, clearing and settlement occur at one point only during the day, usually at the end of the trading session or up to T+72 hours. It is of utmost importance to highlight that such a time lag for so-called spot transactions is essentially institutional, i.e., that it does not primarily exist as a consequence of any physical or operational constraint. With the advent of computerized technologies at all stages of post-trade processing, real-time settlement (or quasi real-time settlement, as several actors have to be coordinated) could be a perfectly valid and implementable contractual or legal framework. For instance, real-time gross settlement systems (abbreviated RTGSA comprehensive overview of RTGS payment systems is provided by the Bank of International Settlements (1997).) exist for interbank payments — such as Fedwire in the United States and TARGET2 in Europe.
As a preliminary, I shall examine the extent to which high-frequency trades differ from other (“usual”) trades and show that high-frequency trading primarily exists as a consequence of delayed settlement. One key theoretical question for my purposes is actually whether high-frequency trades are akin to “usual” trades that are performed faster (an asset being bought at some date and sold a short moment — from microseconds to several hours — later), i.e., trades that could be fully described in theoretical terms by the canonical description of exchange phenomena (see Mises, 1996, for example). I aim to show that high-frequency buy-and-sell trades cannot be understood theoretically as a combination of spot buy and sell transactions.
I shall begin with a mere description of the steps involved in any combination of spot buy and sell transactions. For trader A, a usual buy-and-sell transaction amounts to (i) agreeing with B on prices and quantities, (ii) paying the agreed-upon monetary units to B in exchange for the agreed-upon good, and at a later date (iii) agreeing with C on prices and quantities and finally (iv) delivering the agreed-upon good to C in exchange for the agreed-upon monetary units.
On the contrary, high-frequency buy-and-sell operations do not imply, at any time, either any disbursement of cash or any physical delivery of a security or good. This is due to the fact that steps (i) and (iii) occur between two settlement dates, so that the buy and sell transactions never have to be paid for or delivered. If a buy-and-sell operation is performed within a few seconds, or even within a few hours, it will never have to be physically settled. One characteristic of high-frequency trading is indeed that investment positions are held for short periods of time so that net exposures are virtually zero at the end of each trading day, when clearing and settlement occur. As a result, high-frequency trading activities can virtually be performed with zero initial cash and zero initial securities (neglecting trading fees or initial cash balances to be maintained at the exchange platform). One may thus move in and out of investment positions thousands of times a day without having either to pay for the securities it buys or to physically deliver the securities it sells. A trader who consistently ensures a zero net open exposure at the end of the trading day can perform his activities without any holding of either cash or securities in the first place.
It must be clear at this stage that the latter feature — the absence of any physical payment or delivery — exists only because of the delayed settlement of all trades. If trades were to be cleared and settled in real time, or in approximately real time, then high-frequency trading would essentially disappear as it would become impossible to trade without virtually any cash or securities initial endowment. What would remain would eventually be buy-and-sell trades that are executed “quickly,” but not high-frequency trades. In order to further understand high-frequency trading, the legal consequences of delayed settlement have to be clearly grasped.
Spot vs. Futures and the Status of Financial TradesGiven delayed settlement, can trades on financial markets be regarded as spot transactions? A clear understanding of the distinction between spot and future transactions is of utmost importance for my purposes, as each of these transactions implies different consequences regarding the property rights at stake. What is usually referred to as a spot transaction is a transaction where both (i) the agreement between two parties on prices and quantities and (ii) the payment on one side, the delivery of the agreed-upon goods on the other side (or clearing and settlement) occur virtually at the same time, meaning that the time span between steps (i) and (ii) is insignificant for human action and for economic theory. One can see that what is crucial to the definition of a spot transaction is whether settlement is delayed or not.
The dichotomy, however, is not as clear-cut as it seems. Strictly speaking, agreement on prices and quantities on one side, and payment and delivery on the other side, are very unlikely to occur at the exact same time in everyday exchanges. Think of a baker who gives a piece of bread to a customer and receives cash only a few seconds after both parties agreed on prices and quantities. Clearly, considering physical time, there is a lag between the agreement between the parties and the process of payment and delivery. Does this imply that this transaction should not be considered as spot but as future? Considering physical constraints, what lag is low enough so that a transaction can be considered spot and not future? One hour? Ten seconds? One microsecond? Phrased this way, the question is misleading and the distinction between spot and future transactions has to be rephrased. The relevant time to be considered is not the physical time but the time of human action. More precisely, one is faced with the problem of continuums in human action and economic behavior. Rothbard (2001, pp. 264–65) argues:
The human being cannot see the infinitely small step; it therefore has no meaning to him and no relevance to his action. Thus, if one ounce of a good is the smallest unit that human beings will bother distinguishing, then the ounce is the basic unit. … If it is a matter of indifference for a man whether he uses 5.1 or 5.2 oz. of butter, for example, because the unit is too small for him to take into consideration, then there will be no occasion for him to act on this alternative.
Similarly, if the lag between the time a trade is agreed and the time it is paid for and delivered has no relevance for human action, then it does not make sense to label as future a transaction where such lag is, say, of 10 seconds. Asserting that it is irrelevant for human action means that the buyer of the agreed-upon good does not and cannot engage in any other transaction or operation involving property rights on the good between the time prices and quantities are decided upon and the time payment and delivery take place. For example, the good bought cannot be pledged as collateral once its purchase is agreed but before it has actually been received. What fundamentally distinguishes a spot from a future transaction is not the physical time lag that virtually always exists (even if very short) between the time a trade is agreed and the time it is paid for and delivered, but whether this time lag is relevant and meaningful for human action. A similar argument has recently been made by Bagus and Howden (2012), who distinguish between demand and term deposits in the debate on fractional reserve banking.
Consider a trading platform with a low level of computerized automation, a relatively low speed of order execution (as compared to present-day speeds) and an end-of-day clearing and settlement. This is roughly akin to what used to exist about fifteen years ago before the tremendous technological improvements underwent by trading platforms. On such an exchange, a lag between clearing and settlement exists but it is essentially irrelevant for human action, as it cannot be exploited — or possibly very marginally. Thus, everyday transactions on such a platform can, without any major theoretical difficulty,In a world where the automation of stock exchanges through computer systems is low or inexistent, i.e., where high-frequency trading or multiple intraday transactions on the same security are virtually not possible, treating as spot a transaction that is technically future (with a maturity of a few hours up to 24 hours) may only matter in case of bankruptcy — for example, if bankruptcy is declared between the time a trade was agreed and the time it was supposed to be paid for and delivered. be treated legally and conceptually as spot.
The whole picture changes with technological improvements when high-frequency trading arises, i.e., when the lag between the time trades are agreed upon and the time they are paid for and settled can be meaningfully exploited. More precisely, a security that has been bought at some point during the day can then be re-sold before being first physically received. Faced with the above-outlined continuum problem, I explained that the distinction between spot and future transactions is to be expressed not in terms of the physical time between agreement and settlement but in terms of time meaningful for human action. Therefore, if high-frequency trades are to be understood as trades that are agreed upon but never paid for and delivered, they can no longer be understood as spot transactions and can conceptually be defined more meaningfully as future transactions. Future transactions differ from spot transactions in that they are agreed in the present but paid for and delivered at a future date, so that the time lag between the agreement on prices and quantities on one side, and the clearing and settlement on the other, is no longer irrelevant for economic and legal theory. In terms of property rights, spot and future transactions are different in esse. Spot transactions are the exchange of property rights over present goods, whereas future transactions are the exchange of claims on property rights on future goods.
If it is clear that high-frequency trades are to be considered as futures, what about trading positions that are kept open until the settlement date, i.e., transactions that will indeed be paid for and delivered? An important issue to highlight is that nothing makes it possible to distinguish ex ante a high-frequency trade from any other trade. When a buy or sell order is executed on the market (“execution” here referring not to the fact that a trade is paid for and delivered, but merely to the fact that a buyer is matched with a seller, i.e., that an agreement on prices and quantities is reached), nothing makes it possible to identify trades of two different types as there cannot exist prescience, at least for an external observer, about whether the position will be liquidated or not before the settlement date. All trades are potentially high-frequency trades ex ante. When there is no real-time settlement, all trades must therefore be regarded as futures in the first place, so as to account for the institutional lag between the time of order execution and the time of clearing and settlement. Indeed, the possibility that a particular trade be high-frequency always exists before the settlement time. In this context, trading positions that are left open over at least one settlement date can be considered similar to future contracts that are kept until maturity, whereas trading positions that are liquidated before settlement date are akin to future contracts that are never delivered.
Legal Treatment and Consequences for Property RightsAll transactions that are usually regarded as spot in economic analysis have been shown to be better understood as futures. Moreover, I explained how different are the implications of spot and future transactions in terms of property rights. Following the above analysis, one needs now to investigate how various legal or contractual arrangements may result or not in the over-issuance of property rights or in the ex nihilo creation of fiat money. Can one think of cases where such over-issuances from high-frequency trades exist because of the lag between the time trades are agreed and the time they are cleared and settled?
First, if all trades on financial markets are to be seen as futures, it must be emphasized that future transactions do not entail any over-issuance of property rights. When one sells at some date a security to be delivered in the future, it does not matter at all whether he actually owns the security in the first place. To understand this, the distinction between a present good and a future good must be restated. What is exchanged in a future transaction is a claim on a future good against a claim on future money. One must emphasize that only claims are exchanged, so that no property rights on present money or securities are exchanged (or involved in any way). Therefore a future transaction, if properly dealt with contractually and legally, is not and cannot imply any over-issuance of property rights. The only point in time where property rights on actual physical securities and on money matter is at the maturity date, i.e., when the future transaction has to be settled. The same reasoning applies for any trade (including high-frequency trades) correctly understood as a future trade. When a security “is bought” during a trading session, what is actually bought is a claim on a future security to be delivered at the settlement time (say, the end of the trading day). Similarly, what is sold in such a transaction is not present money but a claim on future money. If all trades on financial markets are to be treated legally and contractually as future transactions in this precise sense, then high frequency trading does not imply any over-issuance of property rights. A high-frequency trader would then be perfectly akinOne slight difference is that one party usually has to pay a present premium in order to enter a future transaction. This, however, is not a necessary element of a future contract. The only payment that a high-frequency trader has to make — like any other trader — is the trading fee to the exchange platform. to a trader on futures markets who buys and sells contracts on oil, currencies or whatever securities but consistently unwinds his positions before the maturity date (i.e., never gets delivered with the underlying assets nor pays for any of these assets). Such traders consistently trade claims on future goods but never wait for the maturity of the future contract. This cannot lead to the over-issuance of property rights. In such a case, it is likely beneficial to market liquidity, similar to dealers in futures markets providing liquidity to end-user investors.
Alternative theoretical cases shall nevertheless be considered. Up to now, I have explained without further explanation that high frequency trading does not imply the over-issuance of property rights if trades are “treated legally and contractually as future transactions.” Such a proviso is of the utmost importance. Confusion may indeed come from the fact that what has been here described as future transactions is usually, in textbook explanations of the phenomenon, described as spot transactions. What if trades that are factually futures (as they are paid for and delivered only at an end-of-day settlement date) were to be treated legally and contractually as spot? Or, in other terms, what if an inconsistency in the legal framework exists, so that delayed settlement is the norm for transactions legally treated as spot? Once again, I shall make clear that the issue whether trades are treated as future or as spot under various legal systems or jurisdictions is complex and is not discussed in the present chapter, as my focus is on economic theory only.
In this case, a high-frequency trader buying a security during the day (to be delivered at the end of the trading day) could possibly engage in other operations involving property rights on a present security — not only claims on property rights on future securities — for example by pledging this security as collateral. Until either the settlement date or the date the position is liquidated, there would be two seemingly legitimate owners of the exact same security. This case would clearly result in an over-issuance of property rights that are not backed by actual physical securities. This is reminiscent of “circulation credit” or “inflation” in Mises’s sense (Mises 1981; Salerno 2000). Similarly, assume that a seller is able to use intraday the cash he is supposed to be delivered only at the settlement date — for example to repay a maturing debt — then such cash must be considered as ex nihilo created fiat money, as no one renounced yet to this quantity of money in the present. Once again, this would merely be an over-issuance of fiat money, which may have serious implications for liquidity risk in payment and settlement systems in a stressed environment.
ConclusionThis chapter provided a theoretical examination of high-frequency trading, focusing on whether it creates either additional property rights that are not backed by physical securities or ex nihilo created money. This is likely to occur as high-frequency traders can buy and sell large amounts of securities without virtually any cash or securities endowment in the first place. One key feature for a theoretical understanding of high-frequency trading is that it exploits the lag between the time trades are agreed and the time they are paid for and settled. In turn, high-frequency trading as it is currently practiced would essentially disappear if clearing and settlement were to be implemented in real time.
Whereas the time lag between the execution of a trade (i.e., the matching of a buyer and a seller) and its settlement has long been virtually irrelevant for human action as it could not be exploited — or only to a very limited extent — the advent of electronic trading platforms and of computerized trading algorithms enabled exploiting this lag to a greater extent. What used to be considered as spot transactions without any major conceptual difficulty can no longer fit the stylized description of a spot transaction, i.e., a transaction where payment and delivery occur virtually at the same time as the agreement on prices and quantities. Given that powerful computer techniques enable exploiting smaller and smaller lags (nowadays a few microseconds), the dichotomy between spot and future transactions has to be re-thought. Faced with the continuum problem, I argue that the distinctive criterion which ultimately matters is not the physical time lag that almost necessarily exists between trade agreement and delivery, but whether this lag is meaningful for human action — or, eventually, for algorithms executing models designed by humans. In that regard, all transactions usually regarded as spot have to be treated conceptually as futures with the advent of high-frequency trading techniques (of course, as long as the institutional lag between trade execution and delivery is maintained).
Turning to a legal analysis of high-frequency trading, I show that — in a system where settlement is delayed — the issue whether an over-issuance of property rights exists ultimately depends on whether it is treated legally as spot or future. If high-frequency trades are properly dealt with as futures — i.e., not as an exchange of property rights on goods, but as claims on property rights on goods — then no such consequences follow. This implies, for example, that traded securities cannot be pledged as collateral before they are physically delivered. On the contrary, if high-frequency trades are treated legally, contractually or factually as spot, then there exists over-issuance of property rights, even though it is for short time periods. This gives rise to liquidity risk in payment and settlement systems.
Following the above analysis, two research directions are to be outlined for future work. First, I set a theoretical framework indicating under which legal arrangements high-frequency trading may or not lead to the over-issuance of property rights. A survey of the existing legal frameworks in the United States or in Europe would be highly valuable as a complement. Second, from a theoretical perspective, the framework set out above could be extended to the study of another controversial market practice, namely naked short-selling. Naked short-selling occurs when a security is shorted before being first borrowed or located. A legal issue therefore is whether it is fraudulent in that one is selling something he does not own in the first place. This practice could be fruitfully analyzed not as the shorting of a security but as the shorting of a claim on a security, therefore as a future.
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TheEduard Braun holds a postdoctoral position to the chair of economics at Clausthal University of Technology, Clausthal-Zellerfeld, Germany. I attended the Mises University in 2007 and was a summer research fellow in 2008. The present chapter is an outflow of my introduction to and study of German economic thought between 1800 and 1950, which I became interested in while a summer fellow at the Mises Institute under the direction of Professor Salerno. Historical school of economics does not enjoy the best reputation among present-day economists, but especially the Austrian school appears to be out of sorts with its former adversary in the Methodenstreit. It seems fair to say that David Gordon’s (1996, p. 7ff.) account, according to which the members of the Historical school bluntly rejected economic laws like the principle of supply and demand, is generally accepted among Austrian scholars today. In the English-speaking world, Friedrich von Hayek, Joseph Schumpeter, and Ludwig von Mises are mainly responsible for this state of affairs (Hodgson 2010, p. 296; Grimmer-Solem and Romani 1998, p. 268).
I do not try, in this chapter, to overturn this negative judgment. However, I would like to point out that there are some elements in the body of Austrian Economics that definitely stem from the Historical school. Surprisingly, the Historical school acts as the model for Mises’s capital concept and, by implication, for his economic calculation argument against socialism. Mises’s discussion of the fundamental difference between capitalism and socialism does not, or not only, rest upon praxeological reasoning. In fact, the same praxeological laws apply in both capitalism and socialism. In order to make his case, Mises has to presuppose several historical institutions that only exist in developed and monetized market economies. In this context, he draws on concepts developed by the Historical school. It was not necessary for him to acknowledge his debt to this school — and possibly he was not even aware of it — because he could act on the authority of Carl Menger, at least regarding the capital concept they both employed. Carl Menger himself, however, derived the capital concept on which Mises would later rely directly from Richard Hildebrand, a member of the Historical school. Like in monetary theory (see Gabriel 2012, p. 41), the influence of the Historical school on Mises concerning capital theory was an indirect one — via Menger.
The present chapter starts, in section 2, with a short presentation of how Menger, in 1888, changed his point of view on capital, and continues, in section 3, with the demonstration that Menger, in adopting the new and different view, made a step toward the Historical school. Section 4 traces this historical point of view on capital in Ludwig von Mises’s writings. It cannot be said that section 5 demonstrates, once and for all, that Mises implicitly admitted that economics is, in some sense, a historical science. But it tries to indicate the difference he made between praxeology and economics. The former he calls the general theory of human action, but the latter he does not consider to be entirely free from historical preconditions. Finally, section 6 contains a short discussion of Albert Schäffle’s analysis of economic calculation as a central institution of capitalism. Apparently, Mises argument against the feasibility of socialism was at least foreshadowed by a member of the often ridiculed Historical school.
Carl Menger on CapitalCarl Menger changed his point of view on capital theory considerably between 1871 and 1888 (Schumpeter 1997, p. 187; Braun 2014). He did not discuss capital very deeply in his Principles (Stigler 1937, p. 248), but to the extent he did, he advocated a capital theory that is concerned with production. His capital theory was connected to his vision of the production process as divided into several successive stages, where consumer goods result from the successive processing of combinations of higher-order goods to lower-order goods. Menger (1871, p. 155) says that one possesses capital if one “already has command of quantities of economic goods of higher order … in the present for future periods of time.” By adding this aspect to production theory and associating it with capital theory, he laid the groundwork for Austrian capital theory as developed by Böhm-Bawerk (1930), Friedrich von Hayek (1941), and Ludwig Lachmann (1978).
It is seldom recognized that by 1888 Menger had changed his view. In a long article on the subject — Zur Theorie des Kapitals (A Contribution to the theory of capital) — Menger proposed a radically different vision of the scope of capital theory. Streissler (2008, p. 371) is of the opinion that, by writing his article, Menger only made a prepublication attempt to refute the theory of Böhm-Bawerk. However, it seems more probable that Menger turned against all capital theories — including his own one — which have been developed by economists in disregard of everyday language use and established business practices. At the very outset, he declares that it is
a mistake that cannot be disapproved of enough when a science … denotes completely new concepts by words that, in common parlance, already describe a fundamentally different category of phenomena — a category that is also important for the respective discipline — correctly and properly (Menger 1888, 2).
It could be suggested that he was referring mainly to Böhm-Bawerk’s theory in this quote. However, there is every indication that Menger also implicitly revoked his earlier point of view. For the common parlance concept of capital is not identical with his own one from the Principles at all. In Menger’s (1888, p. 37; emphasis added) words, the common parlance view has nothing to do with the production process or the different orders of goods:
When businessmen and lawyers speak about capital, they do mean neither raw materials, nor auxiliary materials, nor articles of commerce, machines, buildings and other goods like this. Wherever the terminology of the Smithian school has not already penetrated common parlance, only sums of money are denoted by the above word.
He hastens to add that capital only embraces sums of money that are dedicated to the acquisition of income, and that “sums of money” not only refers to plain money, but to the monetary value of all kinds of business assets in economic calculation.
Menger thus switched sides in a debate that seems to be as old as economics itself. Does the term “capital” refer to a production factor or does it refer to the organization of the market economy by calculating entrepreneurs who maximize the monetary yield on their financial capital? At a first glance, the distinction between these two viewpoints does not seem to create a great problem. To give an example, even Mises (1949, p. 260 ff.) contains traces of both concepts of capital. He reserved the plain term “capital” for the economic calculation of entrepreneurs but, for lack of a better term, he referred to the produced goods of higher orders as “capital goods.” The next section will demonstrate, however, that the two sides of the term capital do not fit together harmoniously; rather they roughly correspond to the two sides of the Methodenstreit between the Austrian and the Historical school of economics. Menger’s earlier concept was elaborated to Austrian capital theory, whereas his concept of 1888 turns out to be the one endorsed by the Historical school.
The Historical School as the Source of Menger’s Later Viewpoint on CapitalThe first thing that must be mentioned is that Gustav Schmoller, Menger’s principal opponent in the Methodenstreit, was quite happy with Menger’s later standpoint on capital theory. In his Grundriß der allgemeinen Volks-wirtschaftslehre, Schmoller (1904, p. 180; emphasis added) appreciated Menger’s step toward the common parlance concept of capital:
Where one has provisions of goods in mind that technically serve further production, one may also use the term capital; often it will be better to say acquisitional wealth. All in all it seems to me to be the right thing to return, with C. Menger, to the capital notion as established in business life.
In fact, it can hardly surprise that Schmoller welcomed Menger’s shift of opinion. In his 1888 article, Menger clearly adopted the viewpoint of the Historical school of economics.
It is easy to demonstrate this point. When Karl Rodbertus (1843, p. 23ff.) made, probably for the first time in the history of economic thought (Jacoby 1908, p. 27), the distinction between social and private capital — between capital as a production factor and capital as a means of acquisition and calculation denominated in money — he ascribed each term to a distinctive problem area. For him, social (or real) capital is a universal, absolute, and pure concept that can be defined independently of time and place. It is the capital concept that he thought is apt for economic science. Private capital, on the other hand, only has relative importance. It results “from the arbitrary ingredients of a historical state of affairs. It would disappear if profit-yielding property disappeared” (Rodbertus 1843, p. 24, n.; emphasis added).
In other words, the capital concept which Menger used in his Principles and which later Austrians like Böhm-Bawerk, Hayek, and Lachmann adopted (and which relates to Mises’s “capital goods”) can be found in any economic system and in any time period. Individuals in isolation, like Robinson Crusoe, employ higher order goods in the same way as a socialistic and a capitalistic society does. It is a general theoretical concept and independent of historical factors. Monetary calculation, on the other hand, which is the background of Menger’s later (1888) capital concept, is only a historical phenomenon. It is neither part of Robinson’s island nor of a socialist society. It only appears in a developed and monetized market economy where property rights to the means of production are enforced. Later on, German economists like Adolph Wagner generally referred to this concept of capital as the historical-legal one (Jacoby 1908, p. 28).
That Carl Menger adopted the viewpoint of the Historical school becomes even more obvious when one compares his 1888 article with what Richard Hildebrand had written five years earlier. Hildebrand, a member of the Historical school teaching in Graz, Austria (Schulak and Unterköfler 2011, p. 25), had written a book on monetary theory that contained one chapter on capital. There, he clearly foreshadowed Menger’s later position. First of all, like Menger (1888), he rejected the efforts of economists to create capital concepts that deviate from common parlance. Hildebrand (1883, p. 72, n. 35) counters the
idea that the capital concept is open to arbitrary terminology at all, or that science, in a way, has to create or invent the concept in the first place. To the contrary, the concept of capital … is a fact that is already given by economic life.
Second, Hildebrand’s positive view of the common parlance concept unsurprisingly coincides with Menger’s. He (1883, p. 74, n. 35) states that “capital indeed can only be thought of or imagined as a certain sum of money,” and, like Menger, he immediately adds that capital also comprises real assets in so far as they have or represent monetary value.
Ludwig von Mises on CapitalAs opposed to nearly all other Austrian economists to the present day, Ludwig von Mises did not follow Menger’s discussion of capital as contained in the latter’s Principles, but was oriented toward the 1888 article on capital theory. This shines through, for the first time, in his treatise on Socialism where he explicitly refers to Menger (1888) and states:
[W]e must first ask what significance is attached to the term [capital] in business practice. … The concept of capital is derived from economic calculation. Its true home is accountancy — the chief instrument of commercial rationality. Calculation in terms of money is an essential element of the concept of capital. (Mises 1951, p. 123)
In his Human Action, Mises went a step further and not only stuck to the monetary notion of capital, but explicitly rejected the social (or real) capital concept. He (1949, p. 262) called it a confusion to argue, as some economists do,
that “capital” is a category of all human production, that it is present in every thinkable system of the conduct of production processes — i.e., no less in Robinson Crusoe’s involuntary hermitage than in a socialist society — and that it does not depend upon the practice of monetary calculation.
So in fact, without admitting it though, Mises adhered to the capital concept developed and called for by the Historical school of economics. He did not follow the early Menger or Böhm-Bawerk, who had assigned capital theory to the analysis of the production process; he rather built upon Menger’s later article which was, as shown above, a concession to the Historical school.
The Historical Character of Economics — According to Ludwig von MisesWhy did Mises rely on the historical-legal capital concept? After all, Mises argued that economics is a part of the more universal science praxeology, and that praxeology is the science of every kind of human action (Mises 1949, p. 3). According to this classification, no historical relativity is involved in economics, and therefore the real capital concept, which can easily be reconciled with every individual human action like it is done in Crusoe economics, seems to suggest itself. However, it is often overlooked that economics is not identical with praxeology, even in Mises’s own thinking.
Whereas praxeology, the general theory of human action, “can be precisely defined and circumscribed” (Mises 1949, p. 235), the scope of economics can not so easily be demarcated. Its relationship to praxeology is not a simple one, and especially its area of application is not easy to determine.
The specifically economic problems, the problems of economic action in the narrower sense, can only by and large be disengaged from the comprehensive body of praxeological theory. (Mises 1949, p. 235; emphasis added)
And here comes the main point. Other than praxeology, which is general and absolute, economics is bound to special preconditions and, consequently, is not a general theory in the same way as praxeology. This claim is emphasized by Mises himself when he adds that “in this disengagement [of economics from praxeology], historical and conventional aspects cannot be ignored” (1940, p. 226; emphasis added).I quote from Mises’s Nationalökonomie because the same passage in Human Action does not seem to make sense: “Accidental facts of the history of science and conventions play a role in all attempts to provide a definition of the scope of ‘genuine’ economics” (Mises 1949, p. 235). The same is true for the third edition. The historical relativity of economics, which Mises admits in these few words, manifests itself a few lines further where he says that economics and catallactics are “the analysis of those actions which are conducted on the basis of monetary calculation,” and that the analysis of socialism, where monetary calculation does not exist, “is possible only through the study of catallactics, the elucidation of a system in which there are money prices and economic calculation” (Mises 1949, p. 235).
In short, economics itself does not deal with all human actions in all kind of societies, but only with human actions that are directly or indirectly connected to money prices and economic calculation. It is true: in order to do this adequately, economics presupposes a general theory of human action — praxeology — but it is not identical with it.Joseph Salerno comes to a similar conclusion concerning another important economic concept: The entrepreneur-promoter does not exist under all circumstances, either. The entrepreneur-promoter “cannot be defined with praxeological rigor; it can only be identified by a historical judgment” (Salerno 2008, p. 195).
It should be remembered that Mises’s (1951) famous argument according to which a collectively planned society is not feasible is also based on historical institutions. Without exchange between money and producers’ goods, he argued, prices of these goods cannot be determined and consequently economic calculation becomes impossible in socialism. This argument is not based on praxeology alone, but it presupposes, for the market economy which serves as benchmark, the existence of money, monetary calculation, and property rights to the means of production. It was this aspect of capitalism that Mises focused on, and from this perspective it becomes clear why he adhered to the historical-legal capital concept. This kind of capital does not exist in socialism, and therefore it could help to distinguish capitalism from any other economic system.
The Economic Calculation Argument as Found in Albert Schäffle’s WorkThat Mises’s use of the capital concept endorsed by the Historical school is no coincidence is apparent when reading the approach of earlier members of this school to the question of economic calculation. In this regard, especially Menger’s predecessor on the chair of economics in Vienna, Albert Schäffle (1823 — 1903), must be mentioned. It has been noted before that Schäffle at least hinted at the difficulties a socialist society would face when allocating the available resources to the myriads of different uses. Schäffle is cited for having argued, in Hodgson’s (2010, p. 300) words,
that a system based on calculations concerning labour time faced intractable problems, including the heterogeneity of labour and the inaccessibility of relevant data, and would undermine individual incentives.
Apparently, Schäffle had at least a sense of the calculation problem of socialism, although, according to Hodgson at least, he primarily seems to have aimed at the well-known incentive problem. Huerta de Soto (2010, p. 100) goes a step further and imputes to Schäffle the demonstration
that, without imitating the system of price determination found in market processes, it would be inconceivable that a central planning agency could efficiently, in terms of both quantity and quality, allocate society’s resources.
However, neither Hodgson nor Huerta de Soto argues that Schäffle has anticipated Mises’s argument in the proper sense. They merely concede him to have sensed the difficulties of organizing production without the help of economic calculation.
It does not become clear, in their short remarks, how close Schäffle actually came to deal with questions that later became central for the Austrian school. In his Kapitalismus and Socialismus, a book which Hodgson and Huerta de Soto do not analyze and which has not been translated into English, Schäffle demonstrates that he was well aware of the problem that has to be solved by any economic order. In this, he partly anticipated Leonard Read’s famous story I, pencil where it is shown that even in the production of such a simple thing as a pencil more or less the whole world participates.
The social character of the human economy shows that everyone, from morning to night, depends on the work of the whole humanity. I wake up in the morning and put on a dressing gown: the wool it consists of has been grown, years ago, in Australia; it has been shipped to Trieste by Dalmatians, freighted to Moravia by Italian workers and the staff of the Austrian railways, spun and woven there with the help of English machines, and dyed with African colors. (Schäffle 1870, p. 103)
Confronting the complicated relationships of the modern production process, Schäffle (1870, p. 105; emphasis added) uttered the question: “The economic miracle of the much discussed division of labor — by which means is it accomplished?”
So he clearly posed the question that Mises would answer in his discussion of the possibility of economic calculation under socialism. Furthermore, he was well aware of the fact that the socialist authors had either not realized that socialism has to solve this problem or had provided merely superficial solutions. This becomes clear in the second edition of Kapitalismus und Socialismus which was part of a larger work on the social sciences. First, Schäffle pointed out that socialism must think of something that could substitute private entrepreneuship:
With the abolition of private capital as the profit-oriented director of the economy, the difficulty occurs to achieve productivity, which was aspired by private capital in its own interest, in the same or even a larger and progressing measure, so that the fairer distribution of the created wealth does not end up with less to distribute than the present-day market. (Schäffle 1881, p. 317; emphasis removed)
Therefore, he continued, socialism must find a means of minimizing costs. But “[h]ow are the [socialist] managers of the production process supposed to determine the ‘socially required’ amount of costs?” (Schäffle 1881, p. 317). This would be a very difficult task, he noted, as the ‘socially required’ amount of costs depends on numerous and variable factors. Socialist theorists deceive themselves as long as they ignore this problem:
In my opinion, socialism exposes itself to a fateful and economically cardinal calculation error as long as it does not try to contrive ways and means which guarantee, in a better way than the current competition among capitalists does, that no arbitrary measure of “socially required” amount of labor is found and asserted for the determination of exchange value, but the one that is as low as possible from a social and evolutionary point of view. (Schäffle 1881, p. 318)
How deep Schäffle actually analyzed the whole question of economic calculation in socialism is difficult to tell. He wrote several books, like The Quintessence of Socialism and The Impossibility of Social Democracy, touching on this topic. Hodgson (2010), who analyzed them, has not found a systematic treatment of the issue. Kapitalismus und Socialismus, from which I have quoted above, is a treatise of more than 700 pages and consists of public lectures Schäffle had given in Vienna. Therefore, it does not contain a systematic line of argument. Schäffle neither comes up with a proposal for the organization of the production process under socialism nor does he outrightly deny its possibility. He rather seems to advocate a mixed economy as he does in his other books (Hodgson 2010, p. 311). However, a profound judgment can only be made after a thorough study of all of his works which include, next to his lengthy monographs on socialism, several multi-volume textbooks on economics and sociology.
At this place it suffices to register that Albert Schäffle, a member of the Historical school, came close to seeing the problem of economic calculation under socialism. Whether he analyzed it satisfactorily is not top priority. One must not forget that, unlike Mises and Hayek, Schäffle wrote decades before the Bolshevik Revolution and had no real-world example of socialism to consider. Furthermore, he mainly wrote before the neoclassical revolution, thus lacking the apparatus necessary for the dismantling of Marxist theory (Hodgson 2010, p. 306). At any rate, Schäffle and the Historical school can be shown to have points of contact with Austrian Economics, whatever the methodological differences may be. Whether these links are worth a closer inspection and whether modern Austrians can profit from it cannot be foretold. For my part, I believe that the comprehensive rejection of a whole school of thought will rarely be justified.
ConclusionStreissler (1990, p. 31) has called it a myth that the early members of the Austrian school elaborated their novel insights independently of and in contrast to German economics of their day. I would not go so far as to maintain that the fundamental opposition between the Austrian and the Historical school is also a myth. At any rate, I tried to show in this chapter that at least some caveats must be made. Although he did not stress this point, even Ludwig von Mises, the father of the general theory of human action, in some of his theoretical arguments presupposes the existence of historical conditions and institutions. The connection to the Historical school can best be seen in the fact that both Menger and Mises employed its capital concept. Mises’s argument on the impossibility of economic calculation under socialism is based on it, and it even seems that the argument naturally flows from it. At least one member of the Historical school, Albert Schäffle, was led to similar, though less elaborated and precise views concerning the role of economic calculation in capitalism and socialism.
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ModernPer Bylund is John F. Baugh Center Research Professor in the Department of Entrepreneurship at Baylor University in Waco, Texas. I had the great pleasure and privilege of being a summer research fellow in 2009 and 2010, and a postdoctoral research fellow in 2012. This chapter is an extension of the theoretical perspective developed in my dissertation at the University of Missouri, which was originally developed while a summer fellow at the Mises Institute and with the help and encouragement of Professor Salerno. economic theory tends to treat production, the process of generating valued consumption in a market, as a function carried out within firms and so out of reach for the general market (Coase 1937). Firms are seen as “black box” generators of output from inputs in accordance with a calculable and formalized “production function,” and both inputs and outputs are exchanged at competitive money prices in market transactions. The market, consequently, is seen as simply a means for efficiently allocating resources through the price mechanism. The development and production of the specific goods and services that are directly valued by consumers is considered of much lesser import.
In contrast, Austrians emphasize the causal processes in the economy and therefore pay much attention to production — the way value is created through consumer wants satisfaction — and capital theory — how factors are utilized to support production. Austrians recognize that the specialized market process consists of and is dependent on an intricate structure of productive resources. This structure supports roundabout production processes that exploit productivity-enhancing uses of non-permanent intermediate (produced) goods. Such an advanced production apparatus is dependent on the specific uses of capital goods that facilitate taking factors of production through stages aimed at eventually satisfying consumer wants.
This distinctly Austrian perspective on the market as a process of production is the subject for this chapter, with specific emphasis on how changes to the economy’s production apparatus or capital structure are brought about. The aim is to elaborate on the implications of the market’s capital and production structure and thereby illustrate a specific theoretical problem that is conspicuously missing in the Austrian analysis. I draft a solution to this problem by addressing potential remedies made available by market actors exercising productive entrepreneurship. In this sense, the essay elucidates a realm for entrepreneurship within production and capital theory.
Production and Capital StructureCapital goods can be defined as “the produced goods that must be combined still further with other factors in order to provide the consumers’ good” (Rothbard 2004 [1962], p. 299). These intermediate or “produced” goods that can only indirectly satisfy consumer wants are “a necessary way station to increased consumption” (Rothbard 2004 [1962], p. 966; emphasis in original). Seen as a whole, they compose “an intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967; Lachmann 1978 [1956]), a production structure that in its current length and form is configured to satisfy wants already anticipated by entrepreneurs.
A production structure is composed of specific capital goods, themselves a combination of other capital goods and original factors. It is assembled and configured in a specific way for a specific purpose (Lachmann 1978 [1956]) and operated by specialized labor. Production is temporally dependent since it must be carried out in time. Carrying out a production process with already existing, supporting capital goods takes time, as does the production of the capital goods used in the process. The existent production structure was brought together and configured in the past, and is used and operated in the present to produce consumers’ goods available in the future.
Time, therefore, is both a limitation and a factor of production: due to its irreversibility, it “puts the future services of certain resources beyond our reach in the present and so makes it impossible to anticipate their use” (Hayek 1941, p. 52). In other words, we cannot conceive of specialized production without capital. Even acknowledging that there is a capital structure supporting production in multiple stages ultimately appears insufficient for us to fully understand the production process. For this reason, a theory of production is of limited use without a capital theory that also includes action and so explains the structure’s dynamic: how and why the production structure has taken a certain shape and how and why the structure changes over time. As we will see, the Austrian conception of production subject to the heterogeneous structure of productive capital indicates a problem related to the structure of tasks in an economy’s production apparatus. This problem does not exist for Robinson Crusoe but is potentially crippling in a specialized market, and it requires entrepreneurship and integration to be solved.
Roundabout Production Without Existing CapitalImagine that a person P, in a world without existent capital, decides to manufacture a product A with the intention of making it available for consumers in the open market. To the extent the production process requires (or is more productive with) capital, these capital goods must first be produced. Regardless of the complexity of the specific production process, the only possible way of realizing production of A is to first produce the necessary intermediate goods such as tools and machinery, and then, at a later time and using the intermediate goods, produce A. To make this happen, P therefore accumulates the resources necessary, gets busy creating the means to carry out the production process, and then produces the end product.
Due to P’s productive endeavor to establish the necessary structure for their envisioned production process, the world now has capital. This capital gives P a competitive advantage in the market by creating a unique production capability (Barney 1995; 1991), which increases in the overall valuable output in the economy. The direct effect of the “advancing capital structure increases the marginal productivity of labor” without requiring an increase in “the labor energy expended” (Rothbard 2004 [1962], p. 578). The capital created is essentially an extension of and therefore facilitates more productive uses of labor. In this sense, the investment creating “non-permanent resources enables us [the market] to maintain production permanently at a higher level than would be possible without them” (Hayek 1941, p. 54, emphasis in original). Overall, P’s endeavor has brought about a situation where the original factors — land and labor — are used more efficiently toward satisfying consumer wants than was the case before. Production has become more roundabout.
The value of this better use of original factors is measured by the subjective valuations of consumers who benefit from this production. As Austrians have known since Menger (2007 [1871]), the market value of the capital produced is derived from consumer benefits. This means the value cannot be established until consumer valuation of the end product has been revealed through market action (purchases of the product). The market value of the produced capital — the indirect means to satisfy consumer wants — is equal to their contribution to the value consumers ultimately place in the consumption good produced (Mises 1951 [1936]; Rothbard 1987).
The temporal sequence of actions within the production process is then exactly the opposite of how its value is derived. Production begins with the extraction of the highest-order goods from their natural state and the production of intermediate or capital goods, and continues through the stages to eventually produce the lowest-order good offered to consumers. Upon consumers’ decision to purchase the lowest-order good at a certain price, the market value of capital goods is established by imputation “upstream” through the higher orders to the highest order and original factors (Menger 2007 [1871]). There can be no capital that is not preceded by production, and there can be no specialized, roundabout production without the existence of capital.
Roundabout Production In the Specialized MarketLet us now turn to analyzing a specialized market economy with existing advanced production structures, as does e.g. Rothbard (2004 [1962]) and Coase (1937). We assume a market with highly specialized production with a capital structure that is well configured to satisfy consumer wants. As capital is heterogeneous, by which is meant that it “is not an amorphous mass but possesses a definite structure [and] is organised in a definite way” (Hayek 1941, p. 6), the capital structure entails both productivity gains and high costs of adjustment. As the market data change, the existing capital structure will be misaligned to real consumer wants. In this sense, the specialized market place is very fragile to (unanticipated) changes.
This problem is partly recognized in the Austrian business cycle theory, but it is scarcely elaborated. Rather, it is acknowledged that the realignment process of the market’s capital structure, from the anticipated and prepared-for market situation to the new and revealed situation, takes time. This is undoubtedly true, and this process is carried out by entrepreneurs (broadly defined), who are “eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor” (Mises 1998 [1949], p. 335). Time-consuming and costly realignment follows (cf. Williamson 1985, pp. 21–22).
Yet this problem does not arise only when the market process is affected by abrupt and/or unanticipated exogenous change such as the expansion of credit by banks and the subsequent distortion of market prices. In fact, any reconfiguration, elaboration, or expansion of the capital structure, whether as a reaction to changing consumer preferences or as a means toward increased productivity and economic growth, is subject to what we can describe as a “specialization deadlock”: production structure based inertia to which both market actions and actors are subject.
A specialized market consists of production processes that encompass many stages and where the stages are carried out separately by specialized labor operating specialized capital structures configured to facilitate this particular (and perhaps similar) stage. While there may be several uses for specialized capital, each of the uses tends to be highly specific and the capital goods are therefore very limitedly substitutable in the market. To the degree capital traded in the market has undergone a particular transformation by being irreversibly combined into a non-decomposable unique (or uniquely aligned) capital good, there is no existent market for the produced means of production. New capital goods exist in a non-salable state to the degree their uses have no or very limited substitutability and lack obvious substitute uses. Whether or not a market for specialized capital goods emerges depends on the competitive discovery process (Hayek 1978) as entrepreneurs imitate and attempt to surpass the original entrepreneur’s successful production achievement (Bylund forthcoming; 2011).
While the uniqueness of particular capital goods in specialized production may severely limit their markets (both in terms of demand and supply), this may not constitute more than a temporary problem. The problem emerges as specialized capital is utilized in roundabout production processes under intensive division of labor. Assuming a market with entrepreneurs alert to and ready to adjust errors and misalignment through arbitrage (Kirzner 1973), and therefore an equilibrating market process, the market should soon approach stasis.
Entrepreneurs, eager for profit, will bid for capital and labor factors that they perceive to be undervalued or in otherwise suboptimal use. Provided entrepreneurs do not commit more errors than successful adjustments, and provided consumer preferences do not frequently, radically, and unexpectedly change, a market without innovation has limited opportunity for growth and productivity increase. In fact, even allowing for innovation of capital goods, which can be usefully thought of as finding new productive combinations of land factors and existing capital (Schumpeter 1934 [1911]), will not facilitate economic growth through productivity increases unless there is also a corresponding intensification in the division of labor. As Mises (1998[1949], p. 164) notes,
The division of labor splits the various processes of production into minute tasks, many of which can be performed by mechanical devices. It is this fact that made the use of machinery possible and brought about the amazing improvements in technical methods of production. Mechanization is the fruit of the division of labor, its most beneficial achievement, not its motive and fountain spring.
The truthfulness of the temporally dependent order in Mises’s claim can easily be shown, as we shall see in the next section.
The Specialization DeadlockConsider the specialized market in the previous section. Assuming the market is minimally regulated and therefore without artificial barriers of entry, we can assume with Rothbard (2004 [1962], p. 369, fig. 41) that the rate of interest income for capitalist investments in each production stage will be approximately the same. Entrepreneurial arbitrage will see to it that this holds true within one production process as well as across parallel, competing processes. Alert entrepreneurs will discover and correct through arbitrage any “errors” revealed by above-normal returns in any process or stage. Profitable (successful) undertakings tend to be imitated and loss-generating (unsuccessful) are abandoned by entrepreneurs eager to earn profits, which suggests an equilibrating process consisting of continuous adjustment through correction (Shane 2003). This, in turn, suggests that markets are effectively created for specific capital goods utilized in production processes as entrepreneurs set out to imitate and emulate processes that earn profits (Stigler 1951; Bylund 2015). The economy in this sense functions as a continuous “discovery process” where competition for profit is the driving force toward better alignment between the totality of the production structure and consumer wants (Hayek 1978).
Along the lines of this reasoning one can develop a theory of strategic management based on the resources used within the firm, as has been done by Barney (1986; 1991) and others. The incentive of any firm (or rather, its owners and management) is here to strive for including and utilizing as rare and unsubstitutable resources as possible that are still valuable in production. The rarer and less substitutable (and imitable) the resources, the longer a firm can stay ahead of its competition and earn above-normal profits — competitors are simply unable to emulate the capital recipe of success. But it should be noted that while this competitive advantage may last for some time due to the unavailability of necessary resources for competitors, it will eventually be undermined by the discovery of better processes or alternative implementations of the same process.
The reason for this is that capital goods are produced and non-permanent. Even in situations where a certain capital good cannot be imitated or emulated (however unlikely this scenario is), it must be reproduced when it is used up or expired. The serviceability of capital can be extended through investments in maintenance, upkeep, and repairs. Still, capital is ultimately consumed during the production process, which means the owner of a unique capital good used in profitable production must at some point invest to extend its productive life. In a specialized market economy, any such reproduction must to some degree depend on the availability of market for materials, parts, etc., — the higher-order goods used in production of the capital good. It is therefore an impossibility that a certain resource combination — a particular capital good — is non-reproducible over time.
But even so, as Mises shows in the quote above, capital is ultimately dependent on division of labor preceding its development and use. Only through the splitting of tasks can capital goods be (1) innovated and (2) utilized in new processes. The former holds true simply because new specializations (that is, a more intensive division of labor) are necessary in order to produce a new type of capital good, at the very least in the tasks of combining factors or configuring an existing capital good. The latter is illustrated by Mises’s example of mechanization of the minute tasks that are made into separate tasks only through the splitting of existing, more broadly defined, tasks.
Consider a production process in our previously assumed specialized market that is dedicated to the production of bread. It consists of the following division of labor: a farmer produces wheat, a miller produces flour, and a baker produces and sells the bread. Each stage uses capital: the farmer uses a plow in the spring and sickle in the late summer, the miller uses milling stones, and the baker uses an oven. One can imagine making this process more roundabout through the innovation of new capital goods to support either of the stages, e.g. a tractor for the farmer or a blender for the baker (Böhm-Bawerk 1959 [1889]). But no such capital can be made available for the farmer or baker without an innovative entrepreneur figuring out the full production process for that specific capital good. This amounts to a much greater undertaking than the error-correction type of arbitrage provided by Kirznerian entrepreneurs (Kirzner 1973; 2009).
An alternative is to make the bread-producing process itself more roundabout through the insertion of more narrowly specialized labor: splitting a task into several (Smith 1976 [1776]; Bylund forthcoming). The splitting of a task is different from simply “adding” labor power. The farmer can “hire” labor workers to carry out the same tasks as he is already carrying out, which increases output through increasing the volume of labor being used in the process. As these workers need to be paid — and likely monitored (Alchian and Demsetz 1972; Williamson 1993) — it is not obvious that this is a profitable investment for the farmer. Where an increase in the number of workers leads to diminishing returns, the farmer is likely to make a loss on invested funds.
The alternative is to engage in intensifying the division of labor, which, as suggested in the Mises quote above, entails taking an existing task and dividing it into a number of more narrowly defined tasks. In the case of the bread production process, this amounts to replacing one of the existing stages with several new and separate tasks in the same way a hypothetical original production process was split from self-sufficiency toward specializations in farming, milling, and baking.
Where a market stage already consists of easily separable tasks, such as the plowing, sowing, watering, and harvesting of farming, specialization may not be more than a minor change. For instance, a farmer having hired labor workers may assign specific tasks to different workers and thereby simplify specialization. This must be preceded by increased density of labor factors (Durkheim 1933 [1892]) and can be facilitated by coordination through centralized ownership (Stigler 1951). As this type of “marginal” or incremental specialization can be rather easily brought about, it may not constitute an economic problem of production. In fact, such productivity-increasing measures should be easily discernible for the actors themselves: we know that “work performed under the division of labor is more productive than isolated work and that man’s reason is capable of recognizing this truth” (Mises 1998 [1949], p. 144; emphasis added). This is not a division of labor as much as it is a rational (re)allocation of labor input across already existing chores. But this means it also cannot constitute a problem for competing farmers, who as (or even more) easily can institute this type of division of labor by imitation or emulation. So we may, for the sake of simplicity, assume that such comparatively simple opportunities have already been exploited. Indeed, we can think of the inefficient use of laborers on the farm as an “error” to be corrected by the alert farmer.
This leaves the type of disruptive specializing that suggests a new production sub-process to replace a commonplace and standardized task carried out by market actors. We can now begin to discern the problem, since all the “low-hanging fruits” in terms of productivity-increasing allocative measures are easily exploitable and so should tend to already be exploited. What remains is the unintuitive or highly coordinative task-splitting that requires foresight, investment, and perhaps development of new types of capital goods to be realized. Add to this situation how within-stage (horizontal) competition should tend to standardize the procedures used and therefore effectively produce market standards around best practices. This is the process through which markets are created, which was explained by Stigler (1951). While the market may not reach a general equilibrium, it can easily be seen how its competitive process brings about standardizing at the production possibilities frontier. At this point, further specializing should seem unattainable if at all advantageous — much like splitting the task of “driving a taxi” into the more specialized tasks of driving straight, driving around corners, and going in reverse.
Further advances in productivity requires the adoption of a more intensive division of labor — the further splitting of existent tasks — and the use of (new) capital to replace labor with automatic execution of newly identified and separated “minute tasks.” The market, in other words, finds a state of rest in the sense of a highly restricting inertia — if not impossibility — of adopting further productivity-increasing measures. Specialization cannot go further through incremental adoption of better utilizations of labor. Whether or not market actors have exhausted all opportunities for further incremental improvements to production processes, the market is in a specialization deadlock.
Breaking Free From the Specialization DeadlockSo far we have considered production in the market: while not all actions necessarily take place independently and under the price mechanism, we noted how markets are generated as new production structures are imitated by competitors (Stigler 1951; Bylund 2011; forthcoming). For all tasks carried out in an economy’s production apparatus, therefore, there is semi-standardization within the limits of substitutability where the price mechanism is applicable. In other words, there is a tendency toward standardization of best practices through competition as improvements are all but universally implemented through profit-induced imitation in the open market.
So far we have not made any assumptions about who brings about or profits from the adjustments made in the market. The reason for this is that opportunities for incremental changes to the production structure are neither difficult to discover nor to implement or observe /imitate. This suggests the function of adjustment can be carried out by most or all market actors and without much foresight, coordination or investment. Indeed, the farmer who hires labor workers and assigns different responsibilities to them is engaging in (a weak form of) specialization and division of labor, but in such a mundane fashion that it is of little analytical importance. These tasks were already carried out — they may even have been identified as separate such — and the increased density due to increased volume of available labor facilitated an “obvious” opportunity for “specializing.” Rather than each labor worker switching between the same or similar tasks, each worker could save time and energy by streamlining their work and so focusing on a single or only a few tasks serially divided among them (Smith 1976 [1776]). This type of improvement in productivity is, indeed, within the limits of man’s capability of reason. In fact, we might expect the common worker, knowledgeable of the production process as well as the “particular circumstances of time and place” (Hayek 1945, p. 521), to identify and act to implement such productivity-increasing measures.
But this only augments our perception that the specialization deadlock is an economic problem. It should furthermore be an increasing problem as a market becomes more intensely specialized, since specializing increases heterogeneity and therefore lowers the overall density of workers carrying out similar tasks in the market place. As opportunities for specializing are exploited, taking specialization even further may necessitate much less obvious changes — and coordination. So far in our discussion, we have not included more than minimal coordination in the market place, primarily through the price mechanism and simple agreements.
Consider the case of the tractor noted above. In order to provide a tractor in this market, actors need to break free from the specialization deadlock. This is a problem of innovation, coordination, and capital investment, since it includes the insertion of a new productive sub-process to produce a higher-order good (the tractor) to be used in farming. This sub-process requires its own division of labor to carry out tasks specific to tractor production. In this case, this is a novel process the tasks of which may not have been more than limitedly known. But this need not be the case: we can easily imagine splitting the existing tasks into several independent subtasks. The solution is however found to be the same: innovation, coordination, and capital investment are necessary for the implementation and thus realization of the new tasks and thereby the more roundabout production structure.
It is not within the scope of this chapter’s discussion to specify the exact nature of implementing such improvements to the production structure. This has been done elsewhere (Bylund 2011; 2015; forthcoming), so it should therefore be sufficient to point out that this is the role of the innovative and imaginative entrepreneur. But it should also be noted that there can be no blueprint for the implementation (realization) of such novel production processes that introduce a radically intensified division of labor since their functioning is strictly unknowable — detailed information about the intricate workings of a previously unseen sub-process is revealed only through its implementation process. For this reason, the entrepreneur can only guide the project and must rely on the decentralized problem-solving or proxy-entrepreneurship of employed workers (Foss, Foss and Klein 2007). This appears to require an integrated production structure, which is commonly referred to as a firm.
Implications for Economic TheoryWhat has been drafted above suggests that production theory is incomplete without both capital theory and entrepreneurship. This may appear obvious to Austrians, but the entrepreneurship aspect appears often missing or lacking in discussions on capital theory. Rothbard’s discussion on production theory in Man, Economy and State can serve as an illustrative example.
Rothbard here provides a groundbreaking discussion on production theory, but his discussion on the effect of saving on the economy’s production stages is severely lacking. Increased saving, states Rothbard, shifts “investment further up the ladder to the higher-order production stages.” And further: “Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages … is to increase the number of productive stages in the economy, i.e. to lengthen the structure of production” (Rothbard 2004 [1962], p. 519, emphasis in original). Perhaps this is a necessary conclusion, but as we have seen in this chapter, increasing the number of production stages implies the splitting of tasks and, essentially, breaking free from the specialization deadlock of the existent capital structure. We can hardly assume that this process is automatic or immediate (and it is of course unlikely that Rothbard would rely on such an assumption).
But even if we allow this process to be time-consuming, any production process must already encompass a full-length process with stages covering the production distance from virgin land to consumer. A more roundabout production process does not add stages to the “top,” but must split a stage into several or insert a new sub-process in-between or to assist existing stages. This has implications for the income accruing to factors and capitalists involved in each stage, since a “local” intensification of the division of labor by splitting one stage into many necessarily disrupts production.
Rothbard seems to assume a preexisting market for each production stage, which suggests standardization and substitutability throughout the market and thus somewhat accurately determined market prices. From the perspective of Rothbard’s discussion, it may not be limiting but useful to rely on analytical aggregates and talk of “readjustment.” But “readjusting” the production structure to new levels of saving is a much messier process than the type of arbitrage-like allocative adjustment we discuss above — and much messier than is shown in Rothbard’s analysis. Changes to the length of the production structure means the structure is disrupted by an imaginative entrepreneur, which has implications throughout the “intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967). It is insufficient and potentially misleading to assume changes in the savings rate reallocates “capital” within the production process (and therefore across the production apparatus’ existing stages). More realistically, productive investments can fundamentally change production processes by splitting or inserting stages, and this can bring about important changes to the economy’s capital structure.
It is furthermore insufficient to treat the entrepreneur as simply the discoverer of price discrepancies who then acts to shift factors from one production process to another to better account for their “real” value (Rothbard 2004 [1962], p. 511; cf. Kirzner 1973; Sautet 2000). As Rothbard (2004 [1962], pp. 858–59) puts it:
to view entrepreneurship as simply the founding of new firms is completely invalid. Entrepreneurship is not just the founding of new firms, it is not merely innovation; it is adjustment: adjustment to the uncertain, changing conditions of the future. This adjustment takes place, perforce, all the time and is not exhausted in any single act of investment.
But as we saw above, while adjustment takes place “all the time” it can and does take place within the limits of the existing division of labor intensity; “adjustment” is unable to deal with the specialization deadlock and therefore excludes disruptive innovation. In other words, it does not include “breaking free” from the deadlock through revolutionizing the production structure, which necessitates realizing an innovative splitting of tasks — which in turn requires integration (a firm) (Bylund 2015). Entrepreneurial adjustment ensues upon and as a consequence of disruption, but it is limited to corrections given the existing production or capital structure and incremental improvements to it.
In this sense, we have drafted a scope for entrepreneurship with the help of capital and production theory that both confirms and challenges Rothbard’s analysis. It confirms Rothbard’s focus on adjustments, which are carried out “all the time” through the market’s competitive discovery process and “is not exhausted in any single act of investment.” This can potentially be seen as a “Kirznerian” type of entrepreneurship (Kirzner 1973; 1979; 1999; 2009). Yet Rothbard, by not including the type of disruptive entrepreneurship that can be found in e.g. Schumpeter (1934 [1911]), sees no significance in organization or its function in the market. He therefore does not recognize the causal relationship between the division of labor and the creation of capital that Mises notes and that we here found to suggest a solution to the interlocking compatibilities of the production structure that we refer to as the “specialization deadlock.”
In fact, it appears Rothbard in Man, Economy and State fails to recognize the great importance of the division of labor for production and capital theory as well as for the evolution of society. This chapter attempts to show, in line with Mises’s view (Mises 1998 [1949]; Salerno 1990) as well as Rothbard’s later and more astute understanding (Rothbard 1991), how the importance of the division of labor hardly can be exaggerated, but that it in fact can be used to explain the process of capital creation.
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InMarek Hudík is postdoctoral fellow at the Center for Theoretical Study at Charles University in Prague, Prague, Czech Republic. I was a summer research fellow at the Mises Institute in 2009. Throughout the fellowship, I greatly benefited from Professor Salerno’s kind help and constant encouragement. his introduction to the second edition of Rothbard’s Man, Economy, and State, Professor Salerno (2004) argues that Rothbard’s purpose in writing his treatise was not to develop a heterodox school of economics and break with the prevailing body of thought. On the contrary, Rothbard examined contemporary literature and attempted to integrate this literature with his own views. As Salerno shows, Rothbard believed that his treatise could draw other economists to the ideas that used to be part of the mainstream in the not-so-distant-past. We now know that Rothbard did not succeed in this and that as of today, there still is a communication gap between the Austrians and the rest of economic profession. This paper argues that the gap could be narrowed if the Austrian economics becomes more mathematized.By “mathematization of economics” I mean the “use of mathematical techniques … in economic arguments” (Backhouse 1998, p. 1848). An alternative definition of the term can be found in Beed and Kane (1991, p. 581), who understand it as the “increasing emphasis given to mathematical economics.” For a discussion of the concepts of mathematization, formalization, axiomatization, and abstraction, see e.g., Weintraub (1998) and Backhouse (1998).
At a first glance, mathematization of Austrian economics may seem to be contradiction in terms. Yet, at a closer inspection, the idea turns out to be not paradoxical at all: note for instance, that the “literary” character of Austrian economics is typically not included among its defining characteristics (Machlup 1982; Leeson and Boettke 2006; O’Driscoll, Jr., and Rizzo 2002); in a similar vein, Vaughn (1998, p. 2) sees the Austrian aversion to mathematics as a “superficial identifying characteristic,” and Backhouse (2000, p. 40) points out that, to the best of his knowledge, no Austrian has “ever explained why mathematics cannot be used alongside natural-language explanations”; on top of that, Moorhouse (1993, p. 71) reviewing Mises’s views on mathematical economics concludes that there is “no major methodological gulf between praxeology and neoclassical mathematical economics.”
Admittedly, Rothbard, as well as some other Austrians, raised objections against mathematization; but his demonstrated preferences speak otherwise: he sometimes expresses his ideas formally or semi-formally (e.g., Rothbard 2004, pp. 120–121, 152–153, 234). In addition, there is a long line of authors whom we may count as Austrian or Austrian-inspired who occasionally use mathematics in their economic writings. These include Wicksteed (1910), Fetter (1915), Hayek (1941), Haberler (1950), Machlup (1939), Morgenstern (von Neumann and Morgenstern 1953), McCulloch (1977), Garrison (1978), Murphy (2005), Leeson (2010), etc.
Some of these authors even explicitly claim that mathematization of economics is, at least to a certain extent, methodologically acceptable or even desirable. For example, Hayek (1952, p. 214) sees mathematization as “absolutely indispensable to describe certain types of structural relationships”; Machlup (1991) roots for “polylinguistic scholarship” characterized by coexistence of mathematical and non-mathematical language; in Boettke’s (1996) view, formal models are “fine” when constrained by an understandability criterion; and according to Morgenstern (1963, p. 19), an outright supporter of mathematization of economics, the laws of society will be written in the language of mathematics, just like the laws of nature.
This paper acknowledges that mathematization has costs and benefits. At the same time, it admits that it is probably impossible to determine the range of levels of mathematization for which benefits outweigh costs. Given this limitation, the aim of this paper is thus rather modest: it merely attempts to show that the optimal level of mathematization is not zero. More specifically, this paper points out the benefits of mathematization that seem to have been overlooked by some Austrian authors and it shows that most of Austrian criticisms which supposedly challenge mathematization, in fact point to different issues.
Benefits of MathematizationMises (1996; 2003; 1977) and Rothbard (2004; 1997a; 1997b) claim that formalization adds nothing to our knowledge as it only involves translation of verbal statements into symbols.This claim seems uncontroversial: it is put forward by both critics of mathematization (e.g., Novick 1954) and its advocates (e.g., Samuelson 1952). However, see Dennis (1982a; 1982b) for criticism of this view; see also Weintraub (1998, p. 1844) who posits the view of mathematics as an engine of discovery as an alternative to mathematics as a language. According to Rothbard (1997a, p. 61; 2004, p. 325), benefits of formalization are none, and therefore formalization should be cut through the principle of Occam’s razor.This Rothbard’s claim is problematic: if true, how would we explain that mathematics itself (or any other discipline) became formalized? Indeed, until the Renaissance, there was basically only “literary mathematics”: for instance the symbols “+” and “—” first appeared in the late fifteenth century and “=” was introduced only in the early sixteenth century (Cooke 2005, p. 432). Mises (1996, p. 333) suggests that if there is any benefit to formalization at all, it is pedagogical: diagrammatic exposition can be helpful to students of economics. Mises thus indirectly admits that mathematics (in a diagrammatic form) contributes to clarity of exposition. But why restrict this benefit only to students? Should not economists always communicate with their colleagues in the clearest possible way, especially when presenting new ideas?
Clarity of exposition achieved through diagrammatic representation is but one (and perhaps even not the most important) benefit of the use of mathematics in economics. I propose that mathematics offers also the following three benefits: First, mathematics is nowadays a common language of most economists and other researchers across disciplines — it is thus necessary to communicate ideas; Second, mathematics is less ambiguous than verbal language as it forces one to define precisely the meanings of concepts; and Third, mathematics is generally more efficient than verbal language, both for “producers” and “consumers” of economic ideas. These three benefits of mathematization are now discussed in turn.
Mathematics as a Common LanguageIf the great majority of economists use mathematics, it pays for each individual economist to use mathematics too; this is simply a coordination problem. The use of verbal language may lead to misunderstanding by the rest of the profession. When an Austrian and another economist speak of marginal utility or time preference, for example, do they in fact mean the same things?For a discussion of different definitions of marginal utility, see Hudík (2014a). On the ambiguity of time preference definition, see Potužák (2014).
There are numerous examples in the history of economic thought when translation into the language of mathematics helped to clarify the differences between competing approaches.Admittedly, there are also instances when mathematization contributed to ambiguity of economic concepts (Stigler 1950). In this context, it should also be noted that there usually is more than one way of formalizing a theory and this further complicates the issue (Beed and Kane 1991). For instance, Marshall’s (1982) translation of Ricardo’s theory of price formation into mathematics allowed for distinguishing between the classical and marginalist theories and facilitated the latter’s acceptance. Similarly, mathematics in the hands of Hicks (1937) and some others helped to detect the differences between “Keynes and the classics” on macroeconomic issues and contributed to the creation of the “neoclassical synthesis.” According to one observer:
Keynes was impressed by the help given by mathematics when numerous economists (Harrod, Hicks, Samuelson, Bryce) cleared up confusions in his General Theory and also presented his system neatly with the help of mathematics. (Harris 1954, p. 384)
Several decades later, formalized language of mathematics revealed that the dispute between “monetarists” and “Keynesians” was not about a general theoretical framework but about different empirical assessment of the value of parameters of the same model (e.g., Modigliani 1977; Mayer 1995). To plunge into more heterodox waters, Roemer (1982; 1988) is one of several economists who formalized Marxian economics and thus helped readers to compare the similarities and differences between Marxism and other mathematized approaches.
With respect to Austrian economics it is interesting to note that according to Chipman (1954, p. 364), “it is hard to find in mathematical economics any discussions more abstruse and difficult to follow than the great verbal debates between the Austrian and American schools on capital theory.” Fortunately for Chipman and others, several attempts to formalize Böhm-Bawerk’s theory have emerged (e.g., Dorfman 1959; 1995; 2001; Potužák 2014) and helped to clarify the debate. Very helpful in this respect is also Garrison’s (1978; 2000) partly formalized treatment of Austrian macroeconomics.
Mathematization is of course not the only way of dealing with the “language-coordination problem.” For instance, one may ignore the majority of economists and choose to “play the game” only with those who use his (i.e., verbal) language. However, this would in effect amount to creating a closed school of thought whose members are able to communicate only with each other but would not be able to interact with the rest of the discipline.Interestingly, until the first half of the twentieth century, i.e., before mathematical methods spread through the discipline, mathematical economics was considered to constitute such closed group. See e.g., Clark (1947). Closed schools of thought are analogous to closed economies: they protect their cherished ideas from competition. As in the case of trade, such a state of affairs benefits “producers” of ideas but hurts the “consumers” who receive products of inferior quality. Rothbard (1987) seems to have been aware of these adverse effects of isolated groups and perhaps that is also why he chose to communicate with the mainstream.Similar attitude was adopted by many Austrians before and after Rothbard, including Böhm-Bawerk, Mises, and Hayek.
Another possibility of approaching the “language-coordination problem” is to stick to verbal language with the proselytizing aim of persuading the rest of the profession to use it, too. In other words, one may be trying to change the language convention, and achieve a switch from a “mathematized equilibrium” to a “verbal equilibrium” of the “language coordination game.” Nevertheless, success of such an attempt seems unlikely, all the more for the fact that the “mathematized equilibrium” is — as I argue below — superior.
Mathematics as a More Precise LanguageOne of the benefits of mathematization is that it forces us to formulate our ideas precisely (e.g., Klein 1954; Tinbergen 1954; Chiang 1984; Clower 1995). It is sometimes correctly argued that verbal language can be made as precise as the language of mathematics (e.g., Menger 1973; Beed and Kane 1991). In reality, however, this opportunity very often goes unexploited: unless one is forced to express ideas formally, one is perhaps not even aware that the language is ambiguous. Perhaps the best example of increased clarity due to formalization is the creation of the supply and demand model. As Schumpeter (1994, p. 602) points out:
the sponsors of supply and demand [of the 19th century], again with the unnoticed exception of Cournot (and very few others, such as C. Ellet and D. Lardner), even experienced difficulty in setting on its feet the very supply-and-demand apparatus, the claims of which to a place in economic theory they tried to assert. They talked of desires or desires backed by purchasing power, of “extent” of demand and “intensity” of demand, of quantities and prices, and did not quite know how to relate these things to one another. The concepts, so familiar to every beginner of our own days, of demand schedules or curves of willingness to buy (under certain general conditions) specified quantities of a commodity at specified prices, and of supply schedules or curves of willingness to sell (under certain general conditions) specified quantities of a commodity at specified prices, proved unbelievably hard to discover and to distinguish from the concepts—quantity demanded and quantity supplied.
Precision of mathematics also helps to derive implications of one’s assumptions and to demonstrate possible inconsistencies (e.g., Dorfman 1954; Clower 1995). For instance, Samuelson (1957), by formulating Marxian model of wages and interest discovered an error in Marx’s theory that went unnoticed for 90 years (Brems 1975). Mathematics may also help to discover inconsistencies in the Austrian economics: Austrian economists work with preference scales; at the same time, they sometimes criticize the transitivity assumption used by other economists (Block and Barnett 2012). Yet, it is straightforward to show formally that an ability to rank alternatives on a single scale corresponds to the assumptions of completeness and transitivity of the preference relation. In other words, whenever a preference scale is introduced, completeness and transitivity of preferences are implicitly assumed (Hudík 2012). To use a different example, with the help of some simple mathematics it can be demonstrated that, contrary to Rothbard’s (2004, p. 240) claim, the principle of diminishing marginal utility does not necessarily imply a downward-sloping demand curve (Hudík 2011a).
Interestingly, Rothbard sees the ambiguity of the verbal language as an advantage. He quotes Bruno Leoni and Eugenio Frola:
the lack of mathematical precision in ordinary language reflects precisely the behavior of individual human beings in the real world. ... We might suspect that translation into mathematical language by itself implies a suggested transformation of human economic operators into virtual robots. (Rothbard 1997a, p. 62)
This argument is unpersuasive on several grounds: First, it is not at all clear why researchers should use imprecise language just because their researched subjects are imprecise; one can (and, indeed, should) talk precisely even about imprecision. Second, Leoni and Frola’s argument seems to imply that economists should not describe human behavior by concepts which are not used by the acting individuals themselves. However, this requirement imposes unnecessary constraint on economic theories. For instance, economists would be barred from referring to the law of marginal utility merely because people are generally unaware of this law. Finally, Leoni and Frola neglect the fact that economics mostly deals with an order which emerges as an unintended consequence of human actions (Hudík 2011b) where their argument is inapplicable. Consider, for example, activities of speculators which inadvertently contribute to efficient allocation of resources. I assume that we want to be able to describe these consequences even though speculators themselves are unaware of them.
Mathematics as a More Efficient LanguageMathematics is often more efficient than verbal language for both “producers” and “consumers” of economic ideas. From the perspective of the “producers”, mathematics economizes on effort: laborious thought processes are “embodied” in simple rules for manipulation of mathematical symbols (Whitehead 1911, p. 41). In this context Duesenberry (1954) understands mathematics as a “capital good” increasing productivity of economist’s “labor.” On the one hand, Duesenberry admits that it may be true that one cannot do anything with mathematics which cannot be done with verbal language; on the other hand, however, he claims that verbal language is much less efficient; according to his analogy, “[o]ne probably cannot do anything with power shovels that cannot be done with picks and hand shovels” (Duesenberry 1954, p. 361). Analogously, Chiang (1984, p. 5) thinks of mathematics as a “mode of transportation.”This metaphor seems to have been used for the first time by Fisher (2007); for similar metaphors, see e.g., Pareto (1897), Champernowne (1954), Tinbergen (1954), Menger (1973) and McCloskey (1994).
Chiang (1984, p. 4) mentions another aspect of the efficiency of mathematization of economics: there exists a large number of mathematical theorems at economists’ disposal. Consequently, we do not have to rediscover these theorems whenever they arise in a new context (Dorfman 1954, p. 376). Thus, for instance, in order to prove his theorem of the existence of (“Nash”) equilibrium in strategic games, Nash applied first Brouwer’s and later Kakutani’s fixed point theorems (Kuhn and Nasar 2002). Half a century before Nash, Euler’s theorem was applied to address the “adding-up problem” in the theory of distribution (Stigler 1994).For more examples of mathematical theorems that were directly applied in economics, see Debreu (1984).
As for “consumers” of economic ideas, mathematics often allows them to economize on their time and attention: as Klein (1954, p. 360) puts it, “[t]here is a real merit in condensing wordy volumes or manuscripts into a few understandable pages.” Nash may again be used as an example here: his famous dissertation thesis that earned him the Nobel Prize has only twenty seven pages; his paper on the existence of Nash equilibrium takes up only one page (Nash 1950a), while his ground-breaking paper on the bargaining problem is eight pages long (Nash 1950b). It is safe to assume that without formalization Nash’s papers would have to be considerably longer.As usual, there is a dissenting view, this time it is Marshall’s: The chief use of pure mathematics in economic questions seems to be in helping a person to write down quickly, shortly and exactly, some of his thoughts for his own use … It seems doubtful whether anyone spends his time well in reading lengthy translations of economic doctrines into mathematics, that have not been made by himself. (Marshall 1982, p. ix)
Costs of MathematizationMathematization does, naturally, have its costs. As pointed out by Morgenstern (1963, p. 2), when evaluating costs of mathematization, one has to distinguish among (i) criticism of inappropriate use of mathematics, (ii) criticism of the underlying economic model which happens to be analyzed mathematically, and (iii) criticism of mathematization.
In the first category we find criticisms of Bourbakism in economics (McCloskey 1994), of the use of calculus (Boulding 1948; Rothbard 1977), or of applying the mathematics of nineteenth-century mechanics to economics in general (Mirowski 1989). Likewise, criticisms of failed attempts to mathematize phenomena which seem to be impossible to address with known mathematics belong to this category (Beed and Kane 1991; Wutscher et al. 2010), as do also criticisms of misinterpreting quantitative economics (Mises 1996, pp. 55–56)It should be added that Mises criticized the use of quantitative methods to test theories; there is no argument in Mises’s writings against using quantitative methods in applied research. See also Leeson and Boettke (2006). and measurement (Rothbard 1977). None of these or similar criticisms, justifiable or not, represent arguments against the use of mathematics in economics as such.
Type (ii) criticisms are also not arguments against mathematization. They include criticism of unrealistic assumptions (e.g., Keynes 1964; Leontief 1971; Beed and Kane 1991; Wutscher et al. 2010) or criticism of particular concepts that happen to be used by mathematical economics, such as equilibrium (Wutscher et al. 2010). It is important to repeat that most mathematization is simply a translation of verbal statements into symbols; hence, the problem must be with theories themselves, not mathematics (Backhouse 1998; 2000). One may interject that the use of certain branches of mathematics (e.g., calculus) requires some additional assumptions such as continuity and differentiability (Menger 1973); but again, this criticism concerns only the application of a particular branch of mathematics to particular economic problem and is consequently not a general argument against mathematization. Furthermore, technical assumptions used by mathematical economics are often harmless: for instance, it is well-known that all important conclusions of standard demand theory can be obtained without the assumption of continuous and differentiable utility functions. Yet, continuous and differentiable functions are often used for the sake of convenience.
Actual costs of mathematization are identified by type (iii) criticisms. What are these costs? I identify three: first, tendency to downplay factors which are difficult to formalize; second, tendency to lose touch with reality; third, decrease of intelligibility for lay people. Note, that the first two costs are not inherent to mathematization per se; they are rather incidental to it and can perhaps be avoided. More importantly, though, none of these costs constitutes by its nature an argument for avoiding the use of mathematics altogether.
Downplaying Factors Not Amenable To FormalizationA tendency to neglect everything that cannot be easily formalized is a drawback of mathematization acknowledged by mathematical economists themselves (e.g., Debreu 1986). For instance, Krugman (1996; quoted in Backhouse 1998) argues that economists ignored important models for spatial economics just because these models could not be formalized.
Sometimes economists go so far as to demand that theories must refer only to quantifiable magnitudes. In his Nobel lecture Hayek (1975, p. 434) points out that
while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated important which happens to be accessible to measurement.
He gives an example of quantifiable relationship between aggregate demand and total unemployment on one hand, and relationship between unemployment and the structure of relative prices and wages on the other. The former is accepted as “scientific,” while the latter is neglected as not testable because we never know what the equilibrium prices and wages are.
Other phenomena that are difficult to treat mathematically and are often mentioned by the Austrians are subjectivism and Knightian uncertainty. Again, these can be argued to receive insufficient attention by economists.For the debate on formalization of Knightian uncertainty, see Caplan (1999) and Wutscher et al. (2010); for an attempt to formalize subjectivism in games, see Hudík (2014b). Still, one may wonder if perhaps the limits of mathematization, whether in this particular case or in general, do not often coincide with the limits of scientific investigation: are currently non-mathematizable phenomena amenable to science at all?
I suggest that the way to deal with the phenomena which are currently difficult to mathematize is not only a careful use of known mathematic tools but also development of new tools. For example, before von Neumann and Morgenstern (1953) mathematical economics (and, as a matter of fact, any branch of economics) was unable to deal with strategic decision problems. Hence, von Neumann and Morgenstern constructed a completely new branch of mathematics to deal with strategic issues. As this example illustrates, the limits of mathematization are not given but constantly evolve.
Losing Touch with RealityIt is often argued that mathematization leads to a loss of contact with reality (e.g., Boulding 1948; Champernowne 1954; Novick 1954; Šímová and Šíma 2012).On the other hand, Brems (1975) provides the following counter-example of verbal treatment leading to focus on imaginary problems: investment in the Keynesian theory was considered a function of the rate of interest instead of the change of the rate of interest, only because verbal economics was unable to handle difference or differential equations. This can have several reasons: In Debreu’s (1986, p. 1268) view, the power of mathematics is such that the “seductiveness of [mathematical] form becomes almost irresistible” and researchers thus tend to forget economic content. Still, Debreu argues that separation of models and reality can sometimes be an advantage. For instance, it is said to bring economics closer to the ideology-free ideal (see Düppe 2010).Morgenstern praised mathematical economics for exactly the same reason. See Leonard (2010).
According to Duesenberry (1954, p. 362), loss of touch with the real world is simply given by the job description of an economic theorist: the aim of the theorist is not to explain a particular set of observations but to show general consequences of a set of premises. To this argument we may add that a theorist also aims at universalization: she also attempts to show that two or several seemingly separate theories are merely different manifestations of the same principle. Hence, theoretical research is necessarily often disconnected from reality as it focuses on logical consistency of theories. From this perspective, criticism of the separation of mathematical models from reality could be interpreted as a criticism of theoretical research as such and as a plea for focusing on applied research. I hasten to add that the debate on optimal allocation of resources between theoretical and applied research is extremely important (see e.g., Šťastný 2010); yet, it is a different debate than the one on costs and benefits of mathematization.
IntelligibilityIt is probably true that the more formalized a model is, the less intelligible it is to lay people. Should economists worry about this trade-off? On the affirmative side stands the consideration that economic literacy is low which in turn has substantial negative externalities as citizens and voters are called upon to form opinions on many economic issues (e.g., Becker 2000; Šťastný 2010). On the other side stands the argument that, as in any other science, researchers should write primarily for other researchers and educating lay people should be left to popularizers: as individual economists differ in their skills and talents, there are benefits from specialization.Steven Levitt is an exception that may in fact prove the rule: his pop-economics books are co-authored with the journalist Stephen Dubner. Trading off benefits of formalization for intelligibility of academic writing to the general public thus seems inefficient. A different question is whether economists have sufficient incentives to be popularizers; but that is again for another debate.
ConclusionExamination of benefits and costs of mathematization suggests that the issue is not whether to use mathematics in economics or not; instead, the issue is what kind of mathematics is appropriate and how it should be used (cf. Backhouse 2000; Rosser 2003). It should be stressed that mathematization by no means is in conflict with the Austrian methodology, although some aspects of Austrian economics may be difficult to formalize at the present state of knowledge. This limitation, however, does not imply that we should give up on pushing the limits of mathematization further. Given that spreading ideas among the bulk of modern economists requires the use of mathematical language, one may only hope to see more and more mathematized Austrian economics in the future. For as they say: b(m) - c(m) > 0, for some m > 0.
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InXavier Méra holds a PhD in economics from the University of Angers and teaches at IÉSEG School of Management in Paris, France. I was a Mises Institute research fellow in 2009, 2010 and 2011, and would like to thank Professor Salerno, my fellow research fellows and the Institute staff and faculty for making these experiences enjoyable and intellectually rich. I am especially indebted to the Institute’s and research program’s donors, without whom none of this would have been possible. This chapter is an extension of a paper originally developed with the help and encouragement of Professor Salerno while a summer fellow. Thanks to Simon Bilo and Per Bylund for their thoughtful comments on a previous version. 2009, I had for the first time the opportunity of participating in the Mises Institute summer fellowship program under the guidance of Professor Salerno. On this occasion, I worked on an article touching upon the theme of monopoly price theory, a shared research interest of ours (Salerno 2003, 2004). My goal was to focus on how the pricing of factors of production is affected when their products are sold at monopoly prices (Méra 2010).
Now, the very nature of the issue at hand required to take a “long run” perspective since it concerns the production decision point, a decision which must be made by some capitalist-entrepreneur in anticipation of its future returns. Because of this focus, I noticed in the course of my research that Ludwig von Mises and Murray Rothbard tend to emphasize the same requirement for a monopoly price to emerge, as far as the demand schedule for the monopolized good is concerned, in the long run and in the “immediate run” (when the good is already available).
This is problematic because, as I intend to explain below, their criterion of a seller or a cartel of sellers facing an “inelastic demand” above the “competitive price” (Mises) or the “free-market price” (Rothbard) is only required in the immediate run. This has consequences in regard to the question of the limits to monopoly pricing, a question that Rothbard (1962, pp. 680–81) briefly but explicitly deals with in his “A World of Monopoly Prices?” section when he asks “Can all selling prices be monopoly prices?” He also provides insights outside of this section which also have direct implications for that question. Most notably, he explains that the very concept of a monopoly price makes sense only as a byproduct of interventionism, arguably an improvement over Mises’s theory. Nonetheless, Rothbard’s take, as well as Mises’s, suffers from this issue of the inelastic demand criterion and related weaknesses that I intend to highlight and repair below. Since these shortcomings happened not to be decisive for the article I worked on under Professor Salerno’s supervision, I had left them at that.In Méra (2010), my remarks in relation to the issue of the inelastic demand criterion are confined to footnotes. The present article essentially elaborates on these remarks. It seems appropriate then to deal with them here.
I begin with a brief summary of Rothbard’s view of monopoly prices as a hampered market phenomenon only. I interpret this modification of Mises’s monopoly price theory in the following way: the limits to monopoly pricing are shown to be narrower than what Mises thought. In other words, there is less room for monopoly prices to emerge in a market economy than Rothbard’s mentor considered.
Then I explain how, on the other hand, the ambiguous treatment of the inelasticity of demand criterion in Mises and Rothbard’s analysis leaves less room for monopoly prices than there really is. Although in contrast the modern neoclassical theory’s treatment of monopoly avoids the same ambiguity and its consequences, I show that the reason is accidental and that this should not be mistaken as a sign that it provides a superior alternative.
Finally, the main theory and policy implications of our findings are stressed: if there can be monopoly prices without inelastic demand schedules above free market prices, the price distortion potential of monopolistic privileges is more important than what Rothbard envisages. It becomes then all the more urgent to refrain from granting them if one wants to spare the bulk of consumers from the effects of factor misallocation.
Re-Thinking the Limits to Monopoly Pricing: Rothbard’s ContributionIn relation to Mises’s exposition of monopoly price theory, Rothbard’s central contribution is to show that the dichotomy between a competitive and a monopoly price is illusory in a free market framework. The movement from a competitive price to a monopoly price and the movement from a sub-competitive price to a competitive price are indistinguishable, for instance. The most fundamental reason is that the seller is in the same position vis-à-vis the demand schedule, whatever case one considers. All that we know based on Mises’s praxeology is that, nonmonetary factors aside, the seller will try to obtain a price above which the demand schedule is elastic. This is true when he can obtain a monopoly price. But this is true as well as when he can only charge a competitive price. Otherwise, he would charge a higher price. In other words, both prices appear to be distinguishable only if one arbitrarily postulates that a certain price is competitive so that a higher price can be considered as a monopoly price if the seller can increase his monetary income or net revenue by selling the good at this higher price. Absent an independent criterion to conceive of this competitive price, the whole dichotomy fades away (Rothbard 1962, pp. 687–98). If one cannot distinguish between two things, they are essentially the same.O’Driscoll (1982, pp. 190–91) argues that “a distinctively Austrian theory of monopoly remains to be written” and more specifically that “Murray Rothbard and Dominic Armentano, present a distinctive theory with roots deep in the history of economics and with strong affinity to the common-law treatment of monopoly. Their theory is not, however, the outcome or development of any particular Austrian insight.” However one might argue that Rothbard’s take is distinctly Austrian in its realization that the usual dichotomy of a competitive and a monopoly price in a free market is an anomaly in the context of Mengerian price theory (as developed by Mises). After all, Rothbard’s point is that the competitive price benchmark in a free market cannot be derived from the fundamentals of action. As a consequence, it appears as a foreign element forced into the theoretical edifice.
On the contrary, there is an identifiable criterion providing the basis for such a distinction once one contrasts actions occurring in a free market framework with actions occurring while some potential sellers are excluded from the market under threats of or outright aggression. As Rothbard (1962, p. 904) puts it:
We have seen above that on the free market, every demand curve to a firm is elastic above the free-market price; otherwise the firm would have an incentive to raise its price and increase its revenue. But the grant of monopoly privilege renders the consumer demand curve less elastic, for the consumer is deprived of substitute products from other potential competitors. Whether this lowering of elasticity will be sufficient to make the demand curve to the firm inelastic (so that gross revenue will be greater at a price higher than the free market price) depends on the concrete historical data of the case and is not for economic analysis to determine.
In other words, one can conceive of a monopoly price, as compared to a free market price, because the demand schedules that remaining sellers face are altered. These sellers are then not in the same position vis-à-vis these demand schedules than they would be when anyone has the right to compete with them. They will then be able to charge a monopoly price if the demand schedules they now face, independently or together as a cartel, are inelastic above the free market price, which is only possible if the market demand schedule is inelastic above the free market price (Rothbard 1962, p. 674).If the grant of privilege is given to one seller only, then the demand schedule he now faces is the market demand schedule.
Now, these simple yet profound insights mean the following, in relation to the question of the limits to monopoly pricing. If Mises and all the writers who have claimed that monopoly prices could arise in a free market framework have been mistaken here about their nature, they have underestimated the limits to monopoly pricing in society. Rothbard’s contribution — recasting the theory of monopoly price as part of a theory of interventionism — implies the claim that the scope for monopoly prices is narrower than what Mises thought.It was quite narrow already as compared to the views of some of Mises’ predecessors (Salerno 2003, pp. 60–62). Indeed there was no doubt for Mises that government is by far the main source of monopoly prices (Mises 1949, p. 363).
The Overlooked Case of Monopoly Prices with Elastic Demand SchedulesEven if one endorses Rothbard’s contribution, one might nevertheless argue that there is more room for monopoly prices than he thought. To understand this, one must focus on some condition required for a monopoly price to emerge that both Rothbard and Mises have repeatedly stressed in their writings on the topic. The above quote displays this condition. The demand schedule that the holder of a monopolistic privilege faces must be such that above the free market price (or the competitive price, for Mises), one or several prices bring in more revenue. This is the “inelasticity of demand” criterion. The implication is that monopoly pricing in society is limited to the extent that demand schedules are elastic in the relevant ranges. For Rothbard then, the less goods there are for which people are eager to increase their expenses on above their free market prices, the less room there is for monopoly pricing, no matter how effective the grants of privilege are at hampering competition.
There can be no quarrel with this as long as one takes an immediate run perspective in which the goods to be sold or withheld from the market are readily available. Matters are different however once one focuses on the production decision points, when people try to maximize net income and not necessarily gross income. Increasing one’s net income by restricting one’s production of a good is possible even if one faces an elastic demand schedule above the free market price, provided that one’s average production expenses fall at a high enough pace (or rise slowly enough). All that is really required is that total expenses fall more than total income. The decisive consideration is not inelasticity of demand. If it remains of course a factor of emergence of monopoly prices, it is not a necessary criterion anymore. The limits to monopoly pricing are not as narrow as what Rothbard suggests.
Mises and Rothbard’s Conflation of the Immediate Run and the Long RunNow the reader familiar with Mises and Rothbard’s writings might ponder. These authors did not forget to take production expenses into account in their discussions of monopoly prices, did they? To be sure, they did not. The point is however that Mises (1944), Mises (1949) and Rothbard (1962) never explicitly recognize that the inelasticity of demand criterion needs to be qualified once production is taken into account. In these expositions, they tend to jump from an immediate run to a long run perspective and vice versa without saying so. As a consequence, inelasticity of demand for the product appears to be a required criterion even when the analysis focuses on the production decision point.
For instance, in the paragraph following the above quote, Rothbard (1962, p. 904) mentions the restriction on production and the inelasticity criterion in the same breath, as if maximizing gross income still was the relevant consideration for the monopolist at the production decision point:
When the demand curve to the firm remains elastic (so that gross revenue will be lower at a higher-than-free-market price), the monopolist will not reap any monopoly gain from his grant. Consumers and competitors will still be injured because their trade is prevented, but the monopolist will not gain, because his price and income will be no higher than before. On the other hand, if his demand curve is inelastic, then he institutes a monopoly price so as to maximize his revenue. His production has to be restricted in order to command the higher price. The restriction of production and higher price for the product both injure the consumers.
Here the restriction of production comes as an afterthought, once one has considered which price would maximize gross income. Or, earlier, Rothbard (1962, p. 672) introduces the theory of monopoly price by quoting a passage of Human Action in which Mises focuses on the production decision point:
If conditions are such that the monopolist can secure higher net proceeds by selling a smaller quantity of his product at a higher price than by selling a greater quantity of his supply at a lower price, there emerges a monopoly price higher than the potential market price would have been in the absence of monopoly.
This is compatible with an elastic demand. And yet, Rothbard immediately adds, as if it was no different:
The monopoly price doctrine may be summed up as follows: A certain quantity of a good, when produced and sold, yields a competitive price on the market. A monopolist or a cartel of firms can, if the demand curve is inelastic at the competitive-price point, restrict sales and raise the price, to arrive at the point of maximum returns. If, on the other hand, the demand curve as it presents itself to the monopolist or cartel is elastic at the competitive-price point, the monopolist will not restrict sales to attain a higher price. [Emphasis in the original]It is not without justification then, that Armentano’s summary of Rothbard’s position conflates the immediate run and the long run: “It has been common, of course, to speak of monopoly price as that price accomplished when output is restricted under conditions of inelastic demand, thus increasing the net income of the supplier.” (Armentano 1978, p. 103). See also Armentano (1999, p. 48) and Armentano (1988, p. 8). See also Costea (2003, pp. 47–48) and Costea (2006, p. 45) describing Mises’s position in the same way.
Similarly, in Human Action, the required condition of the inelastic demand for a monopoly price to emerge is defended, and then production considerations are added with no qualification of the criterion. The initial requirement reads as follows:
The reaction of the buying public to the rise in prices beyond the potential competitive price, the fall in demand, is not such-as to render the proceeds resulting from total sales at any price exceeding the competitive price smaller than total proceeds resulting from total sales at the competitive price. (Mises 1949, p. 355)
Then he starts discussing the problem of resource allocation and production expenses. As a consequence, “net proceeds” (Mises 1949, pp. 357, 358, 359, 374) now become the relevant consideration, as they should. And yet, no mention is made of the fact that the previously stated requirement is not strictly valid anymore when he later refers to a “propitious configuration of demand” (Mises 1949, p. 370).
In Mises (1944), the same ambiguity is to be found in an even more pronounced way because Mises shifts back and forth from the immediate run to the long run perspective. First, Mises (1944, p. 2) posits the inelasticity of demand criterion with a numerical example. Given an existing stock of a good, the monopolist does not restrict his sales because demand is such that the total proceeds diminish at any higher price than the competitive one: “If a rise of the price above the competitive price results in a more-than-proportional restriction of the quantity bought by the public, the total proceeds of the seller would drop.” In the next paragraph, he switches to the long run perspective by considering the problem of the allocation of factors and then explains that,
… if some special barriers prevent other people from competing with the monopolistic sellers, a restriction of the production of copper or shoes that does not comply with the demands of the consumers becomes possible. Although the consumers are ready to pay for additional quantities of copper or shoes at prices which would render an expansion of production profitable on a competitive market, the sellers, sheltered by monopoly, do not expand production if they are better off under a state of affairs which results in a higher income for them with curtailment of production. (Mises 1944, p. 2)
Notice how Mises speaks here of mere “income” and not “net proceeds,” despite the fact that he is considering the production decision point. And on the next page, he comes back to the immediate run inelasticity of demand requirement. Both the immediate and long run perspectives are in effect conflated.Klein (2008, p. 177) has noticed that in his general discussion of price determination, “Rothbard (1962) is somewhat imprecise in distinguishing among equilibrium constructs.” We might add that this is true of Mises too, at least in the context of monopoly price theory, as illustrated above. On the distinctions between a “plain state of rest” (PSR), a “final state of rest” (FSR), the intermediate “Wicksteedian state of rest” (WSR) coined by Salerno (1994), and an “evenly rotating economy,” as a complete set of precise equilibrium constructs, see Klein (2008, pp. 172–83). Rothbard’s “immediate run” (PSR) and “long run” equilibriums (FSR) that we have been using here are sufficient for our present purpose however. It does not fundamentally alter Rothbard’s discussion and our analysis here if one interprets them in terms of WSR and FSR instead, since the PSR and the WSR are both about decisions to be made regarding some already produced goods. As one consequently fails to consider the case of a monopoly price with an elastic demand schedule, one narrows the limits to monopoly pricing too much (beyond Rothbard’s reduction to cases of interventions).
Surprisingly enough, given the evidence of conflation that we have shown, it turns out that in one instance Mises has implicitly considered the case of a monopoly price with an elastic demand. Mises (1944, p. 7) draws a table with hypothetical figures showing slightly decreasing average expenses as production expands. There are four prices considered, 5, 6, 7 and 8 monetary units per unit of product and a higher price always implies lower proceeds: the demand is elastic on whatever range we consider above 5, which Mises declares to be the competitive price. According to the inelasticity criterion, there is therefore no room for a monopoly price. But Mises writes that “the monopoly price most favorable to the monopolist is 7” (6, 7 and 8 are monopoly prices)! The reason of course is that, given the figures he chooses, the expenses required diminish more than the proceeds when one reduces the scale of production. Nevertheless, he does not mention explicitly that this is a case of a monopoly price with an elastic demand while, as shown above, he conflates the relevant required criteria for the immediate and the long run perspectives in the same article.
Rothbard too implicitly recognizes the case of a monopoly price with an elastic demand somewhere. In Power & Market, he reproduces an extract from Man, Economy, and State which claimed that an inelastic demand schedule is required for a monopoly price to arise. It is repeated word for word except for one added qualification: “The monopolist, as a receiver of a monopoly privilege, will be able to achieve a monopoly price for the product if his demand curve is inelastic, or sufficiently less elastic, above the free-market price” (Rothbard 1970, p. 44, emphasis added). Inelasticity is not a necessary requirement anymore. He does not explain the addition of the “sufficiently less elastic” criterion but one can certainly see that it makes perfect sense, in light of Mises’ example above and our comments.
To avoid conflation, one can explicitly refer to the two decisions points and thereby disentangle the two required criteria. Kirzner’s exposition comes closer to this than Mises’ and Rothbard’s (Kirzner 1963, pp. 265–96) and is arguably superior in this regard. Another is to call the immediate run and the long run monopoly prices differently. This is, as Salerno (2003, p. 31) notices, what Fetter (1915, pp. 80–81) does, writing of a “crude monopoly price” when the sale of an already produced stock of a good is considered, and of a mere “monopoly price” for a good when its production is considered. Then it can be easily grasped that a crude monopoly price requires an inelastic demand schedule above the free market price, whereas a mere monopoly price does not.
The Trouble with Rothbard’s Falling Costs ProvisoThe lack of a clear-cut explicit distinction in Mises and Rothbard’s analysis between the immediate run and the long run can lead to some further confusion. If one ignores the case of a monopoly price with an elastic demand, it is difficult to make sense of Rothbard’s proviso, according to which a monopoly price will arise when one is striving for maximum net proceeds, “whatever the actual configuration of money costs, unless, indeed, average money costs are falling rapidly enough in this region to make the “competitive point” the most remunerative after all” (Rothbard 1962, p. 674).
The reason is the following. For the “competitive point”Rothbard speaks of a competitive point instead of a “free market point” because the context is his discussion of Mises’ theory. The reader must not get confused by this. This discussion is relevant in Rothbard’s framework once the theory is fixed and depicts how a monopoly price actually contrasts with a free market price instead of a “competitive” price. As Rothbard (1962, p. 903) puts it in his chapter on interventionism and socialism: “In chapter 10 we buried the theory of monopoly price; we must now resurrect it. The theory of monopoly price, as developed there, is illusory when applied to the free market, but it applies fully in the case of monopoly and quasi-monopoly grants.” to yield a higher net return than the restrictive alternative with an inelastic demand, it would be necessary that expenses fall in absolute terms when one increases production, not merely on average, since gross income falls when one expands until the free market point (by definition of the inelasticity of the relevant range of the demand schedule). But this is impossible. Average expenses might fall when production is increased, because of the indivisibility of some factors of production. Total expenses cannot. If the producer-seller will face an inelastic demand for his product in the future, restriction must pay whatever the configuration of expenses is. And believing that a proviso is required here amounts once again to an unjustifiably narrow view of the limits to monopoly pricing.
The proviso makes sense only once one recognizes the possibility of a monopoly price with an elastic demand. In general, the higher the average expenses become as production expands, the more likely it is that cutting production below the free market level pays. Hence the case of a monopoly price with an elastic demand, provided that average expenses become low enough when one reduces production below the free market level (“low enough” meaning that total expenses fall at a faster pace than total receipts in order for net proceeds to rise). In other words, the more they rise instead, or fall at a slow pace, the less likely it is that net proceeds will be higher at a lower level of production, the more chances there are that the free market level of production is the most remunerative. But this possibility arises only when the demand is elastic above the free market price. When doing less brings in more gross revenue, restriction in the monopolized industry always pays. Any other conclusion unduly narrows down the limits to monopoly pricing.
The Current Textbook Treatment as a Superior Alternative?It could be argued that the orthodox take on monopoly as found in Arnold (pp. 223–58) or any microeconomics textbook is superior to Mises and Rothbard’s in at least one respect: there is no risk of the sort of conflation we have pointed out here because there is no immediate run analysis to conflate with a long run perspective in its treatment of the issue. In that neoclassical approach, the sellers are producers too, even in the short run. There is no question of what to do with an available stock of a good. There is no reason then for inelasticity of demand to be a distinguishing criterion since monetary profit maximization — and therefore money costs — are relevant considerations in all cases.
Apart from the fact that getting rid of the immediate run is per se problematic since the useful and realistic concept of a crude monopoly price disappears from the picture, the most fundamental reason why inelasticity has no decisive role in that approach is that it is based on different categories with different criteria than the older monopoly price theory. As Caplan (1997) puts it, in modern neoclassical theory,
there is always some degree of monopolistic distortion unless firms face a horizontal demand curve. For unless firms face a horizontal demand curve, a profit-maximizing firm sets its price above its marginal cost. In the absence of perfect price discrimination, this means that there is a “deadweight loss” — or unrealized gains to trade.
In other words, the fundamental distinction here is between “pure and perfect competition” with perfectly elastic demand schedules and “imperfect” or “monopolistic competition” with downward sloping demand curves (“monopoly” being the extreme case in which only one seller would face the market demand schedule).
Turning toward this approach as an apparently more rigorous alternative brings in its whole theoretical apparatus with its weaknesses that Mises and Rothbard have identified. For although Caplan (1997) claims that he affords “all too little attention to the modern neoclassical theory,” Rothbard (1962, pp. 720–22) actually demonstrates that perfect elasticity is impossible since it is not compatible with the always holding law of marginal utility. As a consequence downward sloping demand curves for individual sellers and the corresponding “failure” to equate price and marginal cost are no signs of monopolistic distortion and the marginal cost pricing criterion cannot serve as a realistic criterion to conceive of a competitive price.
It should be kept in mind that the older monopoly price theory does not depend on the benchmark of “pure and perfect competition,” which explains why Mises and Rothbard found something of value in it whereas they entirely dismissed the newer view (Mises 1949, pp. 356–57; Rothbard 1962, pp. 720–38).
Conclusion: Theory and PolicyIs there more to say about the maximum limits to monopoly pricing than the fact that in the immediate run, elastic demand schedules deprive monopolistic privilege holders of opportunities to charge “crude” monopoly prices? Or that demand schedules which are too elastic in relation to average production expenses deprive monopolistic privilege holders of opportunities to charge monopoly prices for their products? According to Rothbard (1962, p. 681), in the aforementioned “A World of Monopoly Prices?” section of Man, Economy, and State, “monopoly prices could not be established in more than approximately half of the economy’s industries,” among other reasons because it is impossible for every industry to face an inelastic demand schedule since buyers cannot spend more in every industry.
Now, as explained above, the inelasticity of demand criterion is only required in the immediate run perspective of deciding what to do with an available stock of a good. As a consequence, if at most half of the economy’s industries could face inelastic demands above their free market prices, there could still be other monopolized industries able to charge monopoly prices provided that their total expenses fall at a rapid enough pace when they reduce production. More than half of an economy’s industries might then charge monopoly prices. The limits to monopoly pricing are then larger when one focuses on the production decision points. In light of our explanations, Rothbard’s neglect of this insight is attributable to his and Mises’s tendency to conflate the immediate and long run perspectives in their expositions.
The implications are straightforward. As far as pure theory is concerned, Rothbard underestimated the impact of granting monopoly privileges on price formation. If monopoly prices can arise without inelastic demand schedules, factor allocation is correspondingly altered to the detriment of the bulk of consumers, beyond the already recognized alteration occurring under the condition of inelastic demand schedules. As far as policy is concerned, it becomes all the more urgent to abolish monopoly privileges, or to refrain from enacting them in the first place, if one wants to minimize factor misallocation.
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Salerno, Joseph T. 1994. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” Review of Austrian Economics 8(1): 71–115.
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InMateusz Benedyk is a PhD Candidate at the Faculty of Social Sciences, University of Wrocław and the President of Ludwig von Mises Institute Poland. The author would like to thank Mateusz Machaj and David Howden for their helpful comments. I was a summer research fellow in 2012. This chapter was inspired by Professor Salerno’s many contributions in the field of history of the Austrian school of economics and his investigations regarding the monetary theory. recent decades we have witnessed several debates on the legacy of Friedrich von Hayek in the realm of monetary policy. His writings have been both endorsed and attacked by economists from opposing branches of Austrian economics.For example Hayek was attacked for not seeing the merits of fractional reserve banking by Lawrence H. White, “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31, no. 4 (1999): 753–69; and for not blaming fractional reserve bankers for business cycles by Walter Block, Kenneth M.Garschina, “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics 9, no. 1 (1996): 77–94. Part of the problem is that Hayek partially changed his mind throughout his life and gave different policy prescriptions in the 1970s than he did in 1930s.For the discussion of Hayek’s writings in 1970s and 1980s see G. R. Steele, “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14. Here we will deal primarily with the earlier works of Hayek. But even the interpretation of his major works on money, banking and business cycle from 1920s and 1930s poses some problems.
We would like to shed some light on the Hayekian analysis of different monetary institutions. Specifically, we want to clarify what the economic consequences of such institutions: fractional and one-hundred percent reserve banking; and various monetary policy norms of central banks.This list does not pretend to exhaust all of the Hayek’s insights in the field of money. It includes only the problems that created numerous controversies and rivalrous interpretations in the literature. More comprehensive study should include e.g., effects of various international monetary systems and the differences between central and free banking or between token and commodity money. Special attention will be given to the differences between constructs of pure money and business cycle theories as opposed to policy prescriptions. The first section discusses the relation between fractional-reserve banking and the business cycle. It also deals with Hayek’s opinions on one hundred percent reserve banking. In the second section we debate the claim of Hayek endorsing the monetary policy of stabilizing the level of nominal spending. Several concluding remarks are offered in the last section.
Fractional and One-Hundred Percent Reserve BankingIn Hayek’s view the contemporary organization of the banking sector was responsible for the cyclical fluctuations of the economy. He devoted the whole chapter of the Monetary Theory and the Trade Cycle to show that the expansion of credit by fractional-reserve banks must necessarily lead to unsustainable boom even if there is no central bank.Friedrich A. Hayek, “Monetary Theory and the Trade Cycle,” In: idem, Prices and Production and Other Works, ed. Joseph Salerno, Auburn 2008, pp. 73–103.
According to Hayek the magnitude of the bank’s credit expansion depends on its cash reserves. The crucial point is “that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable.”Ibid., p. 91. If, for whatever reason, economic conditions improve and banks consider their cash reserve to be excessive, they will grant additional credit to their customers. “[F]or reasons of competition ... the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks that had not yet experienced a similarly increased demand for credit.”Ibid., p. 93.
This expansion of credit occurres without corresponding growth of savings. Other banks cannot distinguish between deposits created out of new savings and the ones created without it. They will join the credit expansion, as money from other banks will be deposited in their company, and lower their growing reserve ratio. The effect of the process is that the money rate of interest is for the time being lower than the natural rate.
Only so long as the volume of circulating media is increasing can the money rate of interest be kept below the equilibrium rate; once it has ceased to increase, the money rate must … rise again to its natural level and thus render unprofitable … those investments which were created with the aid of additional credit.Ibid., p. 94.
Since fractional reserve banking is in Hayek’s view responsible for the business cycle, it’s hardly a surprise that he mentioned on several occasions the idea of one-hundred percent reserve banking. As early as 1925 he discussed the idea shortly in a review of Federal Reserve monetary policy after the crisis of 1920. Hayek wrote the following:
The older English theorists of the Currency School, who, as we already pointed out, understood the nature of cyclic fluctuations better than most of the economists who came after them, also hoped that cyclic swings could be prevented by their proposals for the regulation of note issues. … If the basic idea underlying the Peel’s Act were consistently implemented and a 100 per cent gold coverage were required for bank deposits as well as for bank notes, the problem of preventing depressions would be resolved in a drastic manner.Friedrich A. Hayek, “Monetary Policy in the United States after the Recovery from the Crisis of 1920,” In: Idem, Good Money. Part I, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008, p. 111, n. 37.
A monetary system without business cycle seems like a desirable goal, but Hayek was not eager to advocate the idea of abolishment of fractional reserves. In Monetary Theory and the Trade Cycle Hayek stated clearly that in case of one hundred percent reserve banking:
[t]he stability of the economic system would be oFriedrich A. Hayek, Monetary Theory…, p. 103.btained at the price of curbing economic progress. The rate of interest would be constantly above the level maintained under the existing system. … The utilization of new inventions and the “realization of new combinations” would be made more difficult, and thus there would disappear a psychological incentive toward progress.
Hayek didn’t elaborate further on this point. It therefore seems unconvincing: why would capitalists earning a higher rate of interest on their capital be discouraged to innovate and invest? Shouldn’t a system where entrepreneurs make mistakes on a regular basis (malinvest during the business cycle) be more disruptive for innovators?On this point see: Joseph Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 22–23, 37–38. Jesús Huerta de Soto thinks that “maybe it would be wiser to interpret the assertions Hayek made in 1929 (in Monetary Theory and the Trade Cycle) in the context of the lecture given before the Verein für Sozialpolitik. ... Hayek’s speech was subject to a rigorous examination by professors who were little inclined to accept conclusions they viewed as too original or revolutionary.”Jesús Huerta de Soto, Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup, Auburn 2006, pp. 470–71, n. 74.
Hayek returned to the idea of one hundred percent reserve banking in 1937 in the series of lectures published as Monetary Nationalism and International Stability. In the fifth lecture he reviewed briefly “The Chicago Plan of Banking Reform.”Friedrich A. Hayek, "Monetary Nationalism and International Stability," In: Idem, Prices and Production and Other Works, pp. 410–13. This time Hayek’s objections to the abolishment of fractional reserve banking were completely different:
The most serious question which it raises, however, is whether by abolishing deposit banking as we know it we would effectively prevent the principle on which it rests from manifesting itself in other forms. … [T]he question is whether, when we prevent it from appearing in its traditional form, we will not just drive it into other and less easily controllable forms. … The [Peel’s Banking] Act of 1844 was designed to control what then seemed to be the only important substitute for gold as a widely used medium of exchange and yet failed completely in its intention because of the rapid growth of bank deposits. Is it not possible that if similar restrictions to those placed on bank notes were now placed on the expansion of bank deposits, new forms of money substitutes would rapidly spring up or existing ones would assume increasing importance?Ibid., pp. 411–12.
This analysis does not mention any economic deficiencies connected with the system of one hundred percent reserve banking. The obstacle is of a practical nature — whether we will be able to stop the creation of new money substitutes that will take the place of bank notes and deposits.A description of these obstacles is a major part of Hayek’s discussion of the Chicago Plan. It’s therefore an overstatement to say that “in Monetary Nationalism and International Stability, [Hayek] changed his mind, proposed a constant money supply and advocated the demand for a 100-percent reserve requirement in banking” — Jesús Huerta de Soto, Money…, p. 470, n. 74. We may conclude here that Hayek saw the merits of advocating for an end of fractional-reserve banking — a seed of the business cycle in the contemporary economy — but never fully endorsed the program of one hundred percent reserve banking, pointing to problems of both a theoretical and practical nature.
Central Bank’s Policy PrescriptionsThe greatest controversies regarding Hayek’s stance on monetary theory arise from the central bank’s policy norms that Hayek allegedly proposed. Since we live (as Hayek did as well) in a world of central banks managing the fractional-reserve banking system, we may ask if there is something the monetary authorities can do to mitigate the business cycle.We have already discussed the possibility of central banks requiring banks to hold one hundred percent reserves on deposits, so we won’t mention the subject in this section. Recently Lawrence White stated:
Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms, the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.Lawrence H. White, “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40, no. 4 (2008): 754–55, emphasis added.
White’s bold statements led Marius Gustavson to propose a ‘Hayek Rule’ — understood as keeping MV constant — as a norm for Federal Reserve’s policy in the 21st century.Marius Gustavson, The Hayek Rule: A New Monetary Policy Framework for the 21st Century, Reason Foundation Policy Study 389 (2010). Gustavson’s study includes references to White’s 2008 paper. Two questions arise:
(1) Did Hayek endorse such a policy?
(2) Does Hayek’s business cycle theory provide a justification for “Hayek Rule”?
To properly answer these questions it’s useful to consider the theoretical context of Hayek’s business cycle investigations. For Hayek the main puzzle was how to integrate the theory of business cycle into the general equilibrium theory.In Hayek’s words: “By ‘equilibrium theory’ we here primarily understand the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics.” — Friedrich A. Hayek, Monetary Theory…, p. 19, n. 15. In other words: how it is possible that forces leading markets to clear fail to coordinate consumers’ preferences and producers’ decisions during the business cycle? Hayek’s view was that we should focus on the active role money plays in the economy. The introduction of money breaks the clear process of price formation in barter and makes it possible that “real” factors responsible for price formation will be for some time hindered by monetary factors.
Beginning in mid-1920s Hayek struggled to describe the active role money plays in price formation in a more detailed fashion.Between 1925–1929 Hayek was preparing a book on the subject titled Geldtheoretische Untersuchungen, which he never completed. Two articles Hayek published at the time were excerpts from the book: Intertemporal Price Equilibrium and Movements in the Value of Money (originally appeared in German in 1928) published in Good Money. Part I; The Paradox of Saving (published in German in 1929) published inter alia in Prices and Production and Other Works. The English translation of the unfinished manuscript of the Geldtheoretische Untersuchungen has been recently published as Investigations into Monetary Theory, first chapter of: Friedrich A. Hayek, Business Cycles. Part II, ed. Hansjoerg Klausinger, The Collected Works of F.A. Hayek, vol. 8, Chicago 2012. He came up with the idea of “neutral money” — a set of conditions needed for the money to be neutral toward prices. His first idea was that the supply of money must be constant in order to be neutral. In the 1930s he changed his mind and advocated the idea that money may be neutral when the effective money stream (MV) is constant.This evolution of Hayek’s thought is well documented in another paper of Lawrence H. White, “Hayek’s Monetary Theory and Policy: A Critical Reconstruction,” Journal of Money, Credit and Banking 31, no. 1 (1999): 109–20. Does it follow that Hayek advocated the monetary policy of stabilizing MV? Not necessarily.
In the second edition of Hayek’s Prices and ProductionFriedrich A. Hayek, Prices and Production, [In:] Idem, Prices and Production and Other Works, pp. 301–04. and in a paper from 1933 titled On ‘Neutral’ MoneyFriedrich A. Hayek, On ‘Neutral’ Money, [In:] Idem, Good Money. Part I, pp. 228–31. we find some clarifications as to the proper relation between the theoretical concept of neutral money and the prescribed monetary policy. In the latter Hayek wrote: “The concept of neutral money was designed to serve as an instrument for theoretical analysis, and should not in any way be set up as a norm for monetary policy, at least in the first instance.”Ibid., p. 228. Hayek stressed the monetary policy can have different goals than getting close to the state of neutral money. He also mentioned the stable MV is not the sufficient condition for money to be neutral.
It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, first, the total money stream remained constant, and second, all prices were completely flexible, and, third, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.Friedrich A. Hayek, Prices and Production, p. 304. Almost identical statement in: Friedrich A. Hayek, On ‘Neutral’ Money, p. 230.
Lack of perfect foresight regarding the future value of money and any degree of price stickiness make neutral money an impossibility. One could argue that even though we cannot reach perfection, it is still a good idea to pursue the ideal. But Hayek saw other problems with stabilizing the level of nominal expenditures. In Prices and Production he briefly discussed the problems with changing money velocity due to hoarding, dishoarding, changes in business organization etc.
For, in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.Friedrich A. Hayek, Prices and Production, p. 297.
For Hayek it was clear that pumping money in any place in the economy as a reaction for increased demand for money in another place would not suffice to get closer to money neutrality. The money would have to be given to exactly those persons whose demand has increased. Hayek understood well that giving more money to a single person will result in a series of small adjustments of incomes and spending habits of many individuals cooperating with the agent, who got the money in the first place.Example of such an analysis can be found in: Friedrich A. Hayek, Monetary Nationalism…, pp. 353–59. Increasing the quantity of money in places where the demand for money remained unchangedFor example when central bank buys large quantities of securities in a Quantitative Easing program. would entail another round of necessary adjustments of incomes and spending patterns without accommodating the original change in money velocity.
Apart from abstract arguments about problems with implementation of stable MV policy Hayek specifically argued against monetary policy measures to combat deflation during the Great Depression as late as 1932. In a preface to English translation of Monetary Theory and the Trade Cycle Hayek wrote:
[The existence of deflationary process] does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. … To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.Friedrich A. Hayek, Monetary Theory…, pp. 5, 6–7.
Not only did Hayek differentiate between theoretical concepts and policy norms, find practical problems in stabilizing MV and explicitly rejected fighting the recession with money creation, but he actually proposed another policy norm in the writings on money neutrality and constant flow of spending. In Prices and Production he mentions only that “Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by over-caution.”Friedrich A. Hayek, Prices and Production, p. 298. In On ‘Neutral’ Money Hayek dared to propose a more specific solution:
[I]t seems to me that the stabilization of some average of the prices of the original factors of production would probably provide the most practicable norm for a conscious regulation of the quantity of money.Friedrich A. Hayek, On ‘Neutral’ Money, p. 231.
In light of these passagesInterestingly White quoted the same passage from “On ‘Neutral Money’” in Lawrence H. White, Hayek’s Monetary Theory…, p. 117. it seems that White’s statement about Hayek’s clear policy recommendation of stabilizing the level of nominal spending is unfounded — Hayek explicitly endorsed another rule and found problems with implementing targeted nominal spending rule.
There are big differences between stabilizing MV and stabilizing the prices of factors of production. Proponents of stabilizing MV claim that a shrinking nominal GDP is an indication that the central bank should increase the money supply (we need to remember that NGDP is only an approximation of the level of spending, since GDP excludes transactions of goods that are not final. If we want to measure the level of spending properly we should include all money transactions). A proponent of stabilizing MV could argue that even if money expenditures rose during the boom phase, it would be unwise to let it shrink to the pre-boom level. Therefore Quantitative Easing I in the USA would be justified since NGDP was falling between Q3 2008 and Q2 2009.According to “The Economist”: “Hayek believed the central bank should aim to stabilise nominal incomes. On that basis Mr [Lawrence] White thinks the Fed was right to pursue the first round of quantitative easing, since nominal GDP was falling, but wrong to pursue a second round with activity recovering.”
A proponent of stabilizing the prices of the factors of production could argue that it’s unwise to maintain prices at the inflated boom level. Lower input prices would actually stimulate the demand by entrepreneurs to start investing again. Hence, if we look at the level of factors of production prices we see a different story. Let’s take for example Producer Price Index. At the end of the previous recession — in 2002 the index (1982=100) stood at around 100 points. At the bottom of recession in February 2009 it stood at around 160 points, so it would indicate that monetary policy was extremely accommodative.All the data is taken from Federal Reserve Bank of St. Louis.
There is also another “Hayekian” problem connected with advocating QE: can the central bank actually gather and process all the information needed to fight the shrinking money expenditures in the same manner as private banks would do.For the discussion see: William N. Butos, “Monetary Orders and Institutions: A Hayekian Perspective,” Quarterly Journal of Austrian Economics 15, no. 3 (2012): 259–76.
ConclusionsFriedrich von Hayek rarely stated clearly his monetary policy proposals. He was mostly interested in the field of pure monetary theory (at least in the 1930s). It seems to us that his theories of money and business cycle can give good arguments for people advocating one hundred percent reserve banking. When it comes to monetary policy of the central bank Hayek briefly proposed the idea of stabilizing the prices of factors of production, but did not elaborate on why this should be the best policy.
Perhaps it is unfortunate Hayek used the framework of general equilibrium theory to investigate the problem of the business cycle.For other problems associated with Hayek’s methodological choices see: Joseph Salerno, "Mises and Hayek Dehomogenized," Review of Austrian Economics 6, No. 2 (1993), pp. 113–46. This might lead many to confuse the highly abstract and unrealistic conditions of general equilibrium with the desired state of monetary affairs, whereas occurrence of these conditions would actually mean that money is not needed in the economy at all.Ludwig von Mises, Human Action. A Treatise on Economics, Auburn 1998, pp. 250–51. Only late in his life Hayek managed to incorporate his more dynamic view on economy regarding competition and entrepreneurial discoveries into the money and the area of business cycles. In Denationalization of MoneyFriedrich A. Hayek, The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies, [In:] Idem, Good Money. Part II, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008, pp. 128–229. he finally proposed the idea of opening the sphere of money and banking to the competition instead of leaving it to the plans of bureaucrats.
In a lecture from October 1977 Hayek stated:
The interesting fact is that what I have called the monopoly of government of issuing money has not only deprived us of good money but has also deprived us of the only process by which we can find out what would be good money. We do not even quite know what exact qualities we want because in the two thousand years in which we have used coins and other money, we have never been allowed to experiment with it, we have never been given a chance to find out what the best kind of money would be.Friedrich A. Hayek, Toward a Free Market Monetary System, [In:] Idem, Good Money. Part II, p. 234.
This call for a competition in the field of money seems to me the best example of a truly Hayekian monetary policy.
ReferencesBlock Walter, Kenneth M. Garschina. 1996. “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process.” Review of Austrian Economics 9(1): 77–94.
Butos William N. 2012. “Monetary Orders and Institutions: A Hayekian Perspective.” Quarterly Journal of Austrian Economics 15(3): 259–76.
Gustavson Marius. 2010. “The Hayek Rule: A New Monetary Policy Framework for the 21st Century.” Reason Foundation Policy Study 389.
Hayek F. A. 2012. Business Cycles. Part II. In The Collected Works of F.A. Hayek, vol. 8, Hansjoerg Klausinger, ed. Chicago: University of Chicago.
——. Good Money. Part I: The New World, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008.
——. Good Money. Part II: The Standard, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008.
——. Intertemporal Price Equilibrium and Movements in the Value of Money. In idem, Good Money. Part I, pp. 186–27.
——. Monetary Policy in the United States after the Recovery from the Crisis of 1920. In idem, Good Money. Part I, pp. 71–152.
——. Monetary Nationalism and International Stability. In idem, Prices and Production and Other Works, pp. 331–422.
——. Monetary Theory and the Trade Cycle. In idem, Prices and Production and Other Works, pp. 1–130.
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ScholarsAmadeus Gabriel is assistant professor in the Department of Finance and Economics at the La Rochelle Business School, France. I was a summer fellow at the Ludwig von Mises Institute as an undergraduate student in 2006, and later as a graduate student in 2011. of the Austrian tradition are particularly known for their important work in the field of monetary economics. They analyze the dynamics of fiat money and its impact on the real economy. However, empirical attempts to support the theoretical claims are relatively rare. In this chapter, I sketch an empirical strategy to test whether a change in the monetary regime has significantly impacted the accumulation of public debt and government deficits in the United States. Government deficits appear to be significantly lower under the gold standard regime and significantly higher under a regime of fiat money after controlling for other explaining factors such as, for instance military expenses or interest charges.
This chapter is structured as follows. Section 2 gives an overview about the nature of money to understand the dynamics of fiat money. Section 3 outlines why the introduction of a fiat money regime potentially increases the accumulation of public debt. Section 4 outlines the econometric model to account for the effects of different monetary regimes on public debt. Furthermore, potential lines of research are provided to improve the explanatory power and robustness of the model. Section 5 concludes.
Monetary Mechanisms and Monetary PolicyAs Mises repeatedly stresses, money is the fruit of indirect exchange (Mises 1980, p. 45). Thus, the emergence of money is spontaneous and becomes necessary as the division of labor increases and wants become more refined (Mises 1980, p. 5). Individuals only choose to have recourse to indirect exchange when the goods they can acquire are more marketable than those which they surrender.
As a result, the most marketable commodities will become common media of exchange and their position is strengthened as their relative marketability increases in comparison to other commodities (Mises 1980, p. 6). The main function of money according to Mises is its universal employment as a general medium of exchange (Mises 1980, p. 7).
Hülsmann (2008) introduces a further distinction between natural and forced monies. Natural money corresponds to money that arose through voluntary actions of individuals which circulates until it is displaced by an external pressure. Alterations to the former type of natural money are defined as forced money. In this case, money no longer complies with individual preferences, but is the result of a welfare reducing imposition. As a consequence, forced monies are per definitionem less socially beneficial than natural monies, as they only exist due to the violations of individual rights. Based on this distinction, it is possible to introduce a further division between credit money and paper money. As Hülsmann (2008) points out, the value of credit money (a claim to money in the future) is based on the trust that the respective sum of money is eventually refunded in the future.
Paper money or fiat money owes its existence to legal privileges. Hülsmann (2008) emphasizes that paper money has never spontaneously emerged as a result of the voluntary actions of individuals. Legal tender laws impose the use of a lower quality paper money at the expense of the natural money. The bad money, i.e., the overvalued paper money, drives the good money, i.e., the undervalued natural money out of the market as their legal equivalence is only due to imposed laws and do not reflect the economic reality. This process is known as Gresham’s law, named after Thomas Gresham (Hülsmann 2008, p. 127). Naturally, this leads to inflation of the overvalued money, “because this money is produced and held in greater quantities than would be the case in the absence of the price control” (Hülsmann 2008, p. 127). The natural limit in money production is distorted as the full consequences are not borne by the money producer. Legally established values are not altered and constraining competitive processes are suspended under legal tender laws. Moreover, Cantillon effects, named after the French economist Richard CantillonSee Richard Cantillon, La nature du commerce en général (Paris: Institute national d’études démographiques, 1997). enforce the enrichment of money producers under the regime of legal tender. As Hülsmann (2008, p. 44) points out, there can be no simultaneous increase of all prices as newly created money enters the market. The first users of the new money have the privilege to use it on goods priced according to the quantity of money that existed before the increase in the money supply. However, the newly acquired purchasing power does not remain unnoticed and spreads out through the economy. Prices eventually adjust upward due to the increased demand of the initial users. The last receivers have not benefited from the new money. To the contrary, they suffer a deteriorated quality of the money and higher price levels.
As Hülsmann (2008, p. 89) argues, debasement was traditionally the way to inflate the money supply. The nominal value of a coin was modified not reflecting the metal content any longer or the content of metal was reduced without an according change in the nominal value. However, debasement reached a whole new level with the emergence of fractional-reserve banking, i.e., the issuance of coins or bank notes which are not fully covered by the available reserves. This significantly reduced the cost of money production. According to Hülsmann (2008, p. 93), there are three main reasons that led to this phenomenon.
In the first place, the warehousing institutions, the original function of banks to the late 1700s, have been perverted. Second, credit banking has been perverted as banks use deposits for loans. Lastly, it was a natural response to the threat of government expropriation. As banks feared that their holdings would be eventually confiscated, they preferred to lend out the funds. However, as individuals eventually find out about the debased monies, it is necessary to guarantee a continual demand through legal tender laws. This privilege is the ultimate explanatory link for all other monetary advantages.
In addition to the outlined factors, the twentieth century witnessed the development of maturity mismatching in the banking sector (Bagus and Howden, 2009), i.e., borrow short and lend long. Nowadays, this is considered as one of the main functions of banks. For instance, Freixas and Rochet (2008) point out that “modern banks can be seen as transforming securities with short maturities, offered to depositors, into securities with long maturities, which borrowers desire.” Necessarily, this implies a certain “risk” for banks if the credits are not covered by corresponding savings of depositors. If depositors require their funds, banks can have recourse to derivatives (such as swaps or futures) or engage into interbank lending to limit this “liquidity risk.” However, this type of risk management is very costly. In a competitive environment where the success of a bank’s business is based on its ability to gain confidence of depositors, the constant mismatching of maturities must be relatively limited. Depositors are not likely to give their money to banks that accumulate negative working capital and struggle to refinance their debt.
To recapitulate, money evolved spontaneously in the market. Historically, gold and silver were chosen as the common medium of exchange for their practical purposes. For reasons of convenience, warehouses arose to store these metals and certificates were issued. As a consequence, certificates were traded in everyday business and rarely redeemed into gold. Unfortunately, this created a temptation to engage into fractional-reserve banking and to issue certificates in excess of the actual gold reserves. At some point, governments entered into the game and monopolized the minting of coins and established legal tenders laws. Under the classical gold standard from 1815–1914, a fractional gold standard was institutionalized and guaranteed by the respective states. As already outlined above, fractional-reserve banking diminishes the cost of money production and increases the profitability of banks. As a consequence, there is a tendency to threaten the financial stability of banks as the continual issuance of credits in excess of savings is eventually discovered by depositors and creditors. Bank runs and the liquidation of assets are naturally the cause as people lose confidence.
The drawbacks of this business model must be resolved by some external institution that guarantees the liquidity of banks. This is the role of central banks (Bagus 2012). Central banks are lenders of last resort for commercial banks. Banks can now refinance their debt through short-term credits and liquidity problems can be limited as the production of money is coordinated by the central bank. However, under the gold standard, even coordinated money expansion was limited by the fear of redemption in a crisis. By the 1970s the burden of the gold standard was removed and the doors were further opened for the lucrative business of money creation.
Monetary Policy Since the 1970s in the United StatesThe abolition of the gold standard on August 15, 1971, led to the establishment of a regime of paper monies for most of the national currencies. Before this date all national currencies were linked to the gold standard via the US dollar. As the US decided to go off gold altogether, the fractional-reserve gold certificates basically became paper money (Hülsmann 2008, p. 223). The new fiat money standard magnified moral hazard at a large scale. Fiat money allows producers of money to “create ex nihilo virtually any amount of money” (Hülsmann 2006, p. 10). The growth of the money supply increased significantly after the decision to go off the gold window. The M3 monetary aggregate grew by 12.42 percent in 1972 in the US, although the average growth rate was about 6.76 percent in the decade before.
Under the regime of William McChesney Martin from 1951 to 1970, monetary policy was relatively conservative. Growth rates of the CPI were below three percent during the early 1960s (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 23). As Martin points out in testimony to the Joint Economic Committee: “the Fed has a responsibility to use the powers it possesses over economic events to dampen excesses in economic activity by keeping the use of credit in line with resources available for production of goods and services.Martin’s testimony to the Joint Economic Committee, February 5, 1957. Cited by (Bremner 2004, p. 123). In 1964, Martin expressed his concerns about increasing inflation as federal spending increased a lot during the second half of the 1960s. Bremner (2004, p. 191) cites a quote by Martin which summarizes his worries: “I think we’re heading toward an inflationary mess that we won’t be able to pull ourselves out of.” Martin expressed in his last press conference that he had “feelings of failure for not having controlled inflation” (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). By 1970, Martin was replaced by Arthur F. Burns. He commenced a period of high inflation and very low real interest rates, a byproduct of loose money now simplified by the full fiat money standard. However, even before the suspension of payment by the Fed in 1971, the federal funds rate was already lowered from 8.02 percent during the first quarter in 1970 to 4.12 percent by the fourth quarter of the same year (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). What are the implications of low or even negative real interest rates? They reduce the incentives for people to save money and at the same time the cost of debt is significantly reduced. Even though federal funds rates were eventually raised during the following years, they never kept up with the running inflation rates and real interest would only be over 2 percent in the second quarter of 1976 (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). Thus, during his tenure until 1978, real interest rates were only above 2 percent for three quarters. The Per Jacobsson Lecture on “The Anguish of Central Banking” (Burns 1979) summarizes his views on monetary policy and central banking relatively well. Basically, the upward pressures on prices by interest groups are the real reason for the inflationary policy by the Fed. According to him, the Fed does not have enough power to effectively fight against inflation “as it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies” (Burns 1979, p. 21). After a short intermezzo by Miller whose tenure ended into an emergency sale of US gold and borrowings from the International Monetary Fund (IMF) (Dowd and Hutchinson 2010, p. 251), President Carter moved Miller to the Treasury department and appointed Paul Volcker as the chairman of the Fed.
As a consequence, the federal funds rates increased significantly from 2 percent to 12 percent (Dowd and Hutchinson 2010, p. 251) and real interest rates remained high during the 1980s. Just as Burns, he was also invited to give the Per Jacobsson Lecture, but concluded that inflation had been defeated under his regime. However, as the problem of inflation was apparently controlled, another chairman, Alan Greenspan was appointed. He supported the deregulation of the banking sector under Reagan (Dowd and Hutchinson 2010, p. 252). Greenspan emphasized that inflation must be kept low during his confirmation hearings (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32), however it took only a few months until this plan was scrapped. Greenspan responded to the stock market crash of October 1987 by cutting interest rates and by declaring that the Fed is disposed to provide “liquidity” in such a case (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32). Later, interest rates were kept low, even as inflation reached 6 percent during 1989–1990. The policy of low interest rates continued until 1994, where the Federal funds yield reached the lowest levels since the 1960s. As a reaction to this inflation scare, interest rates doubled, although Greenspan was reluctant to take this action initially.Board of Governors FOMC Transcripts, February 3–4, 1994, p. 55. However, this led to big losses for many entities that were betting on low interest rates. Most notoriously California’s Orange County defaulted on its debt by speculating with derivatives on low interest rates (Dowd and Hutchinson 2010, p. 53).
By February 1995, Greenspan announced that his policy of increasing rates is over.Testimony to the House Banking Committee, February 22, 1995). Effectively, the money supply growth was 2.6 percent higher than nominal GDP during this tenure. The failure of Long-Term Capital Management in 1998 (Lowenstein 2001) illustrated perfectly the approach which was taken by the Fed by now. Not only was a bailout organized, but under Greenspan interest rates were subsequently cut three times to calm down financial markets. This low-interest policy basically allowed the financial sector to maintain more activity of unsustainable trading activities. Ultimately, this policy fueled the dotcom bubble during which stocks were even more overevaluated than during 1929 (Garrison and Callahan 2003). As a consequence, interest rate raises followed in the year 1999 and 2000 which eventually triggered the bust of the stock market. However, already by 2001, the federal funds rate was lowered again to fight the ongoing recession. Together with the occurrence of the 9/11 terrorist attacks and fiscal policy under the newly elected President Bush, interest rates attained the lowest level since 1961 by the year 2002. From 2002 to his retirement in January 2006, Greenspan kept interest low below 3 percent. This period also witnessed the housing bubble and the closely tied structured finance crisis. The burst of this bubble finally led to the current financial crisis. The following “non-moderate” recession is accompanied by nominal interest rates which are currently approaching zero, while real interest rates are simply negative. The development of the federal funds rate can be depicted as follows in figure 1.
To summarize, ever since the fight on inflation of the early 1980s under Volcker, interest rates have been declining. The most substantial reductions happened in the post-era of the dotcom bubble and as a response to the terrorist attacks of 2001. Likewise, federal funds rate have been lowered to an all-time low to fight the current recession. Monetary policy of the last thirty years substantially reduced the cost of debt and consequently eased the issuance of debt securities in the financial market.
Fiat Money and Public DebtFiat money and legal privileges reduce the natural barriers to the creation of credits. Debts are an easy way to increase the expenses of governments. Furthermore, debts are by far more popular than the alternative, i.e., taxes. However, governments are special debtors as they can have recourse to means of financial repression: “Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere” Reinhart, Kirkegaard, and Sbrancia (2011).
There are several measures that increase artificially the demand of sovereign bonds, however the main measure of financial repression is to keep nominal interest rates low through loose monetary policy. It reduces the interest expenses for governments and high inflation reduces the cost of debt at the expense of the creditors. Similarly, traditional investors are more likely to put their money into government bonds as savings accounts are not profitable enough. In the case of negative real interest rates, as witnessed 1945–1980 and since 2007 (Reinhart, Kirkegaard, and Sbrancia 2011), it even becomes a supplementary tax in addition to the redistributive consequences of inflation. Figure 2 shows the evolution of government debt during the phase of positive real interest rates and a sharp increase since 2007 when real interest rates were negative again.
Empirical ImplicationsBuilding upon the theoretical arguments of this paper, it is manifest to test whether public debt and government deficits have, ceteris paribus, significantly increased under a full fiat money standard.
Yoon (2012) shows, using a new recursive method for unit root testing, that the U.S. public debt–GDP ratio was explosive in nature during the sample period. This is an interesting result as a standard unit root test such as an augmented Dickey-Fuller test shows that this series contains an unit root and is therefore stationary (Bohn 2008). As a result, there is no concluding evidence about the properties of public debt in the United States during this period.
Figure 4 suggest that wars played a major role for the accumulation of debt. As Figure 3, Yoon (2012) points out “The War of Independence, Spanish–American War, the Civil War, World War I, and World War II — explain the high debt–GDP ratio in 1791 and the sharp increases in 1812–16, 1861–66, 1916–19, and 1941–46.” By way of contrast, the debt–GDP ratio has generally declined during peacetime periods, with the exception of the Great Depression/New Deal era (1929–39), the 1980s, and the post-1921 period.” Furthermore, the author interprets the exceptional period from the 1980s onwards as a result of the Cold War and the “post-2001 war on terror.”
There might be a potential endogeneity bias for the decision to adopt (or leave) the gold standard or a fiat money standard, which could likely lead to spurious results for our analysis. Basically, this would mean that some underlying factor accounted for both the choice of the monetary regime and the differences in the level of public debt. For example, war times and a suspended gold standard have been highly correlated in history for obvious reasons. However, as Bernanke (2004, p. 16) outlines, those decisions are highly influenced by internal and external political factors so that it is very unlikely to be an issue for our analysis.
Empirical StrategyOne potential empirical strategy has been outlined in Gabriel (2014). As outlined above, there is conflicting evidence about the stationarity of public debt. To overcome this problem, I analyze GDP deficits as the dependent variable for the sample period from 1800 to 2012 (Bohn 2008). In this paper, I use a VAR(2) model which controls for several factors such as military spending to capture the war periods or interest charges to capture the cost of debt.Refer to Gabriel (2014) for the details of the model, where several tests, such as e.g., autocorrelation in error terms, to account for a potential downward bias are provided. The model allows us to make interesting forecasts of how the dependent variable should have evolved during the period of the full fiat money standard (1971 to the present) after controlling for the outlined variables. Figure 4 summarizes the findings of Gabriel (2014).
The red line describes actual data on GDP deficits for the specified period. As described before, the VAR(2) model is applied to the dataset from 1800–1970 to generate a forecast of the how the values should have evolved based on the specified framework. This is the blue line. Finally, the green area corresponds to the confidence interval for the forecast of the VAR(2) model. This graph shows that actual deficits are in general higher (except for the year 2000) than they should be. Thus, the interpretation of this period by Yoon (2012) as a result of the Cold war is not supported by this analysis. The noteworthy GDP deficit figures must be explained otherwise. The theoretical arguments in this chapter make a case that the dynamics of fiat money are a plausible explanation for this observation.
ConclusionAustrian scholars in monetary economics are not tired of pointing out the dynamics of fiat money and their impact on the economy. This chapter attempted to complement their theoretical arguments by providing a short historical overview of monetary policy in the United States. A preliminary empirical assessment provides evidence that the switch to the current monetary regime possibly explains higher GDP deficits after controlling for other factors such as military expenses or interest charges. A more detailed analysis on this issue is left for future research.
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WeMateusz Machaj is assistant professor at the Institute of Economic Sciences at the University of Wroclaw, Wroclaw, Poland. I would like to thank to Professor Joseph Salerno for many years of his invaluable help. This article is an outcome achieved due to indispensable long-term academic guidance of Professor Salerno. My intellectual development would have not been possible without his personal support, and without the study of his masterful works on monetary theory and general economic theory. understand knowledge as an acquaintance with various facts and natures of objects in the real world. By studying and investigating aspects of our lives we get to “know” certain things and we classify these inquiries into disciplines. We can widen knowledge in total by different methods. In order to achieve progress in gained knowledge we use dissimilar frameworks to learn mathematics, physics, economics, social relations, characters of our friends, or languages. It is also important that we can learn some of these things through different methods, especially different methods for different people, or different methods for the same people over time. One term “knowledge” is being used to deliberate in general about all those disciplines, yet this should not cloud first and foremost feature of knowledge: its heterogeneity.
The Austrian school has been mostly successful in economic theorizing because it realistically emphasizes heterogeneous nature of the world. Whereas various neoclassical schools, or their siblings, tend to homogenize economic phenomena, the Austrians tend to do the opposite. The prime example of the case is theory of capital, which in the Austrian version is built on the notion that capital goods do not have a common physical denominator (which could theoretically express its aggregated “amount”). Starting from such basic observation the Austrians were able to build their own theory of socialism and theory of the business cycle. As Roger Garrison notes (1992, p. 171, emphasis added),
If capital goods were wholly non-specific, if the collection of them were fully homogeneous such that any one capital good is a perfect substitute for any other, then production processes could proceed as if time ran both ways. A half-finished performance hall could be completed — with no effects on cost or construction time—as a bowling alley; the production process that yields musical instruments could — with an eleventh-hour change of mind — yield bowling pins and bowling balls instead.
Under homogeneous circumstances the issue of proper allocations would never have to arise, since every process would already be fully integrated and properly coordinated. The problem of the trade cycle would be nonexistent, since any inconsistency in the various diverse stages of production would be absent. Similarly any socialist economy would not fail at the basic problem of equilibrating the capital goods market, because optimal allocations of them would have already been chosen.Mises notes (1966, pp. 206–07) that under perfect substitutability of capital goods would imply that “all means of production ... would be as if only one kind of means — one kind of economic goods of a higher order existed.” Therefore in a socialist economy one could calculate according to the usage of the one universal higher order good (e.g., kilograms of such good), and avoid the problem of valuation of heterogeneous factors of production (non-perfect substitutability of capital goods).
Other important Austrian contributions are also more or less related to the issue of heterogeneity. For this reason it could even be seen as a typical feature of the modern Austrian economist’s toolbox. Austrians are different, because Austrians heterogenize.
The same approach to heterogeneity applies for different types of “knowledge.” A typical model breakthrough comes from Hayek’s example of a breakaway from the neoclassical approach. Hayek’s famous contribution comes from the analysis on how knowledge is “used in society” (Hayek 1945). Yet even though this analysis of complexity of economic phenomena is fruitful and worth of deeper studying, it (along with others) created a lot of side debates about the “knowledge” problem under hypothetical socialist order. We will attempt to refrain from settling those debates here. Our goal is to follow Hayek’s footsteps and to try to distinguish several types of knowledge. The goal can allow us to settle the definitional importance of knowledge for Mises’s argument about the impossibility of the rational allocation of resources under socialism.
Here we offer our (arbitrary) classification of knowledge, which, though not very rigorous, helps to navigate through the usages of the term in the calculation debate. It is important to keep in mind that we don’t want to completely classify various types of knowledge, but to envision how it relates to the socialist puzzle.
Objective “Technological” KnowledgeAlthough other types below could also be seen as objectively existing.The word “objective” seems suitable, because the main feature lies in the interpersonal aspect of this knowledge, which can be simply transmitted from one person to another. It is knowledge which is coded in textbooks and countless publications.During the socialist calculation debate the term “technological” knowledge was used (see Mises 1966, p. 699). Due to its specific “objectivity” it can be communicated between the people with the use of alphabet, algebra and other symbols. Without those symbols there would be no abstract thinking, and consequently man would still live in caves (Cassirer 1944, pp. 46–47). Objectivity is here to be understood as the possibility to be (potentially) universally recognized by any intelligent being, no matter what place and time one lives in. Due to language and objectivity of those statements knowledge can be transmitted (sometimes through the painful process of learning) between all intelligent (and sufficiently capable) individuals.
Such knowledge can include statements from all developed sciences be they empirical or non-empirical; mathematics and logic, physics and chemistry, climatology and biology, economics and sociology, politics and history, etc. Even though all those disciplines differ and use radically dissimilar methods, they can be grouped into one big family of objective Science. There are multiple examples of that knowledge such as (geology) “earth is not flat,” (biology) “spiders eat flies,” (physics) “the speed of light is constant,” (mathematics) “In Euclidean geometry parallel lines do not intersect,” (climatology) “Earth is warmer than it was 40 years ago,” (economics) “minimum wage leads to higher unemployment,” (history) “Julius Cesar did not invent the caesar salad,” and so forth.
The important fact is that none of those statements has to do with distinct characteristics of the particular being who is proposing them. They are as general as possible and can be presented by a male teenager in Africa, a female doctor in Germany, or retired astronaut in the Moon. Also they are conditioned by the concept of Wertfreiheit. They are value-free. Their most important feature is correctness or incorrectness, no matter the values, opinions and views of the person proposing them. During the socialist calculation debate such knowledge was seen as easily obtainable and possessed by socialist bureaucrats.
Hayekian KnowledgeHuman knowledge does not end with such universal and communicative observations. Not all the data can be effortlessly gathered in objectified and interpersonal form. Some information is hard or costly to transfer, so perhaps it seems sensible to use the name “transfer problem.” There exist two main reasons causing the transfer problem to arise. The first one is a subjective nature of individually “witnessed” data, which become a part of “tacit knowing.” Hayekian knowledge is perceived by an individual. At the same time it is being used by the individual even though she or he cannot formulate it explicitly and communicate it to another person. Tacit information is beyond textbooks and often beyond personal recognition of it (Polanyi 1966, p. xviii). Since personal boundaries are difficult to overcome such knowledge remains hidden behind individual barriers of the mind (Huerta de Soto 2010, pp. 27–28).
The second reason for the transfer problem is decentralized nature of Hayekian knowledge. At first it may seem that the reason is no different from the first one. Nevertheless the difference is important, because in the first case barriers have more to do with individual’s limits. In the second case scantiness of the data is an objective fact important for practical reasons. Because countless individuals are working with complex data, it is practically impossible for any isolated individual to gather their knowledge and unify it into one objective formula (even without admitting the “tacit” element of it). Hayek wrote extensively about its economic importance (see his illustrations in Hayek 1945, p. 522). He also made it an important part of the argument against market socialism model (Hayek 1940, pp. 192–93).
The examples of that knowledge could be “John knows unspoken local customs,” “Jack is the only one who knows how to talk to Mary,” “Martin knows how to start that machine,” etc.
Misesian KnowledgeAn important question that arises with the title of the section is: why make a difference between “Hayekian” and “Misesian” knowledge? We are inclined to do so, because Mises emphasized the role of prices in the economy, whereas Hayek attempted to go further and focus on something underneath prices: production functions. For the former, prices per se were of interest. For the latter something more substantial had to be hidden behind those prices. Hence local conditions and knowledge about them was named by us as “Hayekian.” In the case of Mises, all aspects associated with calculation and prices will be seen by us as “Misesian” knowledge.
Therefore Misesian knowledge is strictly associated with monetary prices, and has three interrelated features in different time dimensions:
- past prices and praxeological recapitalizations undertaken in the past,2. current price offers,3. “current allocation activities” (Salernian “social appraisement process”On the appraisement process see Salerno (1990, p. 42; 1994a, p. 120). It is of course debatable to call activities as “knowledge.” But, as we explain below, we will stretch a little bit and name them “knowledge,” because from a certain perspective this is what the central planners would need to “know” — the actions of private owners — in order to act efficiently.).
Strictly speaking prices are ratios of exchange between sovereign owners in a realized transaction. In that sense they are phenomena of the past. Currently existing, though not yet realized, price offers are also often seen as “prices” of the present circumstances. Competing and cooperating owners of the factors of production establish a nexus of contracts that allows them to create the price structure. The phenomena of price activities arise in all instances of economic calculation — realized past prices , past actions undertaken to correct them, current price offers, and current actions based on calculation outcomes and expectations about future prices. Clearly, at every point in time part of the existing Misesian knowledge is objective and known, but part of it is always beyond human recognition, because it will be determined in the future: allocation activities undertaken after the acquaintance with price offers. That is why entrepreneurship consists of a combination of knowledge and ignorance.
Past prices can be observed and expressed in the form of statistics, therefore they belong also to our first category of knowledge (as we emphasized in the beginning we are not searching for fully non-overlapping definitions). Nevertheless past prices are only the beginnings of calculation, since they only reflect past choices conditioned by outdated anticipations (see Mises 1966, p. 330). The next constituents are price offers, which in the Misesian sense are not yet “prices.” They are offers formed today under current market conditions, which are different from the conditions under which past prices had been formed. Therefore in contrast to realized prices they convey some form of current information and views about the future. If someone theorizes about prices as information signals, currently available price offers perform this function (they are not strictly speaking prices as exchange ratios).They also include current understandings of past trends in prices. The information on past prices visioned as valuable is being reflected in the current appraisal.
Price offers and past prices close the category only of existing Misesian knowledge. Economic calculation involves economic activity under uncertainty, what results in changes of economic conditions and unexpected outcomes (with price changes). It is one thing to know past prices and current price offers, but it is another to act upon those prices. Past prices inform entrepreneurs about past events. Current price offers inform entrepreneurs about today’s conditions and expectations about the future. Potential, not realized, prices “transmit” correct and incorrect entrepreneurial anticipations about possible marginal valuations of resources they own. That is why they do not transmit strictly Hayekian “knowledge,” but can include entrepreneurial perspectives on Hayekian knowledge.
All knowledge associated with various past and present instances of monetary calculation is not sufficient for the market process to happen. The driving forces for it are allocation activities (part of yet non-realized Misesian knowledge of what would private entrepreneurs do). These are actions undertaken by entrepreneurs after recognition of current price offers (with considerations on past prices and recapitalizations). The central owner under socialism has precisely the following problem: he cannot know allocation activities based on current price offers.At some point Hayek suggested this is not the main problem, because “price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge” (Hayek 1937, p. 51). In the other paper he suggested otherwise. See Hayek (1984, pp. 57–58). He is not in a position to recognize what private owners would do, and how they would exclude each other from the market process. He is able to gather data on past prices, or even price offers right before the complete nationalization of resources, but he cannot know which allocation activities would have been performed under private property. Even if he or she knew all the relevant Hayekian knowledge, it would not suffice to solve allocation problems under socialism, since all of the Misesian knowledge would have to be known. The activity of entrepreneurs is something which cannot be implicit in the informational parameters of any system of equations, or any prices based on past or current data (see Salerno 1994, p. 120).
Three distinctive examples of Misesian knowledge could be: (1) “Lemons sold for 3 dollars per kilogram yesterday,” (2) “This flat is for sale for a million dollars,” (3) “Martin decided to produce 30 uniquely designed cars and price them at $3 million per car.”
“Full” Economic KnowledgeComplete economic knowledge is not anything “real,” but it is one of the assumptions in the possible “mathematical” solution to the calculation problem (which was never consequently defended by anyone). It boils down to knowledge of all possible “production functions” available to human beings. Hayek had this type of knowledge in mind when he theorized about allocation problems after postulating many ifs; if we possess all relevant information, all preferences, all knowledge of available means, then the problem of allocation is “purely one of logic” (Hayek 1945, p. 519).
In the neoclassical analysis, production functions are very simple (they have to be) and easily subjected to mathematical formulation. They use only a few variables as factors of production. Their coefficients are given and their influence on production is established and well known. At the same time, since the equations are simple and use few variables, “marginal rates of substitutions” can be inferred from those equations. They can become sorts of shadow prices, which could in theory substitute real world monetary prices and entrepreneurial assessments.Stigler and Becker (1977, p. 77) use the term “shadow price” to label a valuation for a good, which is not sold or purchased in the market. They use it for a different type of a discussion, but the idea to use the concept of “shadow price” is similar as in here. A “shadow price” is something which is to be inferred from subjective valuations and can substitute market pricing. Yeager uses “shadow price” in the analogous sense (Yeager 1994, p. 101). Those substitution levels can demonstrate, for example, “how much more is being produced when x amount of factor A is substituted for y amount of factor B?” Such contingent tradeoffs could be used for rational allocation.From the equations we can know how much of an additional amount of one factor of production is needed to replace decreased amount of the other factor if one wishes to maintain the level of output. These types of rate can be known only if production function is simple and known.
In reality such full economic “knowledge” cannot be achieved for two main reasons. Firstly, as Austrian economists have emphasized, production functionsActually the word “function” is a doubtful name, but it is a topic for another discussion. There is not much typically “functional” about production processes. are complex and each one of them is extremely specific. Production functions consist of many factors of production, which cannot be constricted and grouped into such macroeconomic (or microeconomic) variables as “K” (capital goods) and “L” (labor), or additionally “H” (human capital) and “A” (technology, or “total factor productivity”). Real world production functions have many more variables and their coefficients are not stable numbers. Due to complexity of those functions, simultaneous equations of production functions cannot in fact be “solved” even in “theory.” Walrasian equations can surely be solved, because they are simple and have as many equations as unknowns with known coefficients (Walras 1954, p. 238).Walras later on (when he deals with progress) allows for adjustable coefficients, but still the system contains “as many equations as there are unknowns to be determined” (p. 384). They appear to be mathematical tasks. By assuming such a trivial world of flat production functions, one is assuming away essential problems of complex economic reality.
The second reason for the lack of such “full” knowledge of the real world is uncertainty and human creativity. However precise the production functions are, they are never accurate, because people are never in a position to fully determine the future. They cannot “close” production functions and make them “complete,” because they would have to include all possibilities about the future.This is why a neglected Barone stated that “it is frankly inconceivable that the economic determination of the technical coefficients can be made a priori” (Barone 1908, p. 287). Ironically he later became to be quoted for having “solved” the problem of economic calculation under socialism, even though he did not believe so and actually argued the opposite. Assumptions about the knowledge of those functions implicitly embrace the notion that future is largely foreseen, and that man can anticipate what he or she will learn in the future. Human beings are not omniscient and the future is purely uncertain (in the Knightian sense). It cannot even be subjected to calculus of class probabilities, because in the course of economic events case probability prevails. By assuming away the uncertainty of the future, the fundamental problems of entrepreneurship are also assumed away. Change implies necessity for economic decision making (Mises 1966, p. 212).As Hayek (1945, p. 94) notes “economic problems arise always and only in consequence of change.” With full knowledge of the future, human beings do not face the problem of proper judgments, since all of them are optimal and efficient. Henceforth “full” economic knowledge (which would allow “shadow prices” instead of monetary prices) is impossible to be achieved, because production functions are too complex and because people can never have a complete list of “correct” functions (which would include information about future events).
The last few sentences seem too trivial and obvious to be mentioned, but there is an interesting consequence of them for the Hayekian concept of knowledge. The complete full economic knowledge is not split up and partitioned between the individuals, therefore it does not become “Hayekian knowledge” when decentralized. If we somehow summed up all the Hayekian knowledge we would still not achieve “full knowledge.” In referring to the hypothetical concept of full economic knowledge Mises writes “no single man can ever master all the possibilities of production, innumerable as they are,” and so the entrepreneurs are divided between their tasks in the environment of monetary calculation (Mises 1990, p. 17). Hayek has a footnote to that Mises’s passage when he refers to the “division of knowledge” (Hayek 1937, p. 50). Yet this is not what Mises had in mind, since clearly full economic knowledge, “all the possibilities of production, innumerable as they are,” cannot be either known or divided between individuals just as infinity cannot be divided into finite numbers. Mises’s point was that “full knowledge” can never be achieved, not that it is in some way divided between the people (compare with Horwitz 1998, p. 430).
As we see, full economic knowledge is unachievable because of the “complexity” and “indeterminacy” of what we sometimes call “production functions.” Indeterminacy problems were to be avoided only if man could turn into a sort of “Laplace’s demon” — entity capable of gaining knowledge about “everything,” meta-knowledge, which would allow the possessor of it to project reality in any way he or she wanted. Fortunately we deal in this article with humans, not gods; henceforth we can set such issues aside for philosophers and theologians. The theoretical economic system can never be “complete” in such sense.
Knowing, Guessing and the Market ProcessPerfect Laplacian knowledge leads to perfect forecast. All-knowing man possessing features of the Laplacian “demon” could notice and understand the position of any molecule (even a social “molecule”) in the (social) universe. Such recognition would allow for the planning of every future step ahead and effectively adjust actions to any desirable and possible state of affairs. No mistakes would be committed and the equilibrated Utopian dream could be realized. Any step away from such perfect knowledge results in uncertainty. In order to cope with uncertainty people try to forecast future events.
Beyond the point of perfect knowledge the strict connection between knowledge and forecast breaks. At the extreme, perfect knowledge allows for perfect forecast.“It may be added that knowledge, in the sense in which the term is here used, is identical with foresight only in the sense in which all knowledge is capacity to predict” (Hayek 1937, p. 51). It might be stated that we need calculation, because we can never possess enough knowledge. Once we move away from perfect knowledge we also move away from perfect foresight. Moreover, under the circumstances of uncertainty more knowledge does not always mean better forecasts. It may be truer for cases of natural sciences. The more we know about physics, or chemistry, the better we can forecast “behavior” of the matter. It is slightly different with knowledge of social sciences, where knowledge to some extent improves our understanding of the social world (not necessarily forecasting abilities). More Hayekian, or more current Misesian knowledge, does not necessarily lead to a better economic forecast.
Portions of social knowledge do not guarantee that foreseeing will be in a better shape. Entrepreneurs might be equipped with Hayekian knowledge, but this does not guarantee their success. They can gain a lot of Hayekian knowledge in the market, but still these gains will not automatically transform themselves into entrepreneurial successes. Even the elements of Misesian knowledge do not assure that. Entrepreneurs can acquaint themselves with past prices (realized exchanges) and price offers (currently existing ratios). Knowledge of those is not a formula for commercial accomplishments. When the entrepreneur starts to gather all the price data and gets to know current and previous price offers, it is still not enough to bring him good foresight. Moreover, it is almost nothing. The entrepreneur can gather all that knowledge, and still lose money.
Additionally, gains in knowledge per se do not reap entrepreneurial gains. The effective entrepreneur is not someone who knows “more” than others. There are many entrepreneurs who accomplish a lot even though they were less knowledgeable than their rivals. Especially in the light of the fact that many huge entrepreneurial successes work like in the romantic Schumpeterian story of the entrepreneurs, who break the existing social structures. Sources of triumphs for any entrepreneur do not lie in the typical knowledge build-up, but often in envisioning what is unseen and most likely cannot be seen. All those actions are subjected to revisions and to praxeological recapitalizations in the form of losses and profits, as well as changing asset ownership. Good choices are indicated by correct monetary imputation, and do not have to be correlated with gains in information, or any type of “knowledge” acquisition (Salerno 1990a, pp. 59–60; 1990, pp. 42–43).
Naturally, it does not follow that “knowledge” has nothing to do with forecasts and entrepreneurship. Nevertheless, the entrepreneurs are not spreading Hayekian “knowledge” in their calculations. First of all, in the case of the unfortunate word “transmission,” they are transmitting some things, but these are not Hayekian knowledge and not in the form of prices. Entrepreneurs are transmitting their judgments, and they do it mostly in the form of price offers conveying this information. Whether correct or incorrect, price offers given by sellers of goods and services inform us about how market conditions are currently perceived. The yet to be successful entrepreneur is the one who is capable of “spotting” false prices, a discrepancy between current price offers for factors of production and prices for consumer goods which will be created in the future. “Spotting” is a metaphor, since technically we can only “spot” what already exists. “False prices” do not exist yet. They shall only materialize once the future becomes present. Hence the reason why Kirznerian “profit opportunities” are blurred by clouds of uncertainty and they do not exist yet. Current price offers inform us how entrepreneurs envision today future market conditions. Precisely that kind of “information” is hidden behind prices, not information about proper ways of adjusting “production functions.”
In the neoclassical framework entrepreneurial choice is given by the intersection of the marginal revenue curve and marginal cost curve. The main oversimplification in such an apparatus comes from the coincidence of the two and presupposed incidental existence. In reality one can get to know marginal cost curves by searching for price offers (more or less). Nevertheless the marginal revenue curve does not exist; it cannot be spotted and properly acted upon. We cannot be alert to the marginal revenue curve because it is not there yet. Instead of one marginal revenue curve there is virtually unlimited number of potential non-realized marginal revenue curves. Each of them has case probability assigned to it, thus strictly speaking it has no numerical probability at all. Whoever is more successful in picking the “proper” curve, wins. The “proper” solution is offered with the future being realized. In order to foresee the demand, one does not need to “know more” than others. One needs to make a proper judgment (Hülsmann 1997, p. 35). The “selection” mechanism cannot be reduced to gains in any mentioned type of knowledge.
In other words, the market process is not driven by entrepreneurs who know more, but by entrepreneurs who deliberately select arbitrary types of information and act upon them. A real world forecast is based on those selections of information. Information is interpreted, understood and used.As Kirzner points “possessing all this information is not the same as having assimilated it” (Kirzner 1996, p. 150). In this sense “assimilation” process is always subjective (both for the entrepreneur and hypothetical central owner under socialism). What types of information are available to various entrepreneurs? As we saw in the process of economic calculation there is lots of it: realized transactions, which inform us about habits; and recapitalizations, which inform us about the extent of past mistakes. On top of that there are current price offers, which inform us about competitive potential in the market e.g., in which field we can be outcompeted by others and in which fields can we rely on the division of labor. Finally, there are undertaken actions and reallocations by other owners. All this Misesian type of knowledge is generated by the market, based on praxis, and can be referred to as the social appraisement process.
Not only is the world and its information heterogeneous, but so too are individuals. Each entrepreneur is different and has his unique entrepreneurial vision, which can be expressed through the use of property. Entrepreneurs differ in their judgments and disagree on what is economical, and what is not (Lavoie 1985, p. 123). Whoever performs well enough in this task outcompetes his rivals in the market process.
Let us take the case of an entrepreneur producing machines with the use of steel. He can notice past prices for finished products (machines) and past prices of steel. They can inform him about past exchanges and demonstrate past market conditions. He can evaluate them and engage in Verstehen. Any information he gets by contemplation can be useful for current price considerations. Equally useful are “present prices,” price offers for steel. (The entrepreneur also tries to anticipate future prices of the machines). Steel prices inform the entrepreneur how steel is being valued by sellers and by his competitors, other entrepreneurs who alternatively employ steel (to produce something else or similar). Henceforth current prices (offers and transactions from the immediate past) at least inform the entrepreneur of how valuable alternative employments for various factors are, or how other market participants envision the markets of goods produced with steel (compare with Yeager 1994, pp. 95–96). This notification of how much factors are expected to be worth, is a relevant part of the market process and entrepreneurial division of labor.
Accurate anticipation of future prices based on individual understanding of selected information leads to profits. In everyday life we notice how new information changes the prices and actions of market participants. The person acquiring new knowledge cannot be sure that its spread should change prices in a particular way. In some cases we can be almost close to certainty what the effect should be. But it can never be “fully” known in advance. If new fields of oil are discovered, the anticipation is that the price of oil should go down. Nevertheless it need not to, and we can envision scenarios in which the opposite happens. Successful entrepreneur is the one who can “interpret the information” correctly, but only in the ex post sense. He acts very often against the tide and the rest of the market.
The crucial side of the competitive process is its legal aspect. The mechanism of entrepreneurial selection is based on property shifts, which result from monetary calculation. This works despite psychological motivations of the participants, or their “knowledge,” or their “ignorance.” It does not matter what entrepreneurs’ incentives are, or what kind of information they possess. They can know a lot, or little, they can be motivated in their actions by their personal skills, or act upon an ideological bias. Whatever they know, and whatever their incentives are, as economists we do know that those who satisfy consumers most survive in the market. We do not even have to assume that entrepreneurs are interested in “maximizing” profits (Alchian 1950, pp. 212–13).Actually “maximization” is also an improper word, since it would imply we have a particular “function” to be maximized. In reality, entrepreneurs choose between various rates of profits and case probabilities associated with them. Their personal interests and motivations are not important. Profits are the link between consumer satisfaction and entrepreneurial decisions acknowledging them. That is why the market process “works” — because calculation has consequences for allocations.
In the economic analysis of socialism we can assume many things. If we assume that planners have “full knowledge,” then we “solve” the problem with an unrealistic assumption. In the real world planners can only gain other types of knowledge. They can possess all the necessary technological knowledge, and even the more specific Hayekian knowledge of time and place. We can even add that planners could possess scatters of Misesian knowledge: they could accurately know past prices and price offers right before the imposition of the socialist order. Yet even this knowledge does not solve the main socialist deficiency: the central owner does not know what are, or would be, the allocations of private owners. He cannot substitute them, or even hire them as bureaucrats, because tangible entrepreneurial skills are manifested in the realms of praxeological boundaries conditioned by asset ownership. When the central owner nationalizes the resources, all entrepreneurial skills are outlawed and simply lost.Mises (1990, p. 38) brilliantly emphasized this in his initial article: “Unfortunately ‘commercial-mindedness’ is not something external, which can be arbitrarily transferred. … The entrepreneur’s commercial attitude and activity arises from his position in the economic process and is lost with its disappearance.” They cannot be recovered by any bureaucratic structure, because there is no real world competition set in the property regime.
ConclusionsAs we have seen, in economics “knowledge” can have many different meanings. In assessing economic systems one has to be careful in making particular assumptions about “knowledge,” because any discussion may turn out to be blurred by definitional barriers. Depending on what we exactly mean by the term “knowledge” various conclusions about its possession or non-possession can be reached. It all comes down to what exactly we understand by this term.
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AMatthew McCaffrey is an assistant professor of enterprise at the University of Manchester, Manchester, United Kingdom. I was a summer research fellow from 2008–2013. Professor Salerno served on my master’s thesis committee in 2010, and we have since collaborated on several research projects. This essay was inspired by our work on the history and theory of entrepreneurship, for which Professor Salerno was an invaluable mentor. serious interest in the entrepreneur is often considered a defining characteristic of the Austrian school. This attention is evident in its prehistory, in the writings of Richard Cantillon, Jean-Baptiste Say, and others (Hébert 1985; Hébert and Link 1988), and also in Carl Menger’s foundational Principles of Economics (1871). Entrepreneurship plays a central role in the work of Ludwig von Mises as well, who often referred to it as the “driving force of the market.” However, despite the universal importance assigned to the entrepreneur among Austrian economists, there is still much discussion about what exactly entrepreneurs do, and their precise function in the market economy. The questions involved are often complex and cover a wide range of problems, such as the determination of profit and loss, the role of uncertainty and speculation in the market, and the equilibrating properties of arbitrage, to name only a few. As a result, the various theories of entrepreneurship that have appeared in the Austrian tradition, each of which has its own fundamental assumptions and goals, have been the source of disagreements about economic theory and policy.
One controversial problem that remains to be thoroughly examined is the relationship between entrepreneurial theory and public policy. The relevant questions are: does economic policy have a direct effect on entrepreneurial behavior, and if so, can the study of entrepreneurship inform economists regarding the welfare outcomes of intervention into the market process? Thus far, the conventional wisdom on this subject (and on entrepreneurship in general) has been largely informed by the writings of Israel Kirzner, which have proved quite influential among recent generations of Austrian economists. Kirzner argues that policy interventions remove the incentive provided by pure profits, thereby hampering entrepreneurs’ ability to discover beneficial opportunities in the market. This in turn implies that opportunities for mutually beneficial market exchange are passed over, and interference with entrepreneurial alertness therefore undermines the welfare-increasing properties of the market process, which normally encourages entrepreneurial alertness and discovery.
Given that Austrian economists are often critical of the various economic arguments in support of regulation, it should not come as a surprise that an entrepreneurial theory linking intervention to welfare losses would be readily accepted. However, I argue that the view of entrepreneurship advanced by Professor Kirzner faces serious difficulties when it tries to explain the effects of public policy on entrepreneurship. I suggest that more satisfactory answers to questions of policy can be found by considering intervention through the framework of entrepreneurial calculation and judgment. This approach was pioneered mainly by Ludwig von Mises, especially in his famous dispute over the feasibility of socialism. Mises’s work has in turn been expanded and elaborated by later economists, especially Joseph Salerno, whose contributions to our knowledge of the entrepreneur’s distinct role cannot be overstated (1990a, 1990b, 1993, 2008). The work of economists like Mises and Salerno clearly demonstrates that the calculation-judgment theory is applicable to a wide range of policy problems, and firmly establishes the dangers of economic intervention for the market process.
Entrepreneurial Incentives and Economic PolicyThis section explores the relation between alertness theory and economic policy. The framework for Kirzner’s policy analysis is found in his theory of “entrepreneurial incentives,” developed primarily in his book Discovery and the Capitalist Process (1985).A thorough review of the theory of entrepreneurial incentives is beyond the scope of this paper, which deals only with its application to economic policy. For a more complete exposition, cf. McCaffrey (2014). Entrepreneurial incentives are a way to explain the roots of alertness and their role in promoting opportunity discovery. This is necessary because for Kirzner discovery falls outside the conventional economic presentation of incentives, as I will now explain. A consistent theme in Kirzner’s writings is the contrast between what he calls “Robbinsian maximizing” and entrepreneurial alertness. Robbinsian maximizing is a textbook description of how individuals engage in the weighing of alternatives, perform cost-benefit analysis, and maximize utility.It has been argued that Kirzner interprets Lionel Robbins too narrowly, mistakenly concluding that he is simply an early proponent of the conventional economic approach to utility maximization (Salerno 2009). In other words, Robbinsian maximizing involves individuals perceiving and reacting to incentives in the usual economic sense. However, “ordinary” incentives cannot be used to explain entrepreneurs’ discovery of opportunities, Kirzner argues, because incentives must be known to an actor in order to be incorporated into standard utility calculus. But pure profit opportunities are unknown; they are waiting to be discovered, and therefore cannot consciously play into the cost-benefit analysis of individuals. Alertness to opportunities must therefore be explained by factors other than conventional economic incentives.
Kirzner calls these factors “entrepreneurial incentives.” Entrepreneurial incentives are contained in previously-unforeseen profit opportunities. Unlike ordinary incentives, pure profit opportunities attract the attention of entrepreneurs because it is in the entrepreneur’s interest to notice them (1985, pp. 28–29). Previously-unseen profit opportunities represent potential gains for entrepreneurs, who will be alert to them provided the opportunity is valuable enough. Entrepreneurial incentives are therefore another way of saying that opportunities cause their own discovery. Kirzner calls this conclusion a “paradox,” because it is unclear how such causation could occur:
How, one must surely ask, can an enhancement of the desirability of a particular course of action which by the very definition of this kind of incentive has not yet been noticed inspire its discovery? How can an unnoticed potential outcome, no matter how attractive, affect behavior? How can the attractiveness of an unknown opportunity that awaits one around the corner possibly inspire one to peer around that corner? (1985, pp. 108–09; emphasis in original)
Unfortunately, Kirzner does not resolve the paradox. Instead, he suggests that, although the foundations of alertness require serious investigation, the tendency of opportunities to cause their own discovery is a part of our basic factual knowledge of the economy (1985, p. 109).
Kirzner’s views on the foundations of alertness have already received critical attention (Hülsmann 1997; Foss and Klein 2010; Friedman and Evans 2011), and it has been argued that the opportunity paradox places the alertness theory on insufficient foundations (McCaffrey 2014). Because potential entrepreneurs are prevented by definition from knowing of the existence of an opportunity, and even of searching for it, the causal explanation of alertness must come from some other source, specifically the opportunity itself, and the “open-ended” environment it resides in. The problem pointed out by the critics is that it is logically unsatisfactory to think of unknown opportunities as causing alertness, or helping to “[switch] on the entrepreneurial antennae” (1985, p. 109). Opportunities are not acting agents, and without this key connection between opportunities and discovery, alertness theory runs into difficulty, almost anthropomorphizing opportunities in order to explain how they inspire discovery.
Consequently, this problem carries over to Kirzner’s analysis of economic policy as well, in that the alertness approach does not provide a framework for real-world analysis of the welfare effects of government intervention. Kirzner’s research in entrepreneurship is generally intended to demonstrate the equilibrating and welfare-enhancing properties of the market process, with policy considerations playing a secondary role. Nevertheless, thinking in terms of entrepreneurial incentives is supposed to shed new light on economic policy prescriptions too, explaining how hampering the market process produces inferior welfare outcomes, thus adding vital support to more conventional analysis.
Although economists have developed numerous ways to analyze public policy, many of these are framed in terms of the effects of regulation on ordinary incentives. Kirzner, however, argues that there is danger in thinking only in these terms, to the neglect of the welfare implications of entrepreneurial incentives (Kirzner 1984; 1985, pp. 132–33). This is because changes to entrepreneurial incentives affect the market process in a special way. Specifically, economic regulations hamper entrepreneurial alertness, and prevent the discovery of new opportunities, resulting in welfare losses. This assessment depends on the paradox of alertness discussed above.
Kirzner’s view of economic policy is a straightforward application of his incentive theory, and he describes the connection between regulation and entrepreneurial incentives as “intuitively obvious” (Kirzner 2009). Specifically, economic policy poses a threat to human welfare when it reduces or eliminates entrepreneurial incentives. When economic policy eliminates a profit opportunity or renders it less remunerative, it becomes less attractive to entrepreneurs. Because it is no longer in an entrepreneur’s interest to notice the opportunity, it tends not to be noticed. By reducing the rewards (in terms of pure profit) attached to alertness, regulation therefore decreases the likelihood that entrepreneurs will be successful discoverers:
[D]irect controls by government on prices, quantities, or qualities of output production or input employment may unintentionally block activities which have, as yet, not been specifically envisaged by anyone. Where these blocked activities turn out to be entrepreneurially profitable activities (perhaps as a result of unforeseen changes in data), the likelihood of their being discovered is then sharply diminished. Without necessarily intending it, the spontaneous discovery process of the free market has thus been, to some extent, stifled or distorted. (Kirzner 1982)
Intervention eliminates new and unknown opportunities, preventing entrepreneurs from being drawn to them, and ultimately preventing welfare-enhancing market coordination. How precisely does regulation affect alertness? The answer seems to be that,
To announce in advance to potential entrepreneurs that [for example] “lucky” profits will be taxed away is to convert open-ended situations into situations more and more approximating those of a given, closed character. The complete taxing away of pure entrepreneurial profit can, it is clear, succeed only in removing from potential entrepreneurs all incentive for paying attention to anything but the already known. (Kirzner 1985, p. 111, emphasis in original)The last sentence seems to imply that entrepreneurs can pay attention to the unknown. Unfortunately, Kirzner does not explain exactly what this might entail.
Kirzner seems to be arguing that entrepreneurs possess a general knowledge of “where to look,” such that if this general field becomes less profitable, they will be less likely to notice specific opportunities in it. Yet if opportunities are discovered without ordinary incentives (such as those involved in search efforts), it is not clear how giving entrepreneurs general information would aid or hamper discovery. Would not information about where to look simply affect ordinary, known incentives? If expressed in these terms, the thrust of Kirzner’s argument would be unobjectionable. It would imply that when government announces a certain kind of production is no longer profitable, entrepreneurs acknowledge this change, alter their calculations accordingly, and shift their resources to more remunerative forms of production. Yet this view of entrepreneurship and regulation relies on the conventional approach to incentives: the open-ended-vs.-closed distinction is most plausible if entrepreneurs can act and search for opportunities, or, even better, exercise judgment about how to use resources. But if we try to apply the specific notion of entrepreneurial incentives to policy analysis, the causal problem of alertness appears again.
Consider an example. Suppose there are two industries, auto manufacturing and software engineering. In each of these industries entrepreneurs are earning the same returns, and as far as all potential entrepreneurs are concerned, both industries are equally attractive. Let us then suppose the government announces that a new tax will be levied on the profits of the auto industry, while the software industry will be left unhampered. According to Kirzner, opportunities in auto production have been eliminated, and potential entrepreneurs will now perceive the industry as closed, which in turn means relatively few profit opportunities will be discovered there. There are two ways to explain this result. First, entrepreneurs might acknowledge the new policy, ignore the auto industry, and focus their attention elsewhere. This would involve action and search, however, and is not consistent with Kirzner’s theory of alertness. The second possibility is that entrepreneurs do not act differently in response to the new tax policy, but instead the lack of profitability in auto manufacturing unconsciously steers them away from that industry and toward others. This seems more in keeping with Kirzner’s theory, but it returns us once again to the question of causation.
A potential entrepreneur’s knowledge of the tax could certainly influence his deliberate search efforts and decisions about production. But how could it influence the passive state Kirzner uses as a starting point? If a profitable opportunity cannot, by itself, cause its own discovery, how can we be sure that an unprofitable opportunity will have the opposite effect, and tend to remain unnoticed? If an entrepreneur does not know that an opportunity exists, how can a policy that decreases the profitability of that opportunity change the likelihood of his noticing it? In order to answer these questions, it seems we must incorporate other kinds of behavior, such as search or judgment.
I will not add to this criticism other than to point out that if entrepreneurial incentives cannot be integrated into a theory of unhampered markets, then the implications for restricted markets are ambiguous. If one believes there is no necessary tendency for entrepreneurs to notice opportunities (or even that opportunity discovery is not the best basis for a theory of entrepreneurship), then the above policy analysis loses its force; regulation might just as well hamper erroneous incentives or errors as prevent entrepreneurial success.Also, regulation need not simply inhibit the discovery of profitable opportunities: it might also produce new opportunities for rent-seeking or other forms of destructive entrepreneurship (Foss and Klein 2010). Based on the above discussion, it should be clear that policy analysis poses a problem for alertness theory.
In addition to typical policy questions, the opportunity-causation problem also has implications for the debate over the feasibility of central planning, a system of organization Kirzner argues is subject to a lack of proper entrepreneurial incentives (1982). Using the entrepreneurial-incentives approach, however, the case against central planning might actually be weakened:
It is true in a trivial sense that entrepreneurs can be defined as those who are “alert to profit opportunities,” but we wonder why agents of the central planning board could not be equally alert. The real issue is not alertness, but the magical property that Kirzner attributes to those who are alert: the property of thereby finding what they are looking for (a profit opportunity) and knowing what to do about it. If mere alertness — activated by “the profit motive” … — were all it took to produce the requisite knowledge, one could incentivize central planners with the same motive or an even stronger one, such as the death penalty … (Evans and Friedman 2011)
There is then a difficulty in explaining how entrepreneurial alertness differs in market versus non-market (e.g., socialist) settings. If alertness is a universal phenomenon, as Kirzner believes, then it is unclear how or why government agencies do not also possess some degree of alertness — or why they could not be motivated to alertness. Once again, the necessary links between opportunity and alertness — and between decreased opportunity and non-alertness — are missing. Without them it does not seem possible to apply Kirzner’s alertness theory to economic policy, at least in the manner he suggests. The solution, I argue that we can solve this problem by relying on the concept of entrepreneurial calculation using money prices.
As mentioned above, Kirzner recognizes the problem involved in not explaining opportunity causation, yet still draws theoretical and policy conclusions as if the paradox had been resolved. It is difficult to escape the feeling that Kirzner accepts it as a matter of course that the market process produces beneficial welfare outcomes, and further, that this is the direct result of entrepreneurs tending to discover profitable opportunities. As he himself puts it, “there can be no doubt that such inspiration [i.e., entrepreneurial alertness] has been of enormous importance throughout recorded human history” (1985, p. 109). But this is a conclusion to be reached by careful reasoning, not a fundamental assumption. And until we clarify these assumptions and more clearly explain the foundations of entrepreneurial theory, economic policy is bound to remain a controversial subject. While this is far from an exhaustive discussion, I hope it is sufficient to demonstrate the need for careful scrutiny of the alertness hypothesis in economic policy, and moreover, to spark economists’ interest in alternative theories of entrepreneurship that more easily explain the effects of regulation on entrepreneurial behavior.
Entrepreneurial Calculation and JudgmentThe problems of the alertness approach do not mean that entrepreneurial theory must give up any hope of policy relevance. However, they do require us to more carefully consider the basic elements of theory, and how they relate to real-world human behavior. To this end, I suggest that instead of a theory of entrepreneurial alertness, what is needed is a theory of entrepreneurial judgment. The judgment approach to entrepreneurship has a long history within the Austrian school, and can be traced back at least as far as Menger’s writings. Menger did not write extensively on the entrepreneur, but he did describe a number of different ways entrepreneurship can occur (1994, pp. 159–61). Two forms of entrepreneurship that are relevant for judgment are “the act of will by which goods of higher order … are assigned to a particular production process” and the “supervision of the particular production process” (Menger 1994, p. 160; emphases in original). Both of these aspects of entrepreneurship point to the idea of a capital-owning, decision-making entrepreneur (Salerno 2008).
The judgment approach flourished in the works of Menger’s disciples, especially in the writings of Böhm-Bawerk (McCaffrey and Salerno 2014), Frank Fetter (McCaffrey unpublished), and Ludwig von Mises. Of these economists, Mises’s writings have received the most attention, and are the subject of controversy. Yet a careful study of his writings shows that his work falls within the judgment tradition. This thread of Mises’s thought begins with early writings such as The Theory of Money and Credit (McCaffrey 2013), and continues on through his more systematic exposition of entrepreneurship in Human Action (Salerno 2008; Foss and Klein 2010). The judgment view was further elaborated by Murray Rothbard, who placed his own discussion in the midst of an extended treatment of production theory (2004, pp. 509–55).Rothbard also drew attention to the Austrian heritage in entrepreneurship and pointed out several confusions about this legacy (1985; 1987). Among more recent generations of economists, the judgment theory has been developed by Joseph Salerno (2008) and has crystallized in such works as Foss and Klein (2012). This approach to entrepreneurship is therefore well-established within the Austrian school, and in fact represents a dominant trend in historical Austrian thinking on the subject.
The judgment approach views entrepreneurship as the function of residual decision making about the use of heterogeneous capital goods in production. In other words, the entrepreneur is the individual or group ultimately responsible for the direction of an enterprise, and this entails the ownership of capital and the direction of the factors of production. Because production takes time, arranging the structure of production implies that entrepreneurs make speculative judgments about the future state of the market. Eventually, consumer demand will reveal whether particular uses of capital were justified. If his initial judgments were correct, the entrepreneur earns profits, and if not, he incurs losses. The entrepreneur therefore bears the uncertainty of the future in exchange for the chance to reap profits. The key point, however, is that in order to do this entrepreneurs must exercise judgment about the allocation of resources.
However, when making decisions entrepreneurs first require some method of comparing the costs and benefits of each alternative use of scarce resources in order to determine which combinations of the factors will serve the most urgent needs of consumers. Entrepreneurs find this means of evaluation in monetary calculation. Calculation consists in entrepreneurs appraising the future prices of the factors of production through their “‘experience’ of past prices and … their ‘understanding’ of what transformations will take place in the present configuration of the qualitative economic data” (Salerno 1990a, p. 60). Once these mental estimates have been formed, entrepreneurs are in a position to gauge the relative merits of alternative arrangements of the factors. But their experience and understanding must be expressed in terms of a common denominator, namely money prices:
[A]s Mises points out, economic calculation involves arithmetic computation and … it is for this reason that economic calculation can only be calculation in terms of money prices. … As the only possible tool of calculable action, money prices do not merely permit people to utilize their individual “knowledge of particular circumstances of time and place” to enhance the efficiency with which goods are produced in society, prices render possible the very existence of social production processes. (Salerno 1990b)
Calculation therefore provides the “indispensable mental tool for choosing the optimum among the vast array of intricately-related production plans that are available for employing the factors of production within the framework of the social division of labor” (Salerno 1990a, p. 52). In other words, calculation provides, among other things, a basis for entrepreneurs’ judgment regarding the direction of the factors. More profoundly, calculation is actually the fundamental characteristic of a rational economic system, which is simply impossible in its absence, as in the case of socialist societies (Mises 1998 [1949]; Salerno 1990a; 1990b; 1993).
The distinct traits of calculation and judgment are all absent in the alertness view. This is a necessary result of Kirzner’s distinction between Robbinsian maximizing and entrepreneurial discovery, which excludes capital ownership, uncertainty bearing, and monetary losses from the start. Yet this exclusion is precisely why alertness theory stumbles when it confronts policy analysis. Because Kirzner cannot incorporate ordinary economic decision making into entrepreneurship, he instead explains it by appealing to variables outside the sphere of action, i.e., the existence of pure profit opportunities, which in turn leads to the problems discussed above. However, a capital-owning, uncertainty-bearing entrepreneur who earns monetary profits or losses can play an integral role in policy analysis.
The Policy Implications of EntrepreneurshipWith the ideas of entrepreneurial calculation and judgment in mind, we can now make sense of the link between public policy and entrepreneurial theory. One distinct advantage of the calculation-judgment theory is that it is easily integrated into policy analysis; the causal connections between policy and entrepreneurship are not metaphorical or paradoxical, but can be analyzed using fairly straightforward economic tools. What is more, by showing how policy interventions interfere with the process of economic calculation and judgment, we can more clearly determine the welfare implications of such interference.
Ownership and Political EntrepreneurshipThe application of judgment theory begins with the idea of ultimate or residual control over an enterprise. By determining where the locus of control and decision making lies, we can determine the scope and extent of entrepreneurial calculation, and also see how it might be hampered. More importantly, by discovering which individuals ultimately own and allocate resources, we can see how entrepreneurial behavior is different across institutional and policy contexts. The most obvious examples to contrast are entrepreneurial behavior in the market and in the political realm.
We have already said something about entrepreneurial calculation in the market. In sharp contrast is the element of “entrepreneurship” that occurs within government. Although decision making within government is often complex, it is clear that within any given state there is some form of ultimate authority over resource allocation. The exercise of this control may be termed “political entrepreneurship” (McCaffrey and Salerno 2011). Political entrepreneurship is distinct from market entrepreneurship in at least two important ways: first, it occurs outside the sphere of economic calculation, and second, it is financed through coercive redistribution as opposed to voluntary exchange.Note that Kirzner’s entrepreneur does not possess resources in either a political or a market setting. Therefore, market entrepreneurship cannot easily be distinguished from political entrepreneurship based on this difference or on considerations of the entrepreneur’s methods of finance. The non-voluntary nature of public finance means that no matter how decisions are made, they will conflict with the current preferences of the public at large, while the absence of calculation means decisions lack rational direction. Political entrepreneurship — i.e., government decisions about the allocation of resources—therefore diverts the stream of spending away from the path it would have taken in an unregulated market, and also distorts the structure of production (Rothbard 2004, pp. 1151–55, 1167–68; McCaffrey 2011). Political entrepreneurship cannot therefore produce the same welfare-enhancing effects as market entrepreneurship, and the absence of entrepreneurial calculation within government means that it never could.
Entrepreneurship and the Institutional FrameworkThe judgment approach also allows us to see how policy shifts the entrepreneurial function from one individual or group to another, and how this shift affects welfare outcomes. Changes in the entrepreneurial function are most relevant in a system of economic intervention. Under interventionism, ownership is systematically shared between government and private individuals, or in other words, there is a forcible separation of the ownership and control of the means of production. One way to describe this situation is “institutionalised uninvited co-ownership” (Hülsmann 2006; emphasis in original). For instance, when a government nationalizes an auto manufacturer or even the auto industry, entrepreneurs in these firms surrender their decision making ability, and the entrepreneurial function is shifted from the market to the political sphere. Even if entrepreneurs nominally retain ownership of the firm, they are little more than the managers of the enterprise — they can ultimately be replaced by the political entrepreneurs, who retain residual control. A system of government intervention, because it alters the pattern of ownership of the factors, also involves a systematic transfer of decision-making authority over them. Intervention therefore changes the pattern of entrepreneurship in society, by shifting the entrepreneurial function from some individuals to other more favored groups, be they rent-seeking firms or political entrepreneurs themselves.
“Institutionalized uninvited co-ownership,” is also closely tied to the incentive problem known as “moral hazard,” defined as, “the incentive of a person A to use more resources than he otherwise would have used, because he knows, or believes he knows, that someone else B will provide some or all of these resources” (Hülsmann 2006). When ownership and control are forcibly separated, a wide range of “perverse” incentives — such as moral hazard, adverse selection, and the tragedy of the commons — are brought into play. Under a system of free contracting, entrepreneurs (principals) must use judgment to arrange incentives within the firm, thereby mitigating moral hazard. However, when ownership is forcibly shared, the scope for calculation and judgment are reduced, prolonging or even institutionalizing incentive problems.
Moral hazard is not the only aspect of government intervention that can be viewed in an entrepreneurial light though. A closely related subject is the problem of “regime uncertainty.” This term was coined by Higgs (1997) as a way to explain the conditions which led to the long-term decline in private investment during the Great Depression. Higgs argues that entrepreneurs were reluctant to invest in a political environment hostile to their profit-seeking interests. In particular, widespread fear existed among businessmen that under the New Deal regime, industries would be nationalized, while taxes and other regulations would severely curtail profitability. What is more, the ideological stance of the Roosevelt administration was decidedly anti-business, creating an environment in which the viability of the fundamental institutions of the market economy was thrown into question. The uncertainty produced by the regime thus resulted in depressed investment and significantly delayed recovery.
Yet if the task of the entrepreneur is to allocate resources in the face of uncertainty, why would regime uncertainty pose a special problem? Regime uncertainty is relevant for judgment because it represents uncertainty about the institutional environment in which entrepreneurs make decisions; in a way, it tears the canvas on which entrepreneurs are trying to paint. One way to express this idea is to say that regime uncertainty occurs at a different institutional “level” than entrepreneurs are used to dealing with (Bylund and McCaffrey unpublished). That is, when regimes create fear about the security of the very system of private enterprise — in practice, the security of property rights and profits — they throw the “rules of the game” into question. Entrepreneurial judgment, on the other hand, usually takes place at the level of the “play of the game,” with certain institutional constraints taken for granted.
One result is that regime uncertainty undermines judgment by threatening its raison d’être. In a regime that is considered friendly to private enterprise, entrepreneurs constantly strive to earn profits and avoid losses. When regime uncertainty appears, however, entrepreneurs cannot be sure of the link between successful judgment and monetary rewards, and they therefore restrict their profit-seeking behavior (Bylund and McCaffrey unpublished). Reduced activity by entrepreneurs implies reduced effort to calculate in the economy, and ultimately, decreases in consumer satisfaction. There is then a reasonable chain of causation running from policy (actual or threatened), to entrepreneurs’ perceptions of monetary incentives, to a decline in entrepreneurial activity, and finally, to resulting welfare losses.Note that these links would be absent if entrepreneurs were unaware of the existence of monetary incentives. Judgment therefore provides a substantive connection between regime uncertainty and welfare.
This is one way the conventional effects of regime uncertainty can be expressed in entrepreneurial terms. We can also imagine the reverse of regime uncertainty, when entrepreneurs believe returns will be guaranteed no matter the quality of their judgment. Of course, guarantees of profitability and security are not found in the market; they are, however, often made by government in its negotiations with rent-seeking firms. When guarantees are made, profit-seeking activities increase because entrepreneurs believe they will be protected (e.g., through grants of monopoly privilege or bailouts), whether their investments are wise or not. Entrepreneurs are more likely to engage in risky and unprofitable production when convinced they will not ultimately bear the uncertainty of their decisions. This again hints at moral hazard.
ConclusionThe theory of the entrepreneur is one of the most important components of economic science. But although it is vital for economists to understand the driving force of the market, it is equally important know how public policy hampers this force. The most obvious obstacle to economic progress is government intervention in the market economy, which inevitably involves interference with the decisions of the entrepreneur. Yet how we think of the entrepreneurial function matters greatly for our conclusions about exactly how economic policy changes the entrepreneurial process and the welfare outcomes of the market economy. If, following Kirzner, we view the entrepreneur as a resource-less and inactive agent awaiting the serendipitous discovery of profit opportunities, policy analysis becomes effectively impossible. Because the existence of profit opportunities does not explain a tendency toward entrepreneurial success, it likewise does not show how changes to the policy environment tend negatively to impact discovery and the welfare of market participants. The alertness theory does not then provide a substantial foundation on which to build a distinctly entrepreneurial approach to policy analysis.
However, once we take into account the vital roles of calculation and judgment, it is easy to see that economic policy distorts and changes entrepreneurs’ behavior. Judgment theory relies on the concrete notions of capital ownership, calculation in terms of money prices, and decision making about the use of the factors, all of which can be seen at work in the real world. Intervention shifts the pattern of ownership and therefore also falsifies the money prices entrepreneurs use to appraise the factors of production. Intervention also directly abrogates the judgment of entrepreneurs by diverting the structure of production from the course it would have taken in an unregulated market. The direction and scope of entrepreneurial decision making are thus altered, and consumer welfare is reduced. Moreover, public policy can drastically affect the business environment in which entrepreneurs act, threatening the fundamental institutions of the market economy on which entrepreneurs rely. This depresses entrepreneurial activity, resulting in a general loss of welfare.
Judgment, through its connections to economic calculation, provides a concrete reference point from which to analyze the effects of policy. Calculation is mass to judgment’s velocity, and together they form the driving force of the market. This view of the entrepreneur not only has a long history within the Austrian school, but has already been applied to numerous problems in theory and policy, and will no doubt serve as a useful tool for analyzing many more. It therefore represents a positive way forward for scholars in economics and public policy.
As a final thought, let me add that while the future is bright, so too is the past; in other words, it is vital to recognize that many of the most important advances in Austrian economics have emerged from careful reflection on the foundations laid by the giants of the tradition, whose insights must never be taken for granted. As our thinking on entrepreneurship moves forward, it too should be mindful of its roots in the Austrian school, and always take care to appreciate the contributions of previous generations. With that in mind, it is safe to say that as this tradition grows and thrives in the coming years, it will owe no small debt to Joseph Salerno.
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For the head of the Federal Reserve Board Janet Yellen — and most economists — the key to economic growth is a strengthening in the labor market. The strength of the labor market is the key behind the strength of the economy. Or so it is held. If this is the case then it is valid to conclude that changes in unemployment are an important causative factor of real economic growth.
This way of thinking is based on the view that a reduction in the number of unemployed persons means that more people can now afford to boost their expenditures. As a result, economic growth follows suit.
We Need More Wealth, Not Necessarily More EmploymentThe main driver of economic growth is an expanding pool of real wealth, gained through deferred consumption and increases in worker productivity. Fixing unemployment without addressing the issue of wealth is not going to lift economic growth as such.
It is the pool of real wealth that funds the enhancement and the expansion of the infrastructure, i.e., an expansion in capital goods per individual. An enhanced and expanded infrastructure permits an expansion in the production of the final goods and services required to maintain and promote individuals’ lives and well-being.
If unemployment were the key driving force of economic growth then it would have made a lot of sense to eradicate unemployment as soon as possible by generating all sorts of employment.
It is not important to have people employed as such, but to have them employed in wealth-generating activities. For instance, policy makers could follow the advice of Keynes and his followers and employ people in digging ditches, or various other government-sponsored activities. Note that the aim here is just to employ as many people as possible.
A simple commonsense analysis however quickly establishes that such a policy would amount to depletion in the pool of real wealth. Remember that every activity, whether productive or non-productive, must be funded. When the Fed or the federal government attempt to increase employment through various types of stimulus, this can result in the expansion of capital goods for non-wealth generating projects which leads to capital consumption instead of growth.
Hence employing individuals in various useless non-wealth generating activities simply leads to a transfer of real wealth from wealth generating activities and this undermines the real wealth-generating process.
Unemployment as such can be relatively easily fixed if the labor market were to be free of tampering by the government. In an unhampered labor market, any individual that wants to work will be able to find a job at a going wage for his particular skills.
Obviously if an individual demands a non-market related salary and is not prepared to move to other locations there is no guarantee that he will find a job.
For instance, if a market wage for John the baker is $80,000 per year, yet he insists on a salary of $500,000, obviously he is likely to be unemployed.
Over time, a free labor market makes sure that every individual earns in accordance to his contribution to the so-called overall “real pie.” Any deviation from the value of his true contribution sets in motion corrective competitive forces.
Purchasing Power Is KeyUltimately, what matters for the well-being of individuals is not that they are employed as such, but their purchasing power in terms of the goods and services that they earn.
It is not going to be of much help to individuals if what they are earning will not allow them to support their life and well-being.
Individuals’ purchasing power is conditional upon the economic infrastructure within which they operate. The better the infrastructure the more output an individual can generate.
A higher output means that a worker can now command higher wages in terms of purchasing power.
Image source: iStockphoto.
Interviewed by host Dawn J. Bennet, Mark Thornton discusses how the recent sever of most foreign currency affects the dollar, why Janet Yellen’s only bluffing about raising rates, and why Americans need to pay closer attention to the recent election in Greece.
This essay is adapted from Murray Rothbard’s Austrian Perspective on the History of Ecopnomic Thought, Volume II.
While Ricardo formally admitted that supply and demand determine day-to-day market pricing, he tossed that aside as of no consequence. … Utility Ricardo brusquely disposed of as ultimately necessary to production but of no influence whatever on value or price; in the 'value paradox' he embraced exchange value and abandoned utility completely. Not only that: he frankly and boldly discarded any attempt to explain the prices of goods that are not reproducible, that could not be increased in supply by the employment of labor. Hence Ricardo simply gave up any attempt to explain the prices of such goods as paintings, which are fixed in supply and cannot be increased. In short, Ricardo abandoned any attempt at a general explanation of consumer prices. We have arrived at the full-fledged Ricardian — and Marxian — labor theory of value.
Ricardo’s Gloomy WorldThe Ricardian system is now complete. Prices of goods are determined by their costs, i.e., by the quantity of labour hours embodied in them, trivially plus the uniform rate of profit. Specifically, since the price of each good is uniform, it will equal the cost of production on the highest-cost (i.e., zero rent) or marginal land in cultivation. In short, price will be determined by cost, i.e., the quantity of labor hours on the zero-rent land used to work on the product. As time goes on, then, and population increases, poorer and poorer soils must be brought into use, so that the cost of producing corn continues to increase. It does so because the quantity of labor hours needed to produce corn keeps increasing, since labor must be employed on ever poorer soil. As a result, the price of corn keeps increasing. Since wage rates are always kept precisely at the subsistence level (the cost of growing corn) by population pressure, this means that money wage rates must continue to increase over time in order to keep real wage rates in pace with the ever rising price of corn. Wage rates must increase over time, and hence profits must keep falling until they are so low that the stationary state is reached.
Ricardo's system is both gloomy and rife with allegedly inherent class conflict on the free market. First, there is tautological conflict because, given the fixed total, the income shares of one macro-group can only increase at the expense of another. But the point of the free market in the real world is that generally production increases, so that the total pie tends to keep rising. And, second, if we focus on individual factors and on how much they earn, as does the later marginal productivity theory (and as did J.B. Say), then each factor tends to earn its marginal product, and we need not even concern ourselves with the alleged but non-existent laws and conflicts of macro-class income distribution. Ricardo kept his eye unerringly on the radically wrong problem — or rather, problems.
Ricardo Leads to MarxBut there is even more class conflict here than implied by Ricardo's tautological macro-approach. For if value is the product solely of labor hours, then it becomes easy for Marx, who was after all a neo-Ricardian, to call all returns to capital exploitative deductions from the whole of 'labor's' product. The Ricardian socialist call for turning over all of the product to labor follows directly from the Ricardian system — although Ricardo and the other orthodox Ricardians did not of course make that leap. Ricardo would have countered that capital represents embodied or frozen labor; but Marx accepted that point and simply riposted that all labor producers of capital, or frozen labor, should obtain their full return. In fact, neither was right; if we wish to consider capital goods as frozen anything, we would have to say, with the great Austrian Böhm-Bawerk, that capital is frozen labor and land and time. Labor, then, would be earning wages, land would earn rent, and interest (or long-run profits) would be the price of time.
Recent analysts, in an attempt to mitigate the crude fallacy of Ricardo's labor theory of value, have maintained, as in the case of Smith but even more so, that he was attempting not so much to explain the cause of value and price but to measure values over time, and labor was considered an invariable measure of value. But this hardly mitigates Ricardo's flaws; instead, it adds to the general fallacies and vagaries of the Ricardian system another important one: the vain search for a non-existent chimera of invariability.
The Chimera of Invariability of ValueFor values always fluctuate, and there is no invariable, fixed base of value from which other value changes can be measured. Thus, in rejecting Say's definition of the value of a good as its purchasing power of other goods in exchange, Ricardo sought the invariable entity, the unmoved power:
A franc is not a measure of value for any thing, but for a quantity of the same metal of which francs are made, unless francs, and the thing to be measured, can be referred to some other measure which is common to both. This, I think, they can be, for they are both the result of labour; and, therefore, labour is a common measure, by which their real as well as their relative value may be estimated.
It might be noted that both products are the result of capital, land, savings, and entrepreneurship, as well as labor, and that, in any case, their values are incommensurable except in terms of relative purchasing power, as Say had in fact maintained ...
The Class Struggle Implicit in Ricardo’s Theory of ValueAn even stronger and more direct class struggle than that implied by the labor theory of value stemmed from Ricardo's approach toward landlords and land rent. Landlords are simply obtaining payment for the powers of the soil, which, at least in the hands of many of Ricardo's followers, meant an unjust return. Furthermore, Ricardo's gloomy vision of the future held that labor must be kept at subsistence level, capitalists must see their profits inevitably falling — these two classes doing as badly as ever (labor) or always worse (capital) while the idle and useless landlords keep inexorably adding to their share of worldly goods. The productive classes suffer, while the idle landlords, charging for the powers of nature, benefit at the expense of the producers. If Ricardo implies Marx, he implies Henry George far more directly. The specter of land nationalization or the single tax absorbing all land rent follows straight from Ricardo.
Ricardo and the LandlordsOne of the greatest fallacies of the Ricardian theory of rent is that it ignores the fact that landlords do perform a vital economic function: they allocate land to its best and most productive use. Land does not allocate itself; it must be allocated, and only those who earn a return from such service have the incentive, or the ability, to allocate various parcels of land to their most profitable, and hence most productive and economic uses.
Ricardo himself did not go all the way to government expropriation of land rent. His short-run solution was to call for lowering of the tariff on corn, or even repeal of the Corn Laws entirely. The tariff on corn kept the price of corn high and ensured that inferior, high-cost domestic corn land would be cultivated. Repeal of the Corn Laws would enable England to import cheap corn, and thereby postpone for a time the use of inferior and high-cost land. Corn prices would for a while be lower, money wage rates would therefore immediately be lower, and profits would rise, adding to the accumulation of capital. The dread stationary state would be put further off on to the horizon. Ricardo's other anti-landlord action was political: by entering Parliament by joining Mill and the other Benthamite radicals in calling for democratic reform, Ricardo hoped to swing political power from the grip of the aristocracy, which meant in practice the landlord oligarchy, to the mass of the people.
The Logical Outcome of the Ricardian System: The Land TaxBut if Ricardo was too individualistic or too timorous to embrace the full logical consequence of the Ricardian system, James Mill characteristically was not. James Mill was the first prominent 'Georgist', calling frankly and enthusiastically for a single tax on land rent. In his high office in the East India Company, Mill felt able to influence Indian government policies.
Before obtaining this post, Mill had characteristically presumed to write and publish a massive History of British India (1817) without ever having been in that country or knowing any of the Indian languages. Steeped in the contemptuous view that India was thoroughly uncivilized, Mill advocated a 'scientific' single tax on land rent. Mill was convinced as a Ricardian that a tax on land rent was not a tax on cost and therefore would not reduce the incentive to supply any productive good or service. Hence a tax on land rent would have no bad effect on production — it would only have the effect of eliminating the ill-gotten gains of the landlords. In effect, a tax on land rent would be no tax at all! The land tax could be up to and including 100 percent of the social product caused by the differential fertility of the soil. The state, according to Mill, could then use this costless tax for public improvement, and largely for the function of maintaining law and order in India.
And Yet Ricardo Promoted Laissez-FaireWe see now the pernicious implications of the fallacious view that any part of the expense of production is in some way, from a holistic or social point of view, 'really' not a part of cost. For if an expense is not part of cost, it is in some sense not necessary to the factor's contribution to production. And therefore this income can be confiscated by the government with no ill effect. Despite the deep pessimism of Ricardo about the nature and consequences of the free market, he oddly enough cleaved strongly, and more firmly than Adam Smith, to laissez-faire. Probably the reason was his strong conviction that virtually any kind of government intervention could only make matters worse. Taxation should be at a minimum, for all of it cripples the accumulation of capital and diverts it from its best uses, as do tariffs on imports. Poor laws — welfare systems — only worsen the Malthusian population pressures on wage rates. And as an adherent of Say's law, he opposed government measures to stimulate consumption, as well as the national debt. In general, Ricardo declared that the best thing that government can do to stimulate the greatest development of industry was to remove the obstacles to growth which government itself created.
Image source: Portrait of David Ricardo by Thomas Phillips, public domain, wikimedia.
Interviewed by Emil Franzi and Bruce Ash on AM 1030 KVOI in Tuscon, Mark Thornton offers an Austrian perspective on several issues such as Obamacare, the state of the US economy and the dollar, government success in innovation (or lack there of), and the ruling class.
Orders for US non-military capital goods excluding aircraft rose by 0.6 percent in August after a 0.2 percent decline in July to stand at $73.2 billion. Observe that after closing at $48 billion in May 2009, capital goods orders have been trending up.
Most commentators regard this strengthening as evidence that companies are investing both in the replacement of existing capital goods and in new capital goods in order to expand their growth.
Responding to Markets or the Central Bank?There is no doubt that an increase in the quality and the quantity of tools and machinery (i.e., capital goods) is the key for the expansion of goods and services. But is it always good for economic growth? Is it always good for the wealth-generation process?
Consider the case when the central bank is engaging in loose monetary policy (i.e., monetary pumping and an artificial lowering of the interest rate structure). Such types of policy set the platform for various non-productive or bubble activities.
In order to survive, these activities require real funding, which is diverted to them by means of loose monetary policy. (Once loose monetary policy is set in motion this allows the emergence of various bubble activities).
Various individuals that are employed in these activities are the early recipients of money; they can now divert to themselves various goods and services from the pool of real wealth.
These individuals are now engaging in the exchange of nothing for something. (Individuals that are engaging in bubble activities don’t produce meaningful real wealth. However, by means of the pumped money, they do take a slice from the pool of real wealth. Again, note that these individuals are contributing nothing to this pool).
Now bubble activities, like any non-bubble activity, also require tools and machinery (i.e., capital goods). So various capital goods generated for these activities are in fact a waste of real wealth. This is because the tools and machinery that are generated here are going to be employed in the production of goods and services — that without the monetary pumping of the central bank — would never emerge. In other words, the wrong infrastructure has emerged.
These activities do not add to the pool of real wealth, they are in fact draining it. (This amounts to economic impoverishment). The more aggressive the central bank’s loose monetary stance is, the more drainage of real wealth takes place and the less real wealth left at the disposal of true wealth generators. If such policy persists for too long, this could slow or even shrink the pool of real wealth and set in motion a severe economic crisis.
Strength in Capital Goods Purchases Really Point to a BubbleWe suggest that the strong bounce in capital goods orders since May 2009 is on account of an extremely loose monetary stance by the Fed. Note that the wild fluctuations in our monetary measure AMS after a time lag followed by sharp swings in capital goods orders.
An increase in the growth momentum of money is followed by the increase in capital goods orders to support the increase in various bubble activities. Conversely, a decline in the growth momentum of money supply followed by a decline in capital goods orders.
We suggest that a down-trend in the growth momentum of the money supply since October 2011 is currently on the verge of asserting its dominance. This means that various bubble activities are likely to come under pressure. Slower monetary growth is going to slow down the diversion of real wealth to them from wealth generating activities.
Consequently capital goods orders are going to come under pressure in the months ahead. The build-up of a wrong infrastructure is going to slow down — and fewer pyramids will be built.
Image source: iStockphoto
In their new book "Money", Steve Forbes and Elizabeth Ames write with insight about the dangers of inflation and easy money, but ultimately, they fail to follow through on their analysis and instead make peace with monetary expansionism, writes David Gordon. This audio Mises Daily is narrated by Robert Hale.
In this course, Robert Murphy, author of the study guide to Murray Rothbard's masterpiece, Man, Economy, and State, will guide you through the chapters in which the market economy can finally be seen as an integrated system. This course is a perfect follow-up to Professor Murphy's course "Praxeology Through Price Theory", but is also superb for anyone who is already familiar with Austrian methodology and price theory. Enroll, now: http://academy.mises.org/courses/production/
Common wisdom would purport that those on the so-called “right” are and have always been hawkish and pro-war, while those on the proverbial “left” have always been the tree-hugging, peacenik, anti-war folks. For many conservatives, unfortunately, this is more or less correct. However, progressives have once again airbrushed their own past, which is about as anti-war as, well, war.
Much of this perception is relatively recent and primarily boils down to the Iraq War.The neoconservative warmongering was in full swing and for his part, Barack Obama gave a rather pleasant speech about his opposition to the war before it began. In his book, Obama elaborated,
What I sensed, though, was that the threat Saddam posed was not imminent, the Administration’s rationales for war were flimsy and ideologically driven, and the war in Afghanistan was far from complete.Barack Obama, The Audacity of Hope (Vintage Books, 2006), p. 347.
Not terribly bad, at least for a politician.
Obama then proceeded to escalate the war in Afghanistan, go to war with Libya without Congressional approval, authorize airstrikes in Iraq as well as drone strikes in Yemen, Somalia, and Pakistan while saber-rattling at Syria, Iran, and the Ukraine. Even the American withdrawal from Iraq he oversaw — which is now being ballyhooed by clueless neoconservatives — was hardly different than the schedule George W. Bush had already agreed to.
Indeed, as far as Democratic, and ostensibly progressive, politicians were concerned, Obama was actually abnormal in his tepid opposition to the Iraq War. Senate Democrats voted in favor of letting George Bush go to war 25 to 20. Hillary Clinton, Joe Biden, Dianne Feinstein, and John Kerry all voted yes.
Furthermore, it wasn’t long ago that the supposedly conservative Republicans were the ones against war and the supposedly liberal Democrats in favor of it. The big difference seemed to be nothing more than which party’s politician was in office. For example, regarding the military action in Kosovo in 1999, Senate Republicans opposed the resolution giving Clinton authorization for military action 13 to 32 while the Democrats supported it 38 to 3. The 2000 Republican Party platform even criticized the Democrats for being too militaristic abroad. Only later, after almost unanimous support on both sides of the aisle for the war in Afghanistan, did the parties switch for Iraq. Well, sort of switched.
Progressive opposition to the Iraq War has been very much exaggerated. Both the left-liberal New York Times and Washington Post backed the war. Thomas Friedman, Christopher Hitchens, Jacob Weisberg, George Packer, and Jonathan Chait all supported the invasion. Current Senator and liberal-favorite Al Franken noted that “... I believed Colin Powell. I believed the presumption that the President is telling the truth. So I thought, ‘I guess we have to go to war.’” The popular liberal blogger Matt Yglesias explained his support for the war as having been because he “... adhered to the school of thought (popular at the time) which held that one major problem in the world was that the US government was unduly constrained in the use of force abroad by domestic politics.” In other words, progressives weren’t getting as much war in the 90s as they would have preferred.
Sure, most of them eventually repudiated their former support (with the notable exception of Christopher Hitchens). But almost everyone outside of a few neoconservative perma-hawks have done the same. When Republican Congressman Dana Rohrabacher was asked in 2010 how many of his Republican colleagues thought the war was a mistake, he responded, “I will say that the decision to go in, in retrospect, almost all of us think that was a horrible mistake.” Being against the Iraq War now is kind of like being against slavery now. It’s certainly the correct moral position, but it’s not a particularly brave or impressive stance to take.
And while there were more on the Left who opposed the Iraq War from the beginning, it must be noted that anti-war movement amongst progressives quickly dissipated as soon as Barack Obama was elected. And while some on the Left have opposed Obama’s many interventions (albeit quietly), you’ll find more support than opposition amongst progressives for Obama’s “kinetic military actions.” For example, Nancy Pelosi was pushing for a war with Syria while Progressive-favorite Elizabeth Warren wants to bomb Iraq. DNC Chair Michael Czin even channeled his inner-neoconservative by declaring that Rand Paul “blames America for all the problems in the world” because of Paul’s (unfortunately short-lived) criticism of intervening in Iraq once again.
Before airstrikes began in Libya, Slate ran articles titled “Don’t Let Qaddafi Win” and “Why Obama Doesn’t Need to Ask Congress Before Attacking Libya.” And it was no different for Syria, as Slate writer Fred Kaplan opined,
… [Obama’s] rationale for military strikes (which I agree with) puts him in a box. The organizations charged with enforcing international law are not joining in the attack. The U.N. Security Council is “paralyzed.” ... To gain some measure of legitimacy, Obama at least needs domestic support. And so, in addition to announcing that he’d decided to launch an attack on Syrian targets, he also announced that he would have Congress debate and vote on a resolution authorizing military force.
So Slate, the popular, progressive online magazine, supports the president asking Congress for authorization to go to war, but only when it is not practical or possible for the president to go to war on his own accord. Now that is a peace-loving position if there ever was one!
Democratic voters haven’t been much better. According to a Pew Study, Democrats were slightly more likely (47 percent to 45 percent) to support “conducting airstrikes in Libya” than Republicans. Furthermore, again according to Pew, only 19 percent of Democrats were opposed to taking military action against Iraq in January 2002. When the war began, it was only 37 percent and that number didn’t cross the half way mark until 2004.
It is important to note that Democrat is not a synonym for Progressive, and the party of old cannot be directly compared to the party of today. Still, generally speaking, the Democrats have supported greater economic control and redistribution by the federal government, at least since the New Deal. In other words, the Democrats have, generally speaking, been the party of the progressives. Thereby, it is not insignificant to point out that the United States became involved in all four major American wars in the twentieth century with Democratic presidents in office: Woodrow Wilson in World War I, Franklin Roosevelt in World War II, Harry Truman in the Korean War, and Lyndon Johnson in the Vietnam War. Indeed, in an interesting piece of research, Gallup found that the partisan difference regarding Iraq didn’t exist for Vietnam. In 1965, more Republicans were opposed to military action in Vietnam than Democrats (28 percent to 22 percent). The sides didn’t switch until about 1970 and remained close throughout the war.
Of course, many on the Left have been consistently opposed to war. The socialist Eugene Debs was even imprisoned during World War I for denouncing America’s participation in the conflict. And sometimes, unfortunately, it appears that such leftists are not so much anti-war, but simply on the other side. For example, while the American involvement in Vietnam was an abomination, that doesn’t mean Ho-Chi Minh’s communist regime was something to celebrate. And it’s hard to make the case that Jane Fonda was being “anti-war” when she was photographed sitting on a North Vietnamese anti-aircraft gun or that Noam Chomsky was pushing for peace while shilling for Pol Pot and Khmer Rogue during the Killing Fields in Cambodia.
And in general, the mainstream progressives of old were even more pro-war than the conservatives. For instance, the staunch progressive William Jennings Bryan was an adamant supporter of the Spanish-American War. In the words of historian William Leuchtenburg, “few political figures exceeded the enthusiasm of William Jennings Bryan for the Spanish War.William E. Leuchtenburg, "Progressives and Imperialism," Mississippi Valley Historical Review 39 (1952): 485. Thomas Woods further observes,
The humanitarian aspect of the war — namely, liberating Cuba from Spanish rule — appealed to Progressives. The response of feminist leader Elizabeth Cady Stanton was typical: “Though I hate war per se,” she wrote, “I am glad that it has come in this instance. I would like to see Spain ... swept from the face of the earth.”Thomas E. Woods, 33 Questions About American History You Are Not Supposed to Ask (New York: Random House, 2007), p. 53.
World War I was even worse. Theodore Roosevelt, who started the explicitly progressive Bull Moose Party, was more adamant then anyone about getting the United States involved in World War I. In fact, most progressives were in favor of the First World War, including Walter Lippmann, Herbert Croly, and John Dewey. Murray Rothbard described Dewey’s activism on the matter as follows,
… John Dewey prepared himself to lead the parade for war as America drew nearer to armed intervention in the European struggle. First, in January 1916 in the New Republic, Dewey attacked the “professional pacifist’s” outright condemnation of war as a “sentimental phantasy,” a confusion of means and ends. Force, he declared, was simply “a means of getting results,” and therefore could neither be lauded or condemned per se.”Murray Rothbard, "World War I as Fulfillment," The Journal of Libertarian Studies IX, no. 1 (1989): 96–97.
And the progressives’ support for war continued through World War II to the Korean War. Opposition to the war in Korea was scarce, but the little that was found was mostly on the Old Right, led by Robert Taft. It wasn’t until the Vietnam War was well under way that any real anti-war movement could be found on the Left. And as the politics of today show, a consistent anti-war sentiment is a minority opinion on the Left.
History is crystal clear that progressives have not been universally or even mostly opposed to war. Conservatives are in general no better, and of recent, they are somehow even worse. Thereby, it’s quite unlikely that a cure for the festering rot known as the warfare state will come from the right. But given its history, such a cure will probably not come from the Left either.
Image source: iStockphoto
Austrians have a different point of view about economic growth. Growth requires four ingredients: domestic private investment, sound money, private property, and free markets. Archived from the live Mises.tv broadcast, this lecture by Mark Thornton was presented at How Does an Economy Grow? A Seminar for High School and College Students.
Are we in a recovery? There has been no true recovery since 2008. Private savings rate went down to zero during the boom. Traditional savings rate of Americans has been ten percent.
Archived from the live Mises.tv broadcast, this question and answer period features Daniel J. Sanchez, Mark Thornton and Peter G. Klein, and was was presented at How Does an Economy Grow? A Seminar for High School and College Students. Special thanks to an anonymous donor for making this event possible.
Back in the 1980s, Irwin Schiff, anti-tax activist, political prisoner, and father of free-market pundit Peter Schiff, wrote a marvelous comic book titled How an Economy Grows and Why It Doesn’t, which teaches economic principles through a light-hearted story.
The comic starts with three islanders — Able, Baker, and Charlie — who live off of fish, which they catch in the sea. They have no tools to aid them, so they must fish with their bare hands. Fish, to the islanders, is a consumers’ good: something that is used to directly pursue their goals (in this case, the goals of satisfying hunger and not starving). But, fish can only be a consumers’ good when it is ready for consumption. The fish do the islanders no good while they are still swimming in the sea. So the islanders must engage in production. They must produce the product of “fish on a plate,” which is, to be exact, the true consumers’ good, and not simply “fish” per se.
To produce “fish on the plate,” the islanders must use productive resources, or factors of production. One factor the islanders must use is their own labor. In this case, their labor is the act of fishing: using their eyes to spot the fish, and their hands to grab them. Another factor they must use is land, or natural resources: in this case, “fish in the sea.” “Fishing labor” + “fish in the sea” = “Fish on the plate.”
Using only their bare hands, the islanders can only produce one fish per day, which is very low productivity.
As Schiff writes, with such low productivity, “This is survival and that’s about all.” It is a state of extreme poverty. The islanders have little time for leisure, or to produce anything else they might want to enjoy. They are also extremely vulnerable. What if they get sick, or break their hand? A single bad week of fishing could mean starvation. Life with such low productivity, is life on the brink.
Like a Disney princess, Able dreams of “something more.” He’s tired of being poor, and wants to somehow improve his living standard. He comes up with the idea of building a net to use to catch fish faster (boost his productivity).
The net is a third kind of factor: a capital good, or produced factor of production. Producing a net also requires factors, including natural materials (land), like sticks and vines, and net-building labor. Building the net would take a whole day.
That would be a whole day that Able wouldn’t be fishing. His labor is scarce; it cannot be dedicated to both fishing and net building at the same time, and so it must be economized: dedicated to one and not the other.
And if Able doesn’t fish, he goes hungry for that day. Building the net would require sacrifice: delaying consumption.
Able must decide between two different production methods. Does he stick to hand fishing, or does he switch to net fishing? He must consider the upsides and downsides of each.
The upside of hand fishing is that it has a short period of production. Able starts production, and then gets to eat later that very same day. The downside is its low productivity, and Able’s resulting chronic state of poverty.
The upside of net fishing is its higher productivity, which is two fish per day according to the comic; but for illustrative purposes, let us change the productivity of net fishing to three fish per day. The downside of net fishing is that it has a longer period of production at first. It takes one day to make the net, and then another day to use it. So, Able would start production, and only get to eat two days later.
Able is at a crossroads. He can either stay mired in primitivism, or he can rise above it. Rising above economic primitivism is often considered simply a matter of technology. However, simply having the idea of, and the know-how for, producing a net, is not an immediate, costless benefit for Able. It would be costless if it were simply a matter of choosing between “1 fish today” and “3 fish today.” Of course more is automatically better than less, other things being equal. But other things are not equal: a difference regarding time is an essential consideration here. It is not simply more vs. less; it is “more and later” vs. “less and sooner.”
So the decision for Able whether to adopt the “net fishing” technology involves a trade-off: an “exchange” he deliberates over in his mind. Will he give up the “less and sooner” yield that comes with hand fishing in exchange for the “more and later” yield that comes with net fishing?
The answer to that depends on Able’s personal time preference, or the premium he places on the immediacy with which he achieves his ends: the importance of “sooner.” The lower someone’s time preference is, the more willing someone will be to delay consumption. And the higher, the less.
For example, as the comic book later indicates, the time preferences of Baker and Charlie are too high for them to make the net. Giving up eating today is too great a sacrifice for them, even if it would mean being able to eat three times as much tomorrow. If net fishing were more productive, that might have sweetened the deal enough; i.e., if the net netted five times as much, they might have been willing to wait. Their time preferences are not infinitely high. But they are not low enough to embark on this particular capital project.
But Able’s time preference is low enough, so he is willing to delay consumption, produce the capital good, and increase his productivity.
Morevoer, the day after his first big net-aided catch, he has enough extra fish to not have to fish all day, because he can subsist on what he has already caught. Instead, he can spend the day creating even more capital goods to raise his productivity even higher. For example, he makes a rake to use to farm carrots. And he can use the additional yield from carrot farming to support even more capital accumulation. As he becomes ever more productive, he can also afford to devote more resources toward leisure and comfort as well.
Thus, Able’s low time preference puts him in the fast track of an ascending spiral: a virtuous “Cycle of Growth.” Saving (delaying consumption) supports more capital goods, which boosts productivity, which creates more to save, and around he goes.
With every lap around this loop, he becomes wealthier, as both his capital stock and living standard increases. And with every lap, he inches ever further away from the brink and toward greater security and peace-of-mind. A bad week of production becomes merely a bummer, and not a catastrophe. This Cycle of Growth, by the way, is the way living standards rise in a complex market economy as well.
But then others on the island start getting their own ideas about what Able should do with his newly abundant resources. One man says, “Divvy up.” This is an example of the envy-based egalitarian ethos that has afflicted peoples throughout history and pre-history, keeping them poor and primitive. As Murray Rothbard wrote:
In fact, the primitive community, far from being happy, harmonious, and idyllic, is much more likely to be ridden by mutual suspicion and envy of the more successful or better favored, an envy so pervasive as to cripple, by the fear of its presence, all personal or general economic development. The German sociologist Helmut Schoeck, in his important recent work on Envy, cites numerous studies of this pervasive crippling effect. Thus the anthropologist Clyde Kluckhohn found among the Navaho the absence of any concept of “personal success” or “personal achievement”; and such success was automatically attributed to exploitation of others, and, therefore, the more prosperous Navaho Indian feels himself under constant social pressure to give his money away. Allan Holmberg found that the Siriono Indian of Bolivia eats alone at night because, if he eats by day, a crowd gathers around him to stare in envious hatred.
If every time someone saves more, he is pressured to relinquish his “excess wealth,” that can only discourage savings. And knocking out savings knocks people off the Cycle of Growth. It also knocks them onto a Cycle of Impoverishment. This is because low savings can lead to capital consumption. “Consuming” capital doesn’t mean “eating the net.” It means that the net eventually wears out with use, and to maintain it requires diverting possibly consumed resources away from consumption and toward repair/replacement. Without sufficient savings, capital goods enter a state of disrepair. The net eventually tears and fish start swimming through it, at which point the fisherman must resort again to low-productivity hand-fishing, and finds himself back on the brink.
Another islander waves a club at Able, and suggests, “How about this?” threatening to plunder Able’s savings. Such brigandage has also kept entire peoples poor throughout history and pre-history. Constant raids by roaming hordes will also discourage savings and break the Cycle of Growth. Sometimes the raiders settle in, and, through propaganda, transform themselves into a “state,” and their plunder into “taxation.” What is particularly devastating to the Cycle of Growth is the kind of state plunder called, “proscription.” In ancient times, when an individual managed to accumulate enough wealth, he often became a tempting one-stop shop for loot, and so the state would find some excuse to imprison or execute him so as to facilitate his total expropriation. This explains the rage for “buried treasure” in times and places where princes were particularly grasping. Of course, modern democracies plunder too, often under the cover of egalitarianism and through “progressive taxation.” The more you save, the more you’re taxed. This too is particularly inimical to the Cycle of Growth.
Then a little bird asks if Able’s penchant for accumulation is “greedy” and bad. “Bad for whom?” responds a wise owl. There are only so many fish Able can eat, and only so many uses for his nets. To maximally benefit from his tremendous productivity, he must offer his products to others in the community in exchange for goods and services. And through exchanges like investments, loans, and wages, non-savers can get access to capital goods that would have otherwise been out of reach. For example, Able rents out his nets and loans out his fish at interest. This enables higher-time-preference islanders like Baker and Charlie to increase their productivity and living standards. And since all exchanges are, by definition, projected by both willing parties to be beneficial, the more exchanges the saver makes, the more he benefits the public.
Savings and capital benefit everyone, not just the saver and capital accumulator. The Cycle of Growth lifts the entire community. And so when egalitarianism and plunder discourage saving, it keeps the entire community down, hurting not only the savers, but everyone who might have exchanged with the savers.
There is nothing “fishy” about savings, capital accumulation, productivity, and peacefully acquired wealth. But to paraphrase an old saying, fish and plundering visitors start stinking very quickly.
As Ludwig von Mises wrote:
Every single performance in this ceaseless pursuit of wealth production is based upon the saving and the preparatory work of earlier generations. We are the lucky heirs of our fathers and forefathers whose saving has accumulated the capital goods with the aid of which we are working today. We favorite children of the age of electricity still derive advantage from the original saving of the primitive fishermen who, in producing the first nets and canoes, devoted a part of their working time to provision for a remoter future. If the sons of these legendary fishermen had worn out these intermediary products — nets and canoes — without replacing them by new ones, they would have consumed capital and the process of saving and capital accumulation would have had to start afresh. We are better off than earlier generations because we are equipped with the capital goods they have accumulated for us.
Image Source: from How an Economy Grows and Why It Doesn't
Not unlike governments, ponzi schemer Bernie Madoff used his victims' money to exhibit his "generosity" through charitable giving projects, writes Brandon Dutcher. This audio Mises Daily is narrated by Keith Hocker.
Drug warriors rely on bad and manipulated data to make the claim that respecting private property rights in Colorado is “terrible public policy,” writes Mark Thornton. This audio Mises Daily is narrated by Keith Hocker.
In June, the European Central Bank (ECB) made a historic and downright diabolical announcement. They decided to inaugurate negative interest rates for overnight deposits. Here are the details from the official transcript:
The rate on the deposit facility was lowered by 10 basis points to -0.10 percent. These changes will come into effect on 11 June 2014. The negative rate will also apply to reserve holdings in excess of the minimum reserve requirements and certain other deposits held with the Eurosystem.
Now, the forceful suppression of interest rates by central banks is by no means a new policy. The last century is replete with examples of the abuse of this power and its corresponding consequences. ZIRP (Zero Interest Rate Policy) is inherently inflationary, punishes savers by taking away any yield on money thus forcing them into increasingly risky speculation in order to gain a return. Nor can we forget its central role in engendering the dreaded boom-bust business cycle. For the last five years the US and the Eurozone have been frolicking in ZIRP land. Last week’s decision by the ECB to cross the border into negative territory marks a historic event and shows just how far central banks are willing to go to destroy the global economy.
Why negative interest rates? This is really the same as asking “why zero interest rates?”
The scripted answer from Mario Draghi (and Janet Yellen for that matter) is, “... the measures will contribute to a return of inflation rates to levels closer to 2 percent.”
It’s more correct to say that central banks are terrified of deflation more than to say they want inflation. By deflation they mean a general fall in aggregate prices. They point back to the Great Depression and the 2008 financial collapse as particularly bad episodes of deflation they don’t want to relive. That is why, as prices plummeted, they intervened with extraordinary and unconventional measures (TARP, ZIRP, Bailouts, QE, etc.) to prop it all up again. They want prices to rise, continuously, all of them, from stocks to bonds to salaries to consumer goods. They want the Keynesian wealth effect to take hold. They don’t care if you can’'t buy as much today as you could fifty years ago with the same amount of printed paper (or electronic deposits, for that matter).
They strive to achieve this goal by expanding the total supply of credit, getting more euros (or dollars) in the hands of more people with the hopes they will spend those euros on something, thereby raising the price of that something. While ZIRP already does this as it lowers the overall cost of lending, negative interest rates go one step further. A negative deposit rate means the ECB is actually going to charge you .10 percent to keep your money safe. The ECB’s relationship with European banks is akin to some parents with their children. While ZIRP is the equivalent of holding candy out in front of the kid to try and get him to do what you want, a negative deposit rate would be spanking the kid for not doing what you want.
Of course banks are not kids and neither are business owners. They are much smarter than that. They do not always respond uniformly the way central banks would like them to. This instance is no different. Rather, as in all cases of central planning, this decision will have unintended and costly consequences.
You can show someone the door but you can’t make them walk through it.The market for credit, like any other market, is a two-way street. Simply expanding the total supply of credit is only half of the intended exchange. It will sit there unless adequate demand arrives. At this point it’s important to remember our context. We are five years into ZIRP land — credit has not been particularly hard to come by — we have been saturated with it. In Europe (like in the US) banks are sitting on large piles of reserves, which Draghi hopes to spank the banks into lending. But spanking banks does not magically make corporations or individuals creditworthy. For many, especially among the fringe countries of Europe it simply does not make sense to go back into debt when they are still coming out from under the first (or second) wave. Businesses are not thriving there and unemployment is still rampant. Are those countries really ready to take on more debt? Is the bank really going to lend to them?
Look at it from the bank’s perspective. Which would you choose, if given the choice between paying .10 percent to keep your capital safe, or lending out your capital but only to those who are struggling to pay off prior debts. A simple analysis would say, “Gosh, there really isn’t a good alternative here, but the least costly might be paying the .10 percent given that we could lose a lot more if we extend credit only to have a default later.” At the end of the day, charging negative interest rates might not do as much as Draghi hopes.
Alternatively, and let’s pray this is not the case, punishing banks to play it safe might force them to start playing more dangerously! In order to avoid the fee, they might start lending to whomever they please, solvent or insolvent. Savvy speculators will see the easy opportunity. They will start to package junk debt in attractive secure looking bundles in the hopes that the bank’s credit department won’t review it thoroughly. With this new decision by Draghi, they’ve got a pretty good shot. Negative interest rates make it increasingly costly for the bank to use discretion in lending because they will have to pay (.10 percent) to use discretion. This is the worst-case scenario which introduces the perverse incentive to engender a whole new round of toxic debt with even greater potential for default.
Second, and this makes Draghi look silly, even if the banks lend out their reserves many of them will end up right back in the banking system. Keith Weiner has a great article in Forbes where he says,
Cash never leaves the banking system. It is a closed loop, with money transferring from one party to the next, but always remaining in the custody of a bank. Lending does not avoid the need to deposit cash at the ECB, or in the US, at the Federal Reserve.
When you borrow money from a bank, does the bank actually give you the total sum in stacks of colorful paper? No, what you receive from the bank is a notation in your account of increased credit from the bank. Nothing goes in or out of the bank. It stays right there. This is as true for large scale financing as it is for you and me. Lending does not avoid the need to deposit cash at a bank.
What is more likely to happen and why it’s not any better: while seemingly in a tight fix the banks do have a way to avoid the ECB fee and still lend at little risk. In fact they can lend at virtually no-risk by buying government bonds. Indeed, this is what they have been doing. Look at the charts for the Spanish and Italian 10-year bond yields.
Spanish 10-year Yield
Credit: Bloomberg
Italian 10-year Yield
Credit: Bloomberg
The interest rate is inverse to the price of a bond. If banks are buying government bonds, then their price will be bid up, and the yield will be pushed down. Look at the charts. Since the announcement on June 5, both rates have fallen.
ConclusionThe result of Draghi’s decision will not lead to an increase in prices, new businesses, or increased consumer spending. But it will serve to provide an even lower interest rate on government debt which will allow already insolvent governments to borrow more money and therefore more easily rollover their existing debt obligations. When one stops to think about it, one has to ask, was that the real reason why the ECB decided to impose this in the first place? Could all the pseudo-academic speak be a disguise for the real objective: Central banks exist to make it easier for insolvent governments to borrow more money.
Image source: iStockphoto
Volume 4, No. 1 (Spring 2001)Ingo Pellengahr’s doctoral dissertation, The Austrian Subjectivist Theory of Interest, focuses on one small aspect of these ongoing debates. He traces the development and evolution of what is generally referred to as the (pure) time preference theory (PTPT) of interest. The PTPT is historically associated with the Austrian School, whose characteristically subjectivist members stress the primacy of individual valuations—versus objective facts concerning the productivity of capital—in any discussion of interest. Pellengahr offers a largely critical review of the major Austrian contributions to the evolving PTPT and then presents an original, “essentialist” synthesis which he hopes will be acceptable to the various factions in the debate.
Volume 16, No. 4 (Winter 2013)ABSTRACT: The purpose of this paper is to explain the marginal efficiency of capital.Edward W. Fuller (Edward.W.Fuller@gmail.com), MBA, is a research consultant at SIG. The net present value diagram is derived and used to illustrate how the interest rate regulates the intertemporal allocation of resources. The net present value diagram is then used to show that the marginal efficiency of capital contradicts the net present value method of ranking investment projects. The net present value diagram is integrated into the capital-based framework to demonstrate that the interest rate cannot regulate the intertemporal allocation of resources in Keynes’s theory of investment.
KEYWORDS: John Maynard Keynes, marginal efficiency of capital, net present value, economic calculation, interest rates, interest rate sensitivity, intertemporal allocation of resources, central banking, business cycles, capital-based macroeconomicsJEL CLASSIFICATION: E12, G30, E22, E32, E43, E52, 58 INTRODUCTIONEconomic calculation plays a central role in Austrian economics and Keynesian economics. However, the Austrians and the Keynesians each advocate a different approach to economic calculation. The Austrian school advances the present value approach to economic calculation in which the net present value is used to rank investment projects. In distinct contrast, the Keynesians adopt the rate of return approach to economic calculation in which the marginal efficiency of capital is used to rank investment projects. The purpose of this paper is to explain the marginal efficiency of capital and its implications for macroeconomics.The distinction between the present value approach and the rate of return approach comes from Lorie and Savage (p. 237) and Solomon (p. 124). Both approaches are used widely in practice. Graham and Harvey (p. 33) found that 75% of the financial managers in their study use the net present value to rank investment projects. They also found that 76% of the managers in their study use the marginal efficiency of capital.
NET PRESENT VALUELudwig von Mises and Irving Fisher advocate the present value approach to economic calculation. According to the present value approach, the price of an investment project tends to equal the present value of the project’s expected cash flows. Murray Rothbard (p. 489) shows that the present value of an investment project is completely dependent on the size of the expected cash flows, the timing of the expected cash flows, and the interest rate.Rothbard uses different terminology to describe the present value approach to economic calculation. The term cash flow is identical to the marginal value product (MVP). The term discounted cash flow is identical to the discounted marginal value product (DMVP): “The capitalized value of the capital good is the sum of the future DMVPs, or the discounted sum of the future MVPs. This is the present value of the good, and this is what the good will sell for on the capital market” (Rothbard, p. 491). To demonstrate, Alvin Hansen offers the following numerical example: “Consider the case of a [wooden bridge] costing $2,000 whose life is only three years and which offers the prospect of a series of yields of $1,000 in each of three years” (Hansen, p. 118). The wooden bridge will generate cash flows of 1,000 per year for three years. If the interest rate is 10%, then the present value (PV) of the wooden bridge is 2,486.85.
Rothbard calls the net present value (NPV) the entrepreneurial profit. The net present value equals the present value minus the price of the investment. In Hansen’s example the net present value of the wooden bridge is the present value of 2,486.85 minus the price of 2,000.
The table below summarizes Hansen’s economic calculation.
Table 1. NPV of Wooden Bridge at 10% Interest RateCompetition between investors creates a tendency for the price of an investment project to equal the present value of the expected cash flows. Investors will bid up the price of an investment project when the price is below the present value, and investors will bid down the price of an investment project when the price is above the present value. Since the price of an investment project tends to equal the present value, there is a tendency for the net present value to equal zero. In Hansen’s case, the present value of the wooden bridge is 2,486.85 while the price of the wooden bridge is only 2,000. The net present value is 486.85. Other investors will be drawn to this entrepreneurial profit. Competing investors will enter the market and bid up the price of the wooden bridge to 2,486.85 where the net present value is zero. Competition between investors creates a tendency for the net present value of an investment project to equal zero.
There is an important negative relationship between the interest rate and the present value of an investment project. All else equal, the present value of an investment project increases as the interest rate falls. In Hansen’s example suppose the interest rate is 5% instead of 10%. In this case the expected cash flows are discounted at 5%. Since the expected cash flows are discounted at a lower rate, the present value increases from 2,486.85 to 2,723.25.
Table 2. NPV of Wooden Bridge at 5% Interest RateAll else equal, the net present value of an investment project increases as the interest rate falls. In Hansen’s example the net present value increases from 486.85 to 723.25 when the interest rate falls from 10% to 5%. The NPV schedule lists a project’s net present value at various interest rates. Table 3 is the NPV schedule of the wooden bridge, and it shows that the net present value of the wooden bridge increases as the interest rate falls.
Table 3. Wooden Bridge NPV ScheduleThe NPV schedule can be represented graphically. A continuous graph of the NPV schedule is called the NPV profile. In Figure 1, the vertical axis shows the interest rate and the horizontal axis shows the net present value. The NPV profile shows the net present value of an investment project at different interest rates.
Figure 1. NPV ProfileThe NPV profile has three properties. First, the NPV profile slopes downward from left to right. This indicates that the net present value increases as the interest rate falls. Second, the NPV profile is curved so that the NPV profile becomes flatter as the interest rate falls. Third, the NPV profile intersects the interest rate axis at the point where the NPV is zero.
The net present value is used to compare and rank competing investment projects in the present value approach to economic calculation. It is necessary to introduce another investment option to show how the interest rate affects net present value rankings. Suppose Hansen can build a more durable bridge by using steel instead of wood. The steel bridge generates the same size cash flows as the wooden bridge, but the steel bridge has a longer period of production and a longer life than the wooden bridge. The price of the steel bridge is 5,000. Starting in time three, the steel bridge will generate a 1,000 cash flow every year until time ten. Table 4 is the steel bridge’s cash flow table and it shows that, compared to the wooden bridge, the steel bridge is a long-term investment project.
Table 4. NPV of Steel Bridge at 10% Interest RateLike the wooden bridge, the net present value of the steel bridge depends on the interest rate. Table 5 lists the net present value of both the wooden bridge and steel bridge at various interest rates.
Table 5. Wooden and Steel Bridge NPV ScheduleWealth maximizing investors use the net present value to rank investment projects. According to the NPV rule, wealth maximizing investors give the highest ranking to the investment option with the highest net present value. Table 5 shows that net present value rankings depend on the interest rate. The wooden bridge has a higher NPV ranking when the interest rate is greater than 5.48%, but the steel bridge has a higher NPV ranking when the interest rate is less than 5.48%. In this example, 5.48% is called the crossover rate because the net present value of the steel bridge equals the net present value of the wooden bridge when the interest rate is 5.48%. The crossover rate is the interest rate at which the projects’ net present values are equal. Fisher calls the crossover rate the rate of return over cost: “This hypothetical rate of interest which if used in calculating the present worth of the two options compared would equalize them or their differences (cost and return) may be called the rate of return over cost” (Fisher, p. 155).
NPV profiles can also be used to illustrate how NPV rankings depend on the interest rate. The easiest way to depict how the interest rate affects NPV rankings is by putting both NPV profiles on the same diagram.See Alchian (p. 939) and Lorie and Savage (p. 237) for more on the NPV diagram.
Figure 2. NPV DiagramThe crossover rate is the interest rate at which the two NPV profiles cross. The wooden bridge has a higher NPV ranking when the interest rate is above the crossover rate, and the steel bridge has a higher NPV ranking when the interest rate is below the crossover rate. The two profiles cross because the steel bridge has a flatter profile than the wooden bridge. The steel bridge’s flatter NPV profile reflects that the net present value of the steel bridge is more interest rate sensitive than the net present value of the wooden bridge. When the interest rate changes by a given amount, the percentage change in the net present value of the steel bridge is greater than the percentage change in the net present value of the wooden bridge. In general, long-term projects are more interest rate sensitive than short-term projects.
The interest rate regulates the intertemporal allocation of resources in the present value approach to economic calculation. To demonstrate, Figure 3 combines the NPV diagram and the loanable funds diagram. In Figure 3, the interest rate determined in the loanable funds market is greater than the crossover rate, so the wooden bridge has a higher NPV ranking. In this case the investor will allocate resources to the wooden bridge.
Figure 3. Loanable Funds and NPV DiagramNow suppose there is a change in consumer preferences so that consumers save more and consume less. The increase in the supply of savings causes the supply of loanable funds curve to shift to the right, from S to S’. The increase in saving reduces the interest rate and increases the amount of investment.
Figure 4. Increase in SavingFigure 4 shows that the increase in saving by consumers changes the investor’s NPV rankings. At the lower interest rate the NPV rankings tell the investor to allocate resources to the steel bridge. The lower interest rate changes the NPV rankings because “The price of a factor which can be used in most early stages and whose marginal productivity there falls very slowly will rise more in consequence of a fall in the rate of interest than the price of a factor which can only be used in relatively lower stages of production or whose marginal productivity in the earlier stages falls very rapidly” (Hayek, p. 263). Figure 4 shows how the interest rate coordinates the actions of consumers, savers, and investors by adjusting investors’ NPV rankings to reflect changes in the saving behavior of consumers.
In the present value approach the interest rate determines the intertemporal allocation of resources. The interest rate is the price signal that “tells businessmen how much savings are available and what length of projects will be profitable” (Rothbard, p. 997). The interest rate tells the investor, through his NPV rankings, whether consumers prefer short-term or long-term investment projects. Figure 3 illustrates that resources are allocated to the short-term project when the interest rate is high; Figure 4 illustrates that resources are allocated to the long-term project when the interest rate is low. Figure 4 shows how a lower interest rate resulting from an increase in saving changes NPV rankings so that investors allocate resources into longer, more interest rate sensitive investment projects.
MARGINAL EFFICIENCY OF CAPITALJohn Maynard Keynes advocates the rate of return approach to economic calculation. In the rate of return approach investors use the marginal efficiency of capital (MEC) to rank investment projects. Keynes defines the marginal efficiency of capital as the “rate of discount which would make the present value… equal to its supply price” (Keynes, p. 135).Keynes (p. 135) calls an investment’s expected cash flows the prospective yield. Today the marginal efficiency of capital is better known as the internal rate of return. In Hansen’s example, the marginal efficiency of capital is the discount rate which makes the present value of the wooden bridge equal 2,000. In other words, the marginal efficiency of capital is the discount rate which makes the NPV equal zero.
Table 6. Marginal Efficiency of CapitalThe marginal efficiency of capital of the wooden bridge is 23.38%. When the expected cash flows from the wooden bridge are discounted at 23.38%, the present value equals the 2,000 supply price of the bridge. Put differently, the net present value is zero when the project’s expected cash flows are discounted at 23.38%. This can be seen using the NPV schedule. Table 7 shows that the net present value declines as the interest rate rises, and finally equals zero when the interest rate is 23.38%:
Table 7. NPV Schedule with MECThe marginal efficiency of capital can also be found on the NPV profile. Since the marginal efficiency of capital is the discount rate that makes the net present value equal zero, the marginal efficiency of capital is the point at which the NPV profile intersects the y-axis.The marginal efficiency of capital cannot be used in many situations. Lorie and Savage (p. 237) and Solomon (p. 127) show that projects with nonnormal cash flows will have multiple MECs. There are also situations in which the marginal efficiency of capital does not exist. Therefore, the marginal efficiency of capital cannot be the basis of a general theory of investment.
Figure 5. Marginal Efficiency of CapitalIn the Keynesian rate of return framework investment decisions are made by comparing the marginal efficiency of capital to the interest rate. The MEC rule is to accept an investment project if the marginal efficiency of capital is greater than the interest rate. Put differently, the MEC rule is to accept an investment project if the rate of return is greater than the cost of capital. In Hansen’s example an investor will only build the wooden bridge if the interest rate is less than 23.38%. Conversely, The MEC rule is to reject an investment project if the marginal efficiency of capital is less than the interest rate. In Hansen’s case, an investor will reject the wooden bridge project if the interest rate (the cost of capital) is greater than 23.38% (the rate of return).
Expectations play an important role in Keynes’s theory and the marginal efficiency of capital is Keynes’s outlet for expectations. According to Keynes, a collapse of the marginal efficiency of capital is the cause of the economic crisis: “It is important to understand the dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle” (Keynes, p. 143). The marginal efficiency of capital is completely determined by the investor’s expectations about the size and timing of future cash flows, so the marginal efficiency of capital collapses when there is a collapse in cash flow expectations. To demonstrate, suppose Hansen reduces the cash flow forecast because his expectations suddenly become more pessimistic. The size of the expected cash flows drops from 1,000 to 750.
Table 8. Collapse of MECThe marginal efficiency of capital collapses from 23.38% to 6.13% when the cash flow forecast is revised downward. The present value and the net present value do not change after the collapse in cash flow expectations. The present value is still 2,000 and the net present value is still zero after the drop in cash flow expectations. This example illustrates that Keynes views “the offering price of the capital good as a given, an unchanging, constant amount, even when entrepreneurs’ profit outlook varies” (Huerta de Soto, p. 555).
The most important problem with the marginal efficiency of capital is that it contradicts the wealth maximizing net present value criterion. Keynes (p. 137) and Hansen (p. 118) both erroneously claim that the rate of return approach is identical to the present value approach. The NPV diagram shows that the rate of return approach and the present value approach are related, but they are not identical. According to John Hicks, “Keynes had three elements in his theory: the marginal efficiency of capital, the consumption function, and liquidity preference” (Hicks, p. 142). All of these elements are captured by combining the Keynesian IS-LM diagram with the NPV diagram.
Figure 6. IS-LM and NPV DiagramIn Figure 6 the MEC criterion and NPV criterion yield identical results. The MEC rule is to assign the highest ranking to the project with the highest marginal efficiency of capital. Table 5 shows that the wooden bridge (23.38%) has a higher marginal efficiency of capital than the steel bridge (7.74%). In Figure 6 the wooden bridge’s NPV profile intersects the y-axis at a higher point than the steel bridge’s NPV profile, so the wooden bridge has a higher MEC ranking than the steel bridge. Since the interest rate determined in the IS-LM panel is greater than the crossover rate, the NPV criterion also ranks the wooden bridge above the steel bridge. Figure 6 and Table 5 illustrate that the net present value and marginal efficiency of capital give identical rankings when the interest rate is greater than the crossover rate.
Now suppose there is a change in consumer preferences so that consumers increase saving by reducing consumption. In the Keynesian IS-LM model, an increase in saving causes the IS curve to shift to the left, from IS to IS’. An increase in saving lowers both the interest rate and income.
Figure 7. Increase in Saving in the Keynesian FrameworkIn Figure 7 the MEC criterion and NPV criterion yield contradictory results. Since MEC rankings do not depend on the interest rate, a lower interest rate does not change MEC rankings. At the lower interest rate the wooden bridge has a higher ranking according to the MEC criterion, but the steel bridge has a higher ranking according to the NPV criterion. The MEC rankings tell the investor to allocate resources to the smaller, less interest rate sensitive project; the NPV rankings tell the investor to allocate resources to the larger, more interest rate sensitive project.The marginal efficiency of capital favors small, short-term projects. Alchian (p. 941) and Solomon (p. 126) show that MEC calculations assume that the project’s cash flows are reinvested at the marginal efficiency of capital. In contrast, NPV calculations assume that the project’s cash flows are reinvested at the interest rate. The marginal efficiency of capital’s reinvestment rate assumption penalizes large, long-term investment projects. Figure 7 and Table 5 illustrate that MEC rankings contradict NPV rankings whenever the interest rate is below the crossover rate.
The present value approach is the wealth maximizing approach to economic calculation. Since MEC rankings contradict NPV rankings, Keynes does not provide a wealth maximizing investment demand function: “Keynes’s internal rate of return did not give an investment demand function according to the maximum present wealth criterion of choice by investors” (Alchian, p. 941). Figure 7 shows that an investor using the MEC criterion will not allocate resources to the project that maximizes wealth. The lower interest rate does not lead the investor to allocate resources to the long-term project. In the rate of return approach, the interest rate does not tell investors whether consumers prefer short-term or long-term projects. In Keynes’s theory of investment the interest rate does not regulate the intertemporal allocation of resources. Instead the interest rate is just a hurdle, or obstacle, that prevents investors from increasing investment. In the rate of return approach, a lower interest rate makes some projects which were previously unprofitable become profitable, so the volume of investment rises. By reducing the interest rate to a mere hurdle, the rate of return approach focuses attention on the volume of investment and conceals how the interest rate regulates the time dimension of investment.
The conception of the interest rate as a hurdle rate naturally leads to a monetary policy of manipulating the interest rate. Keynes advocates a monetary policy of an artificially low interest rate: “it is to our best advantage to reduce the rate of interest to that point relatively to the schedule of the marginal efficiency of capital at which there is full employment” (Keynes, p. 375).The Keynesian liquidity preference theory of the yield curve is incompatible with the marginal efficiency of capital. The marginal efficiency of capital requires that all cash flows are discounted at the same rate, while the liquidity preference theory of the yield curve requires that each cash flow is discounted at a different rate depending on the time to maturity. Following Roger Garrison (p. 165) it is possible to expand Figure 6 to include the Hayekian triangle. In Figure 8 an increase in the money supply causes the LM curve to shift to the right, from LM to LM’. An increase in the money supply lowers the interest rate and raises the level of income.
Figure 8. Artificially Low Interest Rate in the Keynesian FrameworkThe structure of production is fixed in the Keynesian system, so the increase in the money supply means “the Hayekian triangle changes in size but not in shape” (Garrison, p. 162). The fixed shape of the Hayekian triangle indicates that the interest-rate effect is absent in Keynes’s theory. Consequently, an artificially low interest rate does not initiate an allocation of resources into long-term projects. The NPV diagram also depicts that the interest-rate effect is absent in the Keynesian theory. The increase in the money supply pushes the interest rate below the crossover rate, but MEC rankings still favor the short-term project. Since MEC rankings do not depend on the interest rate, an artificially low interest rate does not cause the investor to allocate resources into the longer, more interest rate sensitive investment project. The NPV diagram and the fixed Hayekian triangle are mutually reinforcing ways of showing that the interest rate does not regulate the intertemporal allocation of resources in Keynes’s theory.
The NPV diagram reinforces the Austrian critique of Keynes’s monetary policy of manipulating the interest rate. In the Austrian theory an artificially low interest rate results in the intertemporal misallocation of resources. In the capital-based framework (Garrison, p. 69) the supply of loanable funds curve shifts to the right, from S to Sm, when the central bank expands the supply of loans.
Figure 9. Artificially Low Interest Rate in the Capital-Based FrameworkThe loanable funds diagram shows that the central bank creates a double disequilibrium in the loanable funds market when it expands the supply loans.The loanable funds market must be in equilibrium for the goods market to be in equilibrium. The double disequilibrium created in the loanable funds market by central bank loan expansion means the goods market cannot be in equilibrium either. One problem with the Keynesian IS-LM model is that it does not depict the double disequilibrium in the loanable funds market created by central bank loan expansion. At the artificially low interest rate the quantity of loans demanded for investment is greater than the quantity of real savings supplied. In short, investment is greater than savings. The fall in saving means consumption rises, so the wedge between saving and investment depicted in the loanable funds market causes the economy to produce at a level outside the production-possibilities frontier (PPF). The simultaneous increase in investment and consumption shown on the PPF also plays out on the Hayekian triangle:
The tug-of-war between investors and consumers that sends the economy beyond the PPF pulls the Hayekian triangle in two directions…. investors find the longer-term investment projects to be relatively more attractive. A less steeply sloped hypotenuse illustrates the general pattern of reallocation in the early stages of the structure of production…. At the same time, income earners, for whom the lower interest rate discourages saving, spend more on consumption. A more steeply sloped hypotenuse illustrates the general pattern of reallocation in the final and late stages of production…. In effect, the Hayekian triangle is being pulled at both ends (by cheap credit and strong consumer demand) at the expense of the middle—a tell-tale sign of the boom’s unsustainability. (Garrison, p. 72)
The NPV diagram shows that central bank loan expansion causes entrepreneurial error by falsifying net present value calculations. In the NPV diagram, central bank loan expansion pushes the interest rate below the crossover rate and reverses the NPV rankings: “the drop in the interest rate falsifies the businessman’s calculation…. They make some projects appear profitable and realizable which a correct calculation, based on the interest rate not manipulated by credit expansion, would have shown as unrealizable” (Mises, p. 550). The NPV rankings are false because they do not accurately reflect consumer preferences. The falsified NPV rankings tell the investor that consumers prefer the long-term project, but consumers actually prefer the short-term project. The investor commits an entrepreneurial error by allocating resources to the project that will not satisfy the most urgent needs of the consumers. This intertemporal misallocation of resources into long-term projects is called malinvestment. The artificially low interest rate does not just affect the representative investor-entrepreneur in the NPV diagram. Since the interest rate is the universal NPV input, the artificially low interest rate causes a universal falsification of NPV rankings in favor of longer, more interest rate sensitive projects. In the Austrian theory, the universal falsification of NPV rankings causes a massive cluster of investor error. The NPV diagram and the Hayekian triangle are mutually reinforcing ways of showing that an artificially low interest rate results in an unsustainable economic boom.
Volume 8, No. 2 (Summer 2005)The “values-riches” model, on the other hand, seeks to display the relations between the great macroeconomic nominal variables (“values”) and the flows of quantities of consumer goods (“riches”). The two models are therefore to some extent complementary, offering two different viewpoints on the production process. But there are also a number of theoretical disagreements between them, specially about the theory of interest, that must not be overlooked and will be pointed out in this paper.
Volume 15, No. 3 (Fall 2012)
Peter Lewin’s Capital in Disequilibrium is an award-winning, extensive survey of capital theory, which touches on and summarizes an array of issues and phenomena. It fearlessly dives into the depths of the vast and shifting literatures available on each of the topics.
Volume 16, No. 3 (Fall 2013)
The present paper aims at showing that two particular types of arguments in favor of the pure time preference theory of interest (PTPTI) are mistaken. First, the idea that the logical opposite of time reference consists in the proposition that, other things equal, one must always prefer the future (and that therefore one would never consume or act), is problematic. The negation of a universal affirmative proposition is not the universal negative, but the particular negative. Therefore, the opposite of time preference is rather the thesis that man at least once prefers the future, other things equal. This has to be proven absurd for time preference to be established as a praxeological (and not just as a fairly general empirically true) law. Second, it is here argued that the idea that the rate of interest as it emerges in the exchange of present money for future money simply reflects pure time preference is problematic. Money holding and spending is—like all other goods—affected by the problem of timing. Moreover, to say that pure interest is isolated by money interest which, in turn, is a composite magnitude which cannot be grasped unless one already operates with the concept of pure interest, is to argue in a circle.
Interest has a title role in many pre-Keynesian writings as it does in Keynes's own General Theory of Employment, Interest, and Money (1936). Eugen Böhm-Bawerk's Capital and Interest (1889), Knut Wicksell's Interest and Prices (1898), and Gustav Cassel's The Nature and Necessity of Interest (1903) readily come to mind. The essays in F.A. Hayek's Profits, Interest, and Investment (1939), which both predate and postdate Keynes's book, focus on the critical role that interest rates play in coordinating production plans with consumption preferences. The General Theory represents a significant departure from classical (and Austrian) thinking but not because of the title-role status of interest. Rather, the departure stems from the fact that, in Keynesian theory, the role played by a market-determined interest rate is a disruptive one.
In contemporary policy discussions, the interest rate occupies center stage if only because the much-watched federal funds rate is the Federal Reserve's sole surviving policy target. (A quarter-century ago, the Fed lost the ability to target the money supply—or even to identify a distinctly relevant monetary magnitude.) By its very nature an extra-market institution, the Federal Reserve is expected to exert a countervailing force. It is to move against market forces that, presumably, would otherwise be disruptive. In accordance with the Keynesian vision, market interest rates fail to coordinate saving and investment decisions, leaving saving decisions dependent only on incomes and leaving investment decisions dominated by Keynes's "animal spirits." Worse, high rates of interest can stem from fetishistic attitudes toward liquidity and a corresponding deficiency of spending.
The federal funds rate, which is the overnight rate on interbank loans, can be lowered or raised in an effort to control interest rates generally. The Federal Reserve lowers the federal funds rate to stimulate spending and keep the economy from sinking into recession; it raises the federal funds rate to retard spending and keep prices and wages from spiraling upward. Given the Keynesian vision and the implied role for central bank policy, the so-called "art of central banking" is to pick the "right" federal funds rate—the rate that wards off both unemployment and inflation.
As theory and policy have developed, the terms "natural rate" and "neutral rate," though seeming synonyms, provide a contrast between pre-Keynesian and post-Keynesian thinking. Although "natural" and "neutral" are sometimes used almost interchangeably, there is an important conceptual distinction in play: the natural rate of interest is a rate that emerges in the market as a result of borrowing and lending activity and governs the allocation of the economy's resources over time. The neutral rate of interest is a rate that is imposed on the market by wisely chosen monetary policy and is intended to govern the overall level of economic activity at each point in time. Exploring this distinction and its implications can go a long way toward understanding the current state of Federal Reserve policymaking and the difficulties that a central bank creates for the market economy.
The Natural Rate of Interest So named by Swedish economist Knut Wicksell, the natural rate of interest is the rate that reflects the underlying real factors. In macroeconomic terms as applied to a wholly private economy, it is the rate that governs the allocation of resources between current consumption and investment for the future. By keeping saving and investment in balance, the natural rate guides the economy along a sustainable growth path. That is, governed by the natural rate, unconsumed current output (real saving) is used for augmenting the economy's productive capacity in ways that are consistent with people's willingness to postpone consumption.
In the hands of the Austrian economists, the natural rate became the rate that reflects the time preferences of market participants and allocates resources among the temporally defined stages of production. The output of one stage serves as input to the next in this logical and broadly descriptive representation of the economy's production process. The temporal dimension of the economy's capital structure is a key macroeconomic variable in Austrian theory.
Time preference is simply a summary term that refers to people's preferred pattern of consumption over time. A reduction in time preferences means an increased future-orientation. People willingly save more in the present to increase the level of future consumption. Their increased saving lowers the natural rate of interest and releases resources from the final and late stages of production. Simultaneously, the lower natural rate, which translates directly into reduced borrowing costs, makes early stage production activities more profitable. With the reallocation of resources from late to early stages of production, the preferred temporal pattern of consumption gets translated into an accommodating adjustment of the economy's structure of production.
Movements in the natural rate are also critical to the economy's performance when changes occur in the availability of resources or in technology. Suppose that a technological breakthrough makes a time-consuming production process much more productive than before. Future consumption—even increased future consumption—can now be secured with less of a sacrifice of current consumption. People's choices in the marketplace will determine how much of the technological gain will be realized in terms of current consumption (less saving) and how much in terms of future consumption (in which the availability of a new technology more-than-offsets the effect of reduced saving).
A rise in the natural rate during the transition period is portrayed by the Austrian economists as an "interest-rate brake," a term we owe to Hayek (1933, pp. 94 and 179). The interest-rate brake moderates the rate at which the new technology is implemented and thereby allows for increased current consumption even during the period of implementation. Inventories are drawn down in late stages of production and some resources are reallocated toward less time-consuming projects.
In summary terms, the natural rate is seen as an equilibrating rate. It is the rate that tells the truth about the availability of resources for meeting present and future consumer demands, allowing production plans to be kept in line with the preferred pattern of consumption. By implication, an unnatural, or artificial, rate of interest is a rate that reflects some extra-market influence and that creates a disconnection between intertemporal consumption preferences and intertemporal production plans.
An artificially low rate of interest, which might prevail for some time if the Federal Reserve is targeting a low federal funds rate, translates into the business world as longer planning horizons than are justified by people's actual willingness to save. The policy-induced mismatch between production and consumption activities creates the illusion of prosperity but sets the stage for an eventual market correction, which takes the form of an economy-wide downturn.
This is the essence of the Austrian theory of the business cycle. The mismatch and resultant boom-bust sequence can occur as a result of two different but related policy goals, which can be described as "stimulating growth" and "accommodating growth."
Stimulating Growth The Federal Reserve might lower interest rates (by targeting a low federal funds rate) in circumstances where there has been no change in the underlying market conditions. With unchanged technology, resource availability and consumption preference, business firms are led nonetheless to take advantage of cheap credit. Production activities, particularly in interest-sensitive sectors of the economy, appear more profitable. The economy is steered by low interest rates onto an unsustainable growth path. The cheap-credit policy, though ultimately harmful to the economy, is politically attractive. A seemingly strong economy always makes an attractive backdrop for office holders seeking re-election. If the timing is right, the votes can be harvested before the seeming strength is revealed by the market itself to be an actual weakness.
The phenomenon of stimulating growth for political reasons has given rise to a whole literature on "political business cycles." Whether the emphasis is on the intertemporal misallocation of resources (as the Austrian economists would have it) or on the alternating bouts of inflation and unemployment (as mainstream macroeconomists would have it), political business cycle theory takes the underlying undistorted rate of interest to be consistent with macroeconomic health and the policy-infected interest rates (and money-growth rates) to be responsible for a macroeconomic malady in the form of boom and bust. Business cycles that are roughly aligned with the election cycle have been an integral part of the political landscape for the past half-century. In his Constitution of Liberty (1960), F.A. Hayek offered a blend of Austrian macroeconomics and what is now called Public Choice theory to account for these eco-political dynamics of boom and bust.
Accommodating Growth In periods of technological advance, the Federal Reserve accommodates economic growth by lending freely at whatever rate of interest prevailed before the enhancements in technology occurred. Thus, interest rates are not actually lowered, as in the case of stimulating growth. Rather, interest rates are simply not allowed to rise—as they would have in the absence of Federal Reserve accommodation.
In effect, the policy of accommodation overrides Hayek's interest-rate brake. With given intertemporal preference, people would choose to take only a portion of the gains associated with the technological advance in the form of increased future consumption. They would choose to take at least some of those gains in the form of increased current consumption. And given the enhanced technology, gains all around are possible.
People can save less now and still enjoy more future consumption. During the period that the new technology is being implemented, the natural rate would rise as entrepreneurs compete for investable funds. In this way, the temporarily high natural rate allows the economy to adjust to the new technology at a rate that is consistent with people's intertemporal preferences.
The policy of accommodation distorts this market process. It overrides the interest-rate brake and allocates resources in a way that, if not countered by market forces, would cause all the gains from the technological advance to be realized exclusively in the form of future consumption. But the implied intertemporal pattern of consumable output is at odds with people's intertemporal consumption preferences. This means that the spending of incomes on consumer goods during the transition period will disrupt the efforts of the Federal Reserve, revealing its policy of accommodation to entail over-accommodation.
Though there may be some political motivation for accommodating technology-induced growth, this policy is more directly linked to the long-discredited real-bills doctrine. The founding documents of the Federal Reserve identify sound lending with self-liquidating loans—loans that finance production, distribution, or retail activities which, in turn, generate the revenues for repaying those loans. Self-liquidating loans contrast with consumer loans or, more importantly, with loans made for speculative purposes.
The real-bills doctrine, widely accepted in the early twentieth century, does not include any guidance about the rate of interest at which these loans are made. Tellingly, the accommodating, self-liquidating loans are typically made at the interest rate that prevailed before the perceived need for accommodation arose, i.e., before the technological advance. But as already demonstrated, that rate is too low. It would be just right only in the extreme circumstance in which people preferred to take the entire gain from the technological advance in the form of future consumption. This circumstance, labeled in conventional price theory as a "corner solution," is distinctly improbable.
Of course, at a higher rate of interest, one that reflected some increase in current consumption, the demand for self-liquidating loans (and for other loans, for that matter) would be accommodated by the market itself. The Federal Reserve need only allow the interest rate to rise to its new market-clearing level.
The most historically significant applications of the Austrian theory of the business cycle are instances of "accommodating growth" rather than of "stimulating growth." The second decade of the twentieth century was a period of technological advance—involving mass production of automobiles and, with electrification, the widespread marketing of household appliances and processed food. The last decade of the twentieth century was similarly dominated by technological advance—this time involving the internet and other aspects of the digital revolution.
The policy-infected interest rates during each of these two periods were not necessarily low by historical standards but were low relative to the rate that would have emerged in the absence of growth accommodation. The Austrian theory suggests that in each period, a policy-induced boom rode piggyback on a genuine, technology-driven boom. But because the interest rate was not allowed to rise, i.e., because the interest-rate brake was overridden by the adherence to the real-bills doctrine, the economy was set off on a growth path that could not be sustained. These booms, then, were unavoidably followed by busts.
There is a close and obvious kinship between stimulating growth and accommodating growth. In both scenarios, there is a divergence between the rate of interest defended by Federal Reserve and the natural rate of interest. In one case, the policy-infected rate is driven below the natural rate; in the other case the natural rate rises above the policy-infected rate.
The two scenarios can also be distinguished with the aid of the familiar production possibilities frontier—the frontier representing different combinations of consumption and investment, given the economy's resources and the state of technology. Market forces will keep the economy at the point on the frontier that is consistent with people's intertemporal preferences. This judgment reflects the pre-Keynesian—and especially the Austrian—vision of the economy. The market-determined interest rate strikes a balance between current consumption and future consumption.
The policy of stimulating growth is an ill-fated attempt to move the economy away from the preferred trade-off and toward a point that entails less current consumption and more investment. The policy of accommodating growth is similarly ill-fated but applies when technological advance has shifted the frontier outward. Normal market forces, which would entail a temporary increase in the natural rate of interest, would move the economy to a point on the shifted frontier—a point that represents more consumption and more investment. The policy of accommodating growth at an unchanged rate of interest is an ill-fated attempt to move the economy parallel to the investment axis to a point on the shifted frontier—a point that disallows increased consumption during economy's adjustment to the advance in technology.
In short the natural rate of interest is the rate that avoids booms and busts. With given resources and technology, it is the rate that keeps the economy on a sustainable growth path. With increased resources or enhanced technology, it is the rate that governs the adjustment to the new growth path.
The Neutral Rate of Interest From the perspective of Austrian theory, what is remarkable about modern discussions of interest-rate policy is the total absence of any mention of intertemporal preferences and the corresponding trade-off between consumption and investment. Yet, the lack of concern about intertemporal resource allocation is consistent with the development over the past several decades of mainstream macroeconomics.
Keynes made a first-order distinction between consumption and investment spending, claiming that the former magnitude is a stable function of income while the latter magnitude, being largely governed by psychological forces (his "animal spirits"), is fundamentally unstable. This consumption-investment distinction and its rationale was central to the Keynesian revolution. The monetarist counterrevolution strongly down- played the psychological factors that might color investment decisions and, in effect, turned a blind eye to the consumption-investment tradeoff itself.
These two magnitudes were combined into an all-inclusive magnitude summarily called output and symbolized by Q in the equation of exchange. This age-old equation, MV = PQ, allows no scope for a temporally heterogeneous Q. It focuses attention instead on changes in total spending (PQ) and the division of those changes between price-level changes (ΔP) and changes in the level of real output (ΔQ). In this respect (and in many others), the more recent new classical models in which a representative agent operates in a one-good economy bear a strong family resemblance to monetarism.
The focus on real output puts into eclipse the division of that output between consumption goods and investment goods. Even more deeply into eclipse is the Austrian construction of a temporally defined structure of production. The very basis on which the natural rate of interest is conceived is simply absent in modern, highly aggregated macroeconomic theorizing.
It is only a short step from theorizing in terms of P and Q to theorizing (and formulating policy) in terms of inflation and unemployment. Taking the relevant benchmark to be "no inflation" and "full employment" suggests a critical distinction between upward and downward demand pressures in the economy. When aggregate demand is too strong, the pushing upward against the benchmark PQ causes prices and wages to rise, the level of output being bound by the full-employment, supply-side constraint. When aggregate demand is too weak, the pulling downward from the benchmark PQ causes the levels of output and employment to fall, prices and wages being "sticky" in the downward direction. (It is this pattern of movements in P and Q that underlies the so-called L-shaped aggregate supply curve that is characteristic of Keynesian constructions.)
If the aggregate pushing and pulling were a strict "either-or" proposition, the policy implications of this mode of theorizing would be clear-cut: If Q is on the wane, as evidenced by an abnormally high unemployment rate, then total spending (MV) should be strengthened (by reducing the federal funds rate). If P is rising, then total spending should be weakened (by raising the federal funds rate).
In practice, of course, the two problems of unemployment and inflation are competing with one another for the attention of Federal Reserve's policymaking committee. The Federal Open Market Committee (FOMC) has to strike a balance between lowering interest rates and raising interest rates. It would actually lower or raise the federal funds target rate if one problem is judged to be more serious or more pressing than the other. Over time, the FOMC's efforts to fight inflation and fight unemployment gives rise to a sequence of changes in the federal funds rate.
The actual pattern of federal funds rate during the early Greenspan years (1987–1993) is described by a simple equation introduced by John B. Taylor (1993) of Stanford University:
r = p + 0.5 q + 0.5 ( p - 2 ) + 2 where r is the targeted federal funds rate, p is the inflation rate over the previous year, and q is the percentage deviation of actual output from full-employment output. Taylor himself writes the equation using income (y) instead of output (q), but he defines y in terms of real GDP. In effect, y is a measure of q. The simple equation could be written in a still simpler form:
r = 1.5 p + 0.5 q + 1, but the original rendering has more intuitive appeal. It suggests that the implicit goal of the Federal Reserve is "full employment" and "2 percent inflation." Note that if q = 0 (i.e., no deviation from full employment) and p = 2 percent, then r would be 4 percent. That is, the targeted federal funds rate would be 2 percentage points above the (2 percent) inflation rate. The two coefficients of 0.5 give equal weighting to the problems of unemployment and inflation generally. In particular instances, of course, one of those problems may be more severe than the other—as would be indicated by the actual values of p and q. Thus, the targeted federal funds rate r is low with a high and negative q; it is high with a high p.
The discretion needed for the Federal Reserve to fight the good fight (against unemployment and inflation) stands in contrast to the adoption of a Monetary Rule as advocated by Milton Friedman. According to this rule, the Federal Reserve should increase the money supply year-in and year-out at a slow and steady rate that approximates the economy's long-run growth rate of 2 or 3 percent.
In Friedman's judgment, deviations from this Monetary Rule are more likely to do harm than to do good. But modern discussion of Federal Reserve policy suggests that the appropriate federal funds rate is the one that strikes the right balance at each FOMC meeting between fighting unemployment and fighting inflation. If, after a successful fight, the goals of the Federal Reserve are actually achieved, then the neutral rate (of 4 percent in the sample calculation) is the rate that threatens the economy with neither inflation nor unemployment.
Like the natural rate identified by Wicksell and adopted by the Austrian economists, the neutral rate can be described with the aid of a production possibilities frontier depicting combinations of consumption and investment. The dominating concern, in the case of the neutral rate, is not with movements along the frontier or with adjustments from one frontier to another. Rather, the concern is with actually staying on a given frontier. The concern is with Q and not with its division between consumable output and investment.
The economy may lapse into recession or depression, coming to rest in the frontier's interior area. Or it may send itself into an inflationary spiral, with (nominal) movements in spending beyond the frontier. An economy prone to such inward and outward spiraling exhibits movements roughly orthogonal to the frontier. The objective of Federal Reserve policy is to undo any perverse movements away from the frontier and then, by maintaining a neutral federal funds rate, to hold in check any further such movements.
The equation relating the federal funds rate to inflation and unemployment quickly came to be known as the Taylor Rule. But is it really a rule in the same sense as Friedman's Monetary Rule? More broadly, is the Taylor Rule supposed to be descriptive, predictive, or prescriptive?
The short answer to that question—and the answer that implicitly underlies many policy discussions is: it's all three. The original 1993 Taylor article provides the basis for this view. According to Taylor (1993 p. 197; emphasis added), his "hypothetical but representative policy rule …describes recent Fed policy surprisingly accurately" (emphasis added).
Taylor tracks the actual federal funds rate for a half dozen years (ending in 1993) and compares the time profile graphically to the Taylor Rule rate. The difference in the two profiles is surprisingly small. The close fit suggests that considerations beyond those concerning inflation and unemployment are of minor significance. Taylor mentions as the only significant deviation of actual FOMC policy from Taylor-made policy the 1987 episode in which the stock market crashed and the Federal Reserve lowered the federal funds rate to accommodate the high demands for liquidity.
So, barring crashes and consequent high demands for liquidity, the Taylor Rule seems to be a serviceable basis for predicting Federal Reserve policy. But can the rule also be rendered prescriptive, as was the intent of Friedman's Monetary Rule?
Here, we need to bridge the Humean is-ought gap, a feat that has stumped philosophers for centuries. But Taylor does not shrink from the task. The relevant passage deserves to be quoted in full. After acknowledging that there will be a learning curve that leads to improvements in the rule, he suggests how description can morph into prescription:
If the policy rule comes so close to describing actual Federal Reserve behavior in recent years and if FOMC members believe that such performance was good and should be replicated in the future even under a different set of circumstances, then a policy rule could provide some guide to future discussions. This may be particularly relevant when the membership of the FOMC changes. Such a policy rule could become a guide for future FOMCs. (Taylor 1993, pp. 208–09)
With this logic, the original Taylor Rule becomes a starting point for a learning-by-doing approach to Federal Reserve policy. And tellingly, the occasional crashes, such as the one in 1987, are taken to be anomalous deviations rather than as evidence that the rule itself may have serious shortcomings.
Friedman and Taylor In Perspective Even during the heyday of monetarism, the federal funds rate was very much in play. But in those years, roughly 1979–1982, the rate was varied with an eye toward the volume of bank reserves and, looking one step beyond reserves and currency, toward the most basic monetary magnitude M1. The actual target was the money growth rate, typically an annual percentage change in M1 in the mid-to-high single digits. On the heels of the late 1970s double-digit inflation, the federal funds rate was varied between 10 percent and nearly 20 percent in an effort to keep M1 on its target growth path. That effort, though, was less than heroic. The Federal Reserve never actually adopted and abided by Friedman's Monetary Rule. Instead, it periodically announced a new money-growth target as a range of rates and then persistently missed the range on the high side.
With the failure of the Federal Reserve to hit its money-growth target and with significant changes in the regulatory environment that blurred the distinction between money and earning assets, the monetarist experiment ended. Without a well-defined money supply, money-growth targeting was abandoned in favor of interest-rate targeting. But there was no bona fide Interest-Rate Rule to serve as a counterpart to the Monetary Rule. Discussions at policy meetings were informed by up-to-date unemployment statistics and the various price indexes, but policy changes had to be made on the basis of market conditions expected to prevail in the future. In practice, the FOMC was dealing with worries and fears rather than data and rules.
It is well known that if the FOMC picks a federal funds target that is too low, there will be worries about inflation; and that if it picks a target that is too high, there will be worries about unemployment. The goal, then became one of balancing the worries. The Federal Reserve had to find the equi-worry federal funds rate. This is what the neutral rate came to mean.
But just whose worries count? Is it the worries emanating from financial markets? Traders in financial markets might worry about interest rates being too low or too high—but mainly because of the implications about future actions by the Federal Reserve. Is the Fed going to raise rates? Is it going to lower them? The neutral federal funds rate, then, is the rate that causes the financial markets to have no net worry about the federal funds rate changing in one direction or the other.
But if this is the balancing act that underlies Federal Reserve policy, then both the Fed and financial markets are living in a house of mirrors, the actions on each side of the loan market being driven by expectations about actions on the other side. Federal Reserve policymaking and the financial community's Fed-watching interact to produce some interest-rate dynamics akin to the dynamics of Keynes's beauty contest—in which the objective is to pick the winning contestant on the basis of what others are likely to see as true beauty. The modern-day neutral rate is truly neutral only in this sense: it emerges as reflections on reflections and is not otherwise anchored in economic reality.
The Taylor Rule may well describe the temporal pattern of the federal funds rate as the Federal Reserve strives toward neutrality. But to take this description of the past as prescription for the future does not transform the art of central banking into a science. Believing that a seemingly neutral rate will be enduringly so is based on faith rather than on theory and experience.
An Austrian Perspective Is there any known market mechanism that causes the neutral rate to be brought into line with the natural rate? That is, is there any reason to believe that equi-worry about inflation and unemployment somehow translates into interest rates that are consistent with sustainable growth? Or is it quite possible that the neutral rate (the equi-worry rate), lies below the natural rate (the rate that is consistent with sustainable growth)?
While the Federal Reserve, especially during the Greenspan era, often expressed concerns about sustainable growth, there was no interest-rate rule that would assure that outcome or even nudge markets in that direction. The Taylor Rule is tailored to the inflation-unemployment tradeoff. It deals only with P and Q and not with the division of Q (output) between C (consumption) and I (investment).
The evidence is that the neutral rate not likely to be the natural rate, and hence the equi-worry rate itself is something to worry about. Even when financial markets are expecting neither a rate hike nor a rate cut, the economy may be growing at an unsustainable rate. There is no timely way to distinguish between robust growth and financial bubbles. Bob Woodward (2000, p. 217) makes the point in connection with the 1990s boom. "There was no rational way to determine that you were in a bubble when you were in it. The bubble was perceived only after it burst." It is this lack of correspondence between neutral and natural that gives the adherence to the Taylor rule its faith-based whistling-in-the-dark character.
Finally, the distinction made earlier between stimulating growth and accommodating growth casts further doubts on the relevance of the Taylor Rule. Two of the most noteworthy expansions since the creation of the Federal Reserve were episodes of accommodating growth and hence periods of little or no inflation. In both the 1920s and the 1990s, technological developments and the implied increase in productivity largely offset the overall price inflation that would otherwise have occurred as a result of the Federal Reserve's interest-rate—and hence money-supply—policies.
Taylor's p was held in check and his q gave no indication of problems ahead. Interest-rate neutrality in the form of an equi-worry rate was easily maintained—and with little or no worry on either the upside or the downside. Yet, the Austrian theory with its disaggregated Q shows that it is precisely in these circumstances (of growth accommodation as dictated by the fallacious real-bills doctrine) that interest rates are at odds with the natural rate. The excessive future-orientation of the production process is inconsistent with sustainable growth.
The Austrian theory does not offer some Hayek Rule for a natural rate to be recommended over a Taylor Rule for a neutral rate. Rather, it suggests that centralizing the business of banking deprives the market of its ability to find the natural rate.
Mainstream macroeconomists may—and do—disagree with such an assessment, but Austrian macroeconomists rightly consider the Misesian/HayekianThe author recognizes that, at least in terms of emphasis if nothing else, there exist some differences between these two theorists’ treatments of cycles. Nevertheless, the purpose of this essay lies elsewhere, so herein rather little will be made of those differences. theory of the business cycle to be one of the signal achievements of the entire Austrian School of thought. This Austrian business cycle theory (ABCT) offers a unique perspective on the destructive array of private sector incentives created by central bank manipulations of the supplies of money and credit
ABCT is essentially a theory of unsustainable economic expansions, that is, macroeconomic expansions that must unavoidably be followed at some point by macroeconomic contractions. At the center of this scenario is the phenomenon of malinvestment. Thus, in order to explain ABCT one must be able to convey in what malinvestment consists. In the past, Austrians have usually done this either entirely by means of verbal explication or with the assistance of certain unconventional constructions such as Hayekian triangles.Recently, Roger Garrison has expanded this approach by also employing a modified version of the conventional production possibilities frontier (2001, pp. 59–83). This very helpful technique sets investment versus consumption as the alternative production choices, along with the further distinction between sustainable and unsustainable boundaries. These figures relate the stages of production to the magnitude of ultimate output and thus can reveal the effects of a change in market interest rates on the structure of production. However, to grasp the significance of such triangles one must also comprehend certain distinctively Austrian ideas such as“roundabout production” and the average production period. Students of economics who are not already familiar with the Austrian School are thus not likely to find Hayekian triangles to be very enlightening. Something more familiar to such students might prove more helpful.
Pursuing that line of thought, the present paper will offer an interpretation of malinvestment in more conventional terms, using such frameworks as the familiar capital asset pricing model (CAPM) seen so often in finance classes. In addition, the everyday observation about the disproportionate effects of interest rate changes on the present values of assets with different maturities will be shown to be congruent with Hayekian triangles, thus removing the latter from the realm of the exotic. Finally, the important role of the “subsistence fund” in understanding malinvestment will be illustrated. First of all, however, the basics of ABCT will be briefly reviewed
ABCT in a Nutshell The distinctive Austrian approach to business cycles is bundled within the two “universals” of macroeconomics, time and moneyIn financial terms, could one say that the parallel universals are risk and return? (Garrison 2001, pp. 47–52). Production in a modern economy is a roundabout process. It takes time and is measured in monetary units. The intertemporal dimension of the structure of production is, and I believe quite rightly, untiringly emphasized by Austrians. They always distinguish higher-order capital goods, which function at or near the beginning of the temporal string, from lower-order consumer goods, which are the culmination of the process. The complicated and somewhat fragile production structure requires that complementary inputs be available not only in the right magnitudes but also at the right moments in time. If they are not, then projects that appeared profitable are soon revealed to be unprofitable. In other words, what appeared to be capital creation is seen in fact to be capital consumption. ABCT focuses on the “medium run,” because that is where problems arise. In the short run, the capital structure cannot be changed significantly, and in the long run all errors have been rectified. It is in the medium run that there is time enough for capital projects to be initiated and the direction of production to change, but insufficient time for any possible malinvestments to be corrected—at least not without serious repercussions. This inability to smoothly liquidate or redirect projects stems largely from the heterogeneity of most capital goods.
What is the source of the widespread “cluster of entrepreneurial errors” (Rothbard 1970, p. 746; 1975, pp. 18–21) that typifies the boom-bust sequence? It is that market rates of interest are driven below the “natural rate” as result of credit expansion by the central bank. Market rates are the result of the supply of and demand for credit (or loanable funds), while the natural rate is an expression of individuals’ time preferences, that is, their preferred rate of substitution between present goods and future goods. Such declines in market rates make it appear as if consumers have chosen to save (delay consumption) at a higher rate than before, when in fact they have not done so. Furthermore, the increased credit available at relatively low interest rates must appear as an increase in funding for businesses. Otherwise, no cycle will appear (Rothbard 1978, pp. 152–53).
The low rate of interest and abundant credit induce businesspeople to lengthen the production process.Critics of ABCT have challenged the plausibility of pervasive business “errors” of this sort. Carilli and Dempster (2001) have provided an intriguing game-theoretic rebuttal to such a challenge. This occurs because the net present value of longer-term projects rises relative to that of shorter-term projects (see figure 1). Entrepreneurial demand for capital goods thus increases, and producer goods’ prices rise relative to consumer goods’ prices. The result is a production structure that is unsustainable. Consumers will eventually reassert their unchanged time preferences via strong demand for consumer goods, and the prices of consumer goods begin to rise relative to those for capital goods. The resources needed to complete the projects will not be forthcoming, so many such projects cannot be completed at all, or can be completed but at a loss. The economy is being pulled in two directions. Entrepreneurs want more capital goods (and the complements to those capital goods), at the same time that consumers want more consumer goods. The needed correction comes in the form of a recession, during which many projects are liquidated and unemployment rises. Macroeconomic equilibrium can only be re-established when and if the central bank ceases to expand the supply of credit, thus allowing market rates of interest to once again be consistent with time preferences.
Figure 1
The Subsistence Fund Regardless of which aspect of the credit expansion one highlights, whether it is the pattern of market interest rates that first encourages, then discourages, greater roundaboutness, the zero-sum struggle for available resources between lower-order goods and higher-order goods, the overinvestment which prolongs the contractionary, corrective phase of the cycle, the scarcity of resources that serve as complements to the lengthened capital structure, or the “forced savings” imposed on consumers by entrepreneurial malinvestment, one theme (implicitly) runs through the entire exposition of the Austrian theory of unsustainable business cycles: the subsistence fund. It is, in fact, a concept that links all aspects of the theory. Moreover, since it focuses on the actions of the capitalist/entrepreneur as the key appraising agent, it pinpoints a crucial element of ABCT, i.e., the proposition that unsustainable expansions only occur if and when it is businesspeople to whom the artificial increase in credit is made available.
[T]he Austrian theory of the trade cycle reveals that only the inflationary bank credit expansion that enters the market through new business loans (or through purchase of business bonds) generates the overinvestment in higher-order capital goods that leads to the boom-bust cycle. Inflationary bank credit that enters the market through financing government deficits does not generate the business cycle; for, instead of causing overinvestment in higher-order capital goods, it simply reallocates resources from the private to the public sector, and also tends to drive up prices. Thus, Mises distinguished between “simple inflation,” in which the banks create more deposits through purchase of government bonds, and genuine “credit expansion,” which enters the business loan market and generates the business cycle. . . . Mises did not deal with the relatively new post-World War II phenomenon of large-scale bank loans to consumers, but these too cannot be said to generate a business cycle . . . because they will not result in “over” investment, which must be liquidated in a recession. Not enough investments will be made, but at least there will be no flood of investments which will later have to be liquidated. Hence, the effects of diverting consumption [/] investment proportions away from consumer time preferences will be asymmetrical, with the overinvestment-business cycle effects only resulting from inflationary bank loans to business. (Rothbard 1978, pp. 152–53)
By what standard is a credit expansion deemed to be cycle-generating? First of all, it must be an “artificial” expansion, that is, not the result of a decline in the rate of time preference. This is the necessary but not sufficient condition. A further stipulation is needed: the gap between credit and saving must be experienced by businesses, not consumers. Entrepreneurs must have access to credit in excess of the saving that is available to them. That is the fundamental message which Rothbard conveys quite emphatically in the citation above. Some Austrians may speak and write about a contrast between generic “saving” and the supply of fiduciary credit, but that is insufficiently precise. As Rothbard recognized so clearly, the only discrepancy that really matters insofar as business cycles are concerned is that between the magnitude of saving at the disposal of entrepreneurs and the magnitude of credit at the disposal of entrepreneurs. The former sets the limit on a sustainable lengthening of the capital structure, and the latter identifies the maximum initial investment in capital projects (see figure 2).
Figure 2
It is not saving per se that is the benchmark, but the magnitude of the subsistence fund. What, exactly, is this subsistence fund?
Saving and Productive Expenditure The labor expended by employees of business firms is not, contrary to widespread assumption, the primary or original source of income. One of the serious flaws of classical economics was just that erroneous assumption.It is likely that this error, plus the absence of marginal analysis, has caused some Austrians to pay rather little attention to classical economics. Reflect on a pre-capitalist, primitive world in which there are no businesses, but of course there does exist both labor and land. When goods are produced, what should the income receipts be called? They cannot be wages, because there are no employers to pay wages. They are, unavoidably, profits. In such a world, laborers sell goods but not their own labor. “Smith and Marx are wrong. Wages are not the primary form of income in production. Profits are” (Reisman 1996, p. 479). What occurs as capitalists appear? The proportion of total income that is profit (100 percent in the primitive state) declines as those capitalists provide funds to their employees (wages) in advance of the sale of the finished goods.Here “profit is taken in the accounting sense, rather than the economic sense of the term. That is, the imputed values of the resources possessed by the capitalist are not subtractedfrom his gross receipts. And Since, initially, he makes no payments to the owners of resources, his “explicit costs” are zero. Thus, in the primitive state, all income is profit. This transfers most of the risk from the workers to the capitalists, but it also allows the capitalists to benefit from the increased productivity of the more roundabout production processes.
What then is the source of wages? It is capitalists and their decision to save a portion of their earned income. Placed in the hands of businesspeople, this saving becomes productive expenditure which is used to acquire the factors of production. The greater the amount saved, the more that is available to be spent for labor and other inputs. The wages fund, or subsistence fund,Subsistence fund is really the more accurate term, since businesspeople must compensate the suppliers of any and all inputs, not just the suppliers of labor. is that part of the monetary income of capitalists which is saved and invested in productive projects. Equivalently, it is that portion of the funds which capitalists make available to entrepreneurs that is then used to purchase inputs.It must be noted at this point that there is one category of laborers whose wage incomes do not depend on prior saving by capitalists, namely labor which is not used as a means to the end of generating revenues for businesses. The best examples are domestic servants and government employees (Reisman 1996, p. 695). It overlaps, but is not identical to, the concept of saving.
Some economists will reject the concept of the subsistence fund on the grounds that firm revenues depend on sales to consumers and therefore, in effect, consumers provide the funds that businesses need to hire labor and other inputs. Such a train of thought may seem reasonable, but it flies in the face of another classical insight. John Stuart Mill realized that there was a “fundamental theorem” regarding capital which was often misunderstood even in his day. It appears to be almost wholly forgotten today.
What supports and employs productive labour, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labour when completed. Demand for commodities is not demand for labour. The demand for commodities determines in what particular branch of production the labour and capital shall be employed; it determines the direction of the labour; but not the more or less of the labour itself, or of the maintenance or payment of the labour. These depend on the amount of the capital, or other funds directly devoted to the sustenance and remuneration of labour. (Mill 1987, p. 79; emphasis in original)
One might think of the above in the following terms. From a macroeconomic perspective, the level of saving determines the level of potential total demand for, and thus the potential total employment of, inputs. It sets an upper limit on sustainable production. From a microeconomic perspective, consumer demand for final goods determines the relative demand for inputs, and thus the pattern of employment of those inputs in the production of particular goods and services. At one level, capitalists and entrepreneurs steer the economy. At a different level, consumers (indirectly) steer the economy. Classical economists emphasized the first; while Austrians emphasize the second. One should note carefully that it is not saving per se that is crucial, but the productive expenditures of entrepreneurs, which are made out of the totality of funding available to those entrepreneurs. In a properly functioning, free-market economy, that pool of funds will consist only of real saving, and no unsustainable macroeconomic expansions will result.On the other hand, in a central banking system with fiat currency, the supply of loanable funds is not coextensive with saving. Therefore, the funds at the disposal of businesses can increase while real saving remains constant, or even declines. This latter situation is, of course, a distinctive feature of ABCT.
Austrians are accustomed to thinking in terms of the relative prices of all things including those of inputs, the imputation of values for higher-order, capital goods from the demand for lower-order, consumer goods, and the allocation of inputs based on their discounted marginal value products.See, for example, Rothbard’s presentation of this approach (1970, pp. 387–424), in the course of which he reminds us that “wages are paid out of capital.” Do Austrians need to abandon that approach? Not at all. Allocations of inputs between industries and firms are driven by the discounted marginal productivity of those inputs; while relative prices drive specific output choices. However, consideration of the subsistence fund yields some insights that may be more difficult to achieve if one avoids the use of the concept. First of all, in a central banking system with fiat currency, the link between real saving and the supply of loanable funds is very loose. Therefore, the link between real saving (by both consumers and businesspeople) and the pool of funds available for business investment is equally loose. In such a system, businesses that invest in new projects may not, in fact, be engaging in truly productive expenditures. This will not be evident ex ante, but it will become painfully clear ex post when the investments have to be liquidated. What appeared to be capital creation reveals itself to be capital consumption.
Also, one might recall the two dimensions of erroneous investment that characterize a typical, credit-driven business cycle: malinvestment and overinvestment. Austrians have explained the former very well.However, in one summary of ABCT, Rothbard surprisingly refers only to overinvestment (1978, pp. 152–53). Malinvestment occurs due to misleading relative price signals, and it necessitates a corrective contraction. But what of the overinvestment? That is, why must the contraction persist for a substantial time and, thus, bring about considerable suffering? The answer to that question may become less opaque if one applies the concept of the subsistence fund. Briefly stated, the overinvestment occurs because entrepreneurs are led to believe that the subsistence fund is larger than it actually is.
The pivotal role played by the concept of the subsistence fund is addressed directly, although from a slightly different angle, by George Reisman, a Misesian who sees much in classical economics that he thinks should be of interest to Austrians:
The wages-fund doctrine held that at any given time there is a determinate total expenditure of funds for the payment of wages in the economic system, and that the wages of the employees of business firms are paid by businessmen and capitalists, out of capital, which is the result of saving; not by consumers in the purchase of consumers’ goods. . . . [T]he abandonment of the wages-fund doctrine and with it, classical economics’ perspective on saving and capital, made possible the acceptance of Keynesianism and the policy of inflation, deficits, and ever expanding government spending. (Reisman 1996, p. 474)
The usefulness of the subsistence fund concept also extends to the issue of complementarity. In ABCT the credit expansion that initiates the cyclical sequence leads to a capital structure that cannot be maintained, because
[I]t is relative scarcity of complementary factors which here causes excess capacity and upsets plans. . . . [C]omplementarity is of the essence of all plans, and withdrawal of a factor, or its failure to turn up at the appointed time, will equally endanger the success of the production plans. (Lachmann 1978, p. 107)
Imagine that the absent factor is labor of a particular kind. If it is unavailable, why is it unavailable? Does it not exist? Surely it does exist, for otherwise no one would plan a project that required its participation. Then why is it not forthcoming in the context of a roundabout production process that entrepreneurs have made lengthier?
A lengthier production structure means that the labor must be applied in an earlier stage of the process, farther removed from the final goods. In other words, the time interval between application of the labor and sale of the final product has expanded. This requires, in real terms, that the workers have available a greater stock of consumer goods by means of which they can sustain themselves over this longer time period. Without such goods, no labor will be made available for these lengthier projects, or the labor may be available but only for a period shorter than the duration of the project. In a crucial sense, consumer goods are used to “purchase” the needed factors of production (Strigl 2000, p. 11). And, ceteris paribus, such an enlarged stock of consumer goods can only exist if time preferences have fallen, proportionately
less is consumed by capitalists, and those capitalists have thus provided businesspeople with a larger subsistence fund. Furthermore, multi-period projects are viable only if the required conditions are replicated intertemporally. “Production can only be maintained if each attained subsistence fund is used to support another roundabout method of production” (Strigl 2000, p. 12). A subsistence fund that is adequate only for one time period will lead, in subsequent periods, to capital consumption as the production process is forced to become more “momentary” and less roundabout.
The tension between capital goods expansion and an undiminished demand for consumer goods helps to highlight the value of the subsistence fund in explaining another key issue in ABCT, that is, why overinvestment occurs as well as malinvestment. Some critics, such as John Hicks, have asserted that while an increased money stock and cheap credit can indeed induce an artificial boom that exhibits a capital-goods bias, the excess money balances in consumers’ hands should quickly correct the restructuring of production or even prevent its appearance in the first place. As Garrison notes, “[w]ithout the over-investment, the malinvestment would be as short-lived as Hicks’s critical remarks suggest” (Garrison 2001, p. 81).
Time is the issue at hand. Entrepreneurs have overinvested in long-term projects, overinvested, that is, in higher-order goods far removed from the final goods. The mix of goods is unsustainable, and so too is the level of production (Garrison 2001, p. 74). To the extent that those higher-order goods are durable and specific, the process of correcting the imbalance will require a significant period of time.
The economy “crashes” because unjustified investments in the early stages of production have been undertaken. The economy recovers slowly, and no doubt painfully, from the contraction because the overinvestment in the early stages of production is sure to involve at least some goods that are durable as well as being firm- or even project-specific. Liquidation of such goods, and the firms or projects employing them, will be a difficult and time-consuming process. Re-establishing a sustainable level and mix of goods will take time. Quick and painless adjustments are out of the question. (Sechrest 2001, p. 68)
This becomes clear when considering the subsistence fund in real terms. Once the boom is seen to be unsustainable, cannot entrepreneurs simply sell the overproduced capital goods? Quite possibly, but this will not help to correct the underlying problem. First of all, the prices they will get are sure to be below the present values they originally thought the capital goods to have. Once the contraction begins, demand for capital goods will decline and market interest rates will rise. Both events will drive down their prices. Furthermore, even if entrepreneurs somehow did retrieve the full original value of their investments, all that will have happened is that the economy will have experienced a redistribution of liquidity. What is needed is a greater quantity of real, completed consumer goods. And capital goods cannot immediately be converted into final consumer goods. Changes in the structure of production cannot easily be reversed. There is a significant degree of “path-dependence” involved with the capital restructuring that occurs in the medium run. The economy cannot simply “erase” the errors and start over. Ultimately the only solution is to have a subsistence fund sufficient to meet consumers’ needs. But if that were the case all along, then no boom-bust cycle would have occurred in the first place.
In Diagrammatic Terms How can the components of this ABCT scenario be illustrated? Moreover, how can they be illustrated in terms more-or-less familiar to the typical economics student? In order to respond, one will first need to revisit figures 1 and 2, which show the effects of interest rates on (a) projects’ net present value (NPV) and (b) business investment decisions. Then, to reveal the excessive risk-taking inherent in malinvestment, one can examine figure 3, a modified version of the capital asset pricing model.
Figure 3
In figure 1, the net present value of a project’s stream of discounted cash flows (the vertical axis) is affected by (a) the time needed to complete the project (the horizontal axis) and (b) market rates of interest. This is notably similar to the dimensions of the Hayekian triangle. In such triangles, “[t]he horizontal leg of the triangle represents production time. The vertical leg measures the value of the consumable output of the production process” (Garrison 2001, p. 46). In figure 1 the market interest rate declines, which increases the NPV of all capital projects. However, such increases in NPV accelerate as the time period of the project lengthens. Longer term projects rise in value by a greater percentage than do shorter term projects, for the same initial decline in interest rates. Therefore, as long as businesspeople think that the required complementary inputs will be available, there is always an incentive to undertake longer term projects in an environment of falling interest rates. And, if businesspeople think that the falling rates are a reflection of falling time preferences, they will indeed believe that those complementary inputs will be available when needed.
In figure 2, businesspeople act on the incentives created in figure 1. The market rate of interest (im), initially equal to the natural rate (in), declines to im*. Businesspeople opt for proportionately more higher-order (capital) goods and proportionately fewer lower-order (consumer) goods. This is made possible by the expansion of credit. Yet time preferences have not fallen, so there is no greater subsistence fund than there was before the credit expansion. The gap between the new level of investment expenditures and the subsistence fund is thus unsustainable.
Figure 3 applies a modified version of the capital asset pricing model to ABCT. Here the required rate of return (the vertical axis) should be thought of as the internal rate of return (IRR) on specific capital projects. Risk, on the horizontal axis, is not the systematic risk of an asset, measured by the asset’s β, but the total risk, measured by the variance of the returns to the project (σ2). As the central bank expands the supplies of money and credit, market interest rates fall, so the rate at which cash flows are discounted declines, driving up net present values. But the forecasted cash flows themselves will also rise, since, in an inflationary environment, output prices usually rise faster than do input prices. From both directions, NPVs increase, with the longer term projects exhibiting the greater percentage increases. This makes it appear as if, for the same level of risk exposure, businesses can now enjoy a higher rate of return. The capital market line (CML) seems to rotate upward from CML (actual) to CML (perceived), and businesspeople move toward what they think will be a higher level of utility (U1 to U2). However, in fact this moves businesses into the realm of exceedingly risky—indeed, ultimately unsustainable—capital investments.
Summary Profit, the return to the entrepreneur, is the original form of income, not wages. Wage incomes only come into being when and if capitalists set aside a part of their income instead of consuming it all. Out of these savings comes productive expenditure (or in real terms the subsistence fund), including the demand for labor, because consumers’ demand for final goods is not the source of demand for originary factors of production. The subsistence fund is the source of demand for originary factors and sets the limit on sustainable expansions by identifying the proper intertemporal allocation of resources.
Both malinvestment and overinvestment appear whenever credit expansions are initiated by a central bank, because in such circumstances the subsistence fund will be inadequate to sustain the new, artificially lengthened production process. An excess of money and credit creates the problem. The solution takes time, because real capital goods cannot be transformed into real consumer goods overnight. Monetary changes can be effected rather quickly, but once undertaken, their impacts on real goods cannot easily or quickly be reversed. To view these issues through the lens of the subsistence fund can be very helpful. To do so certainly reminds one that it is capitalist/entrepreneurs who lie at the center of the process, most critically with regard to a distinction emphasized by Rothbard. That is, it is not the gap between saving and credit per se that matters, but the gap between saving in the hands of businesspeople (the subsistence fund) and credit in the hands of businesspeople.
The subsistence fund has really always been an implicit part of ABCT. The verbal and diagrammatic analysis found in the present paper has attempted to make it an explicit part of ABCT. Moreover, in order to more readily convey these essentials of Austrian macro thought to mainstream students of economics, certain rather conventional constructions have been employed. It is hoped that pedagogical considerations, important though they may be, have not detracted from the more important, theoretical objective.
Volume 9, No. 4 (Winter 2006)Austrians frequently lament the absence of an Austrian undergraduate money-macro curriculum, especially at the intermediate level. This is ironic in that a large body of work currently exists, both from “the masters” and more recent researchers that provides the essential theoretical underpinnings and historical and empirical analysis from which to mount a coherent Austrian macro course suitable for second or third year students. Unfortunately, that literature generally presupposes significant background knowledge in Austrian economics and thus does not ordinarily serve as a suitable platform upon which to build an intermediate money-macro course. Butos suggests all the components for such a course are in hand save one: an intermediate macro text appropriate for classroom use.
Low interest rates combined with high-risk fractional reserve banking creates a powder keg on which we’re sitting today, writes Frank Hollenbeck. This audio Mises Daily is narrated by Keith Hocker.
Volume 12, No. 2 (2009)
Andrew Young (2009) suggests a capital-based theory for secular growth that is consistent with Austrian capital theory. He argues that investment in intangible capital can create secular growth through a combination of external effects (because intangible capital is nonrivalrous), and opening paths for further innovation (“standing on the shoulders of giants”). In reality, all that is required for secular growth is that some form of nondepreciating capital is produced. So, the central insight from Young — that “technological change [is] the output of intangible investments and, therefore, a capital-based engine of sustainable secular growth” — is stronger and simpler than Young suggests. To demonstrate this, I will present two examples styled after Salerno (2001).
Volume 12, No. 2 (2009)
Engelhardt’s analysis implicitly assumes away the presence of diminishing returns. Diminishing returns have long been at the heart of growth theory — from Thomas Malthus’s ([1803] 2003) prediction of starvation as the result of population growth to Robert Solow’s (1956) conclusion that technological change is a necessary condition for secular growth. An account of secular growth in the presence of diminishing returns is featured prominently in both my critique of Roger Garrison’s (2001) theory of growth through capital accumulation and my alternative theory based on intangible, nonrivalrous capital.
Volume 12, No. 3 (2009)
This paper briefly summarizes Ulrich Fehl’s important contributions to Austrian capital theory. While his work is well known in Europe he remains a relative unknown to the English speaking world. The intent of this paper is to introduce Ulrich Fehl to English-speaking economists who are interested in the Austrian School of economics.
Volume 12, No. 1 (2009)
Roger Garrison (2001) provides a welcome diagrammatic exposition of Austrian, capital-based macroeconomics. The exposition attempts to account not only for Austrian business cycles (ABCs), but also for long-run, secular growth. Secular growth is a focus of mainstream growth theory that has arguably been neglected by Austrian analysis. However, Salerno (2001) argues that the type of secular growth described by Garrison (2001) is implausible. He argues that, in the absence of technological or institutional change, time preferences must be falling over time for net capital accumulation to be sustainable. This paper outlines a capital-based theory of secular growth based on the consideration of intangible capital. The nonrivalrous nature of intangible capital goods allows for external effects. The technology becomes available to firms and individuals that (a) are not forced to wait through the innovative stages of production and (b) do not compensate those firms and individuals that do. Furthermore, (c) innovative stages of production may be viewed not only as aimed towards the production of consumption goods, but also towards further innovation — “standing on the shoulders of giants.” The theory presented here reconciles Garrison's exposition to the Salerno critique. It also provides a bridge between many insights of mainstream, endogenous growth theory and Austrian, capital-based macroeconomics.
Volume 14, Number 3 (Fall 2011)
Hayek is seen as one of the main opponents of Keynes because of the debate about macroeconomics that they had in the early thirties. A few years after this controversy, Keynes published The General Theory (1936), and Hayek was expected to criticize Keynes’ new model. But, surprisingly, Hayek decided to remain silent and let his opponent go unchallenged. He regretted it ever after. However, this paper argues that in Hayek’s work after 1936, there is a criticism of The General Theory that to a certain extent has remained unnoticed. Thus, this approach reopens the great debate between Hayek and Keynes just where they had apparently left it, that is, after the publication of The General Theory.
Volume 4, No. 3 (Fall 2001)This book is a long-awaited project among Austrian economists; some of the central contributions found in the book date back nearly a quarter of a century. The consensus of opinion is that it has been worth the wait and that the book is an important contribution to Austrian economics as well as to the comparative study of macroeconomics schools of thought. Some contributors tended to emphasize the unique analytical contributions of the book, while others tended to focus on its value as an expository device. Many noted that it could provide the platform for the next generation of Austrians to make substantive advances in the area of macroeconomics and capital theory.
Volume 4, No. 3 (Fall 2001)According to this writer Garrison’s Time and Money is precisely what it purports to be: an exercise in comparative frameworks. Even if it should be recognized that the comparison of different theoretical traditions within a unified graphical and conceptual—framework may require a number of concessions that are not without drawbacks—in the sense that one or more of the theories thus compared may come out of the exercise more or less mutilated —there can be no doubt that Garrison’s endeavor must be considered a success. The foundation has now been laid not only for renewed and fruitful discussion with different and related schools of thought at the highest level of scholarly debate—an event without its equal since the Hayek-Keynes debate during the first half of the last century—but also for further research along Austrian School lines.
Volume 5, No. 4 (Winter 2002)Originary interest does not spring from the passing of time, but from the value relationship between means and ends. the means of action are inherently less valuable than the ends they serve. Therefore there is a value spread between means and ends—originary interest—in all human actions in which means and ends can be distinguished. Originary interest determines how each market participant chooses between production alternative of different length and physical productivity. The combined originary interests of all market participants determine the time structure of production of the entire economy, as well as of interest rates.
Volume 4, No. 3 (Fall 2001)Garrison has a vivid sense for the necessity of adequate pedagogy to communicate Austrian ideas about the working of the economy, and he is very conscious of the power of symbols. His book is a great pedagogical effort aimed at replacing the dominant graphical representation of main macroeconomic relationships-the ominous Keynesian Cross-with a new representation, more genuine to the Austrian viewpoint, which stresses the time element in the structure of production. This focus on pedagogical problems has been an old theme in Garrison's work and now finds a consummation in Time and Money. At the book's center stage is an original three-quadrant diagram that is used (a) to illustrate how a market economy works and grows,(b) to illustrate the causes and nature of business cycles, and (c) to discuss and criticize the Keynesian and monetarist paradigms.
Volume 4, No. 3 (Fall 2001)I would like to emphasize two implications of my argument. First, the concept of secular growth as an uncaused phenomenon contradicts the Mengerian method of analyzing dynamic market processes as well as modern Austrian capital and interest theory and should be purged from capital-based macroeconomics. In its place should be substituted a causal analysis that accounts for the stylized fact of a steady secular growth trend in industrial economies in terms of the dynamic coordination of entrepreneurial plans with the historical development of time preferences, the size and quality of the labor force, natural resource endowments, and technological progress. This substitution can easily be made without in the least affecting the basic structure of the Garrisonian analytical framework. Second, and more important, the analytical simplification of the loanable funds market, while it may be a useful component of capital-based macroeconomics in treating the effects of changes of preferences and policies that impinge on the supply side of the intertemporal market, is liable to be dangerously misleading when dealing with demand-side influences on the capital structure. Consequently, perhaps a richer conception of the time market could be formulated and incorporated into capital-based macroeconomics without seriously damaging its potential appeal to mainstream macroeconomists.
Volume 4, No. 3 (Fall 2001)Garrison's Time and Money picks up where Hayek left off, developing a macroeconomic model based on Austrian capital theory that provides significant insights into macroeconomic phenomena. My title here is slightly misleading: how does one count contributions? In one sense, Garrisons's Time and Money makes more than two contributions, but in another way, maybe the whole book should just count as one contribution. The two contributions referred to in the title here are the book's contributions to macroeconomics and to Austrian economics, which are sufficiently distinct that they can be counted separately.
Volume 15, No. 2 (Summer 2012)
Hayek’s works have continued to influence Foss, so it is only appropriate, therefore, that the author pay homage to him. Specifically, Foss pays homage by addressing a favorite Hayek topic—namely that of capital theory.
Volume 4, No. 3 (Fall 2001)Time and Money is a multifaceted achievement. Within its pages the reader will encounter business cycle theory, capital theory, comparative economic thought, and many contemporary macroeconomic topics, as well as the tools needed to convey all of it to university students. Academic economists, regardless of school of thought, should welcome this book. It is lucidly written and well-organized, and every page reflects the years of thought that Garrison has devoted to these subjects. One manifestation of this is the fact that throughout the book he successfully navigates between the Scylla of pedagogical simplicity and the Charybdis of theoretical complexity. The net result has just the right proportions of the two.
Volume 7, No. 1 (Spring 2004)The Austrian theory of the business or trade cycle is an intricate blend of monetary theory and capital theory. Mises’s (and Hayek’s) monetary and capital theories differ in both significant and subtle ways from the neoclassical approach. Economists working in the Misesean tradition are still plagued by problems of communication with non-Austrian economists. While the terminology used is similar in both theories, the definition of key terms, the understanding of the nature of the economic problem, and the role of prices, especially prices for the means of production, differ considerably.
Volume 4, No. 3 (Fall 2001)Professor Garrison’s work in Austrian macroeconomics over the past twenty-plus years has been most influential. Time and Money and its detailed development of a capital-based macroeconomics is the most important of these recent developments. The capital-based approach has the advantage of providing a seamless macroeconomics of the short run, the medium run, and the long run, particularly when compared to current mainstream analysis, which lacks a medium run and has long-run and short-run models that are often in conflict. Cochran and Glahe argue that it is only with a “greater understanding of the forces actually shaping events in a monetary production economy that we can make rational decisions about policy and monetary institutions.” Time and Money is certainly a major contribution to our further understanding of these complex market processes.
Volume 3, No. 3 (Fall 2000)Factoring into our national accounting scheme the true value of nonrenewable resources and the imputed value of natural-resource degradation is seen as an essential corrective for the myopia that would otherwise distort the market process. The key to resolving the problem is "new institutions and conventions." Elaboration of this solution involves references to licenses and the like and thereby confirms what the reader suspects from the beginning: Far sighted governmental interventions are needed to override the short-sighted market process. This conclusion of neo-Austrian modeling, of course, could never had been reached by Austrian subjectivists working in the tradition of Menger, Böhm-Bawerk, Mises, and Hayek.
Volume 16, No. 3 (Fall 2013)Jeffrey Herbener (jmherbener@gcc.edu) is a professor of economics at Grove City College and is a senior fellow with the Ludwig von Mises Institute.ABSTRACT: In response to Topan and Păun in this issue, this comment upholds two lines of argument in defense of the Pure Time Preference Theory of interest. Ludwig von Mises claimed that time preference is a fundamental concept of human action. It is not the conclusion of arguments about interest and consumption-saving decisions, but a presupposition of such arguments. Frank Fetter held that the exchange of present money for future money, not the exchange of present goods for future goods, can isolate the time preference element in inter-temporal trade because the monetary unit is the unit of economic calculation. As such, all the monetary units have “equivalent value,” even inter-temporally. When people trade money inter-temporally to satisfy their time preferences, the pure rate of interest isolates time preferences.KEYWORDS: time preference, pure time preference theory of interestJEL CLASSIFICATION: B13, B25, B53, E43 Vlad Topan and Cristian Păun (2013) purport to show that two arguments made in defense of the Pure Time Preference Theory of interest are erroneous, one made by Ludwig von Mises and the other by Frank Fetter. To their credit, they avoid basing their criticism on the ambiguity of expression used by defenders of the PTPT. Instead, they (Topan and Păun 2013, pp. 301-303) rightly quote statements by Mises (1998, pp. 480-481) and Rothbard (2004, p. 15) that define time preference in terms of satisfaction and not goods.On arguments against the PTPT based on ambiguous definitions used by its proponents, see Herbener (2011), pp. 55–58. Unfortunately, Topan and Păun construct their critique under a misapprehension of the arguments made by Mises and Fetter.
Concerning Mises’s views, they (Topan and Păun, 2013, p. 299-300) claim that the opposite of time preference “must be proven absurd for time preference to be established as a praxeological (and not just as a fairly general empirically true) law.” They (Topan and Păun 2013, pp. 300-301 and 304-305) then assert that Mises argued for the existence of time preference as a “praxeological law” on the basis of a reductio ad absurdum: if a person did not have time preference, i.e., he did not prefer a given satisfaction sooner instead of later, then he would never consume; but the idea of a person who does not consume is absurd and therefore, the existence of time preference is proven.
Mises, however, famously claimed that the fundamental conceptual structure of action is known a priori. These a priori categories are not proven as the conclusion of an argument but are the beginning presuppositions of arguments that establish economic laws. Mises (1998, pp. 34–35) wrote:
The fundamental logical relations are not subject to proof or disproof. Every attempt to prove them must presuppose their validity….They are ultimate unanalyzable categories….They are the indispensable prerequisite of perception, apperception, and experience.
The human mind is not a tabula rasa on which the external events write their own history. It is equipped with a set of tools for grasping reality….these tools are logically prior to any experience.
Man is not only an animal totally subject to the stimuli unavoidably determining the circumstances of his life. He is also an acting being. And the category of action is logically antecedent to any concrete act.
Everybody in his daily behavior again and again bears witness to the immutability and universality of the categories of thought and action.
From the reflective knowledge of the fundamental concepts of action, the economist deduces the theorems of economics. Mises (1998, p. 64) wrote:
The scope of praxeology is the explication of the category of human action. All that is needed for the deduction of all praxeological theorems is knowledge of the essence of human action…. The only way to a cognition of these theorems is logical analysis of our inherent knowledge of the category of action. We must bethink ourselves and reflect upon the structure of human action.
As an illustration of how Mises constructed arguments that incorporated the fundamental concepts of human action, consider the concept of preference. He (Mises 1998, pp. 92–98) claimed that preference is a fundamental category of action and hence, a presupposition for economic reasoning. Thus, if Mises were to infer that without preferring and setting aside there can be no action, he would not be attempting to demonstrate the existence of preference by a reductio ad absurdum: if a person did not have a preference, he could not act; but the idea of a person who does act is absurd and therefore, the existence of preference is proven. Instead, Mises would be demonstrating the logical coherence of the fundamental categories of action with the economic theory that explains action. The fundamental categories of action themselves are proven by reflection (Mises 1998, pp. 17–18 and 92–96). Mises (1998, p. 38) wrote:
The starting point of praxeology is not a choice of axioms and a decision about methods of procedure, but reflection about the essence of action. There is no action in which the praxeological categories do not appear fully and perfectly.
Like preference, time preference is a fundamental category of action. As Topan and Păun (2013, p. 304) quote Mises (1998, p. 481):
Time preference is a categorical requisite of human action. No mode of action can be thought of in which satisfaction within a nearer period of the future is not—other things equal—preferred to that in a later period.
The existence of time preference as a praxeological concept is not demonstrated by any argument. Its existence is proven by reflection about action and its meaning is unfolded by apprehending the logical coherence of the fundamental categories of action and deducing economic theory from them. Time preference is the logical requisite for understanding the inter-temporal relationship between the actions of production and consumption. It is not an implication drawn from the relationship between these actions. Mises (1998, p. 480) wrote:
Other things being equal, satisfaction in a nearer period of the future is preferred to satisfaction in a more distant period: there is disutility in waiting.
This fact is already implied in the statement stressed at the beginning of this chapter, that man distinguishes the time before satisfaction is attained and the time for the duration of which there is satisfaction. If any role at all is played by the time element in human life, there cannot be any question of equal valuation of nearer and remoter periods of the same length. Such an equal valuation would mean that people do not care whether success is attained sooner or later. It would be tantamount to the complete elimination of the time element from the process of valuation.
Just as the distinction we make as human persons between more and less of a good is bound up with our preference for more of a good over less, the distinction we make between sooner and later satisfaction of an end is bound up with our preference for sooner satisfaction over later. No argument is necessary to prove the existence of either preference or time preference. They are revealed to be true as one reflects on the meaning of action and that truth is reinforced by drawing out what can be logically implied by them. Mises (1998, p. 490) wrote:
The value of time, i.e., time preference or the higher valuation of want satisfaction in nearer periods of the future as against that in remoter periods, is an essential element of human action. It determines every choice and every action. There is no man for whom the difference between sooner and later does not count. The time element is fundamental in the formation of all prices of all commodities and services.
That Mises is not attempting to prove time preference by a reductio ad absurdum argument dismisses Topan and Păun’s (2013, p. 305) objection that Mises was attempting to “negate a general statement…and arrives at a general statement” instead of negating a general statement with a specific statement.Even if we grant for the sake of argument that Mises is trying to use a reductio ad absurdum to prove the existence of time preference, it is not clear that the form of Mises’s argument is as Topan claims. Instead, Mises’s alleged argument would appear to be a hypothetical syllogism: If a person lacked time preference, then he would not consume; a non-consuming person, i.e., a person who never realizes satisfaction, is absurd and therefore, a person cannot lack time preference. It does not, however, dismiss the objection they (Topan and Păun, 2013, p. 305) make that Mises errs by stating his claim about the logical implication of time preference in terms of consumption instead of action in general. Topan and Păun (2013, p. 304) cite Mises (1998, pp. 481 and 487) who wrote:
If he were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants.
If acting man, other conditions being equal, were not to prefer, without exception, consumption in a nearer future to that in the remoter future, he would always save, never consume.
“Mises frames his expositions of the time-preference principle mostly in terms of consumption,” Topan and Păun (2013, p. 305, italics original) write, “even though it can also be put in (more general) terms of action.” As Topan and Păun (2013, p. 304) have shown, however, Mises states the principle of time preference neither in terms of consumption nor action, but in terms of satisfaction. By re-stating time preference in terms of consumption, which is the realization of the satisfaction a person receives from attaining an end, Mises is providing a transition to further implications of time preference.Time preference as a satisfaction can be stated either in terms of consumption or action as long as it’s kept in mind that the goal of action is receiving the satisfaction from attaining its end. Rothbard (2004, p. 51) states this in the quote cited by Topan and Păun (2013, p. 305). He is attempting to isolate and analyze the inter-temporal dimension of valuing in choice and action (Mises 1998, pp. 476–496). Action can either directly or indirectly satisfy ends. Although some ends can be attained directly in acts of consumption, attaining others requires a series of acts of production before an act of consumption can be taken to attain them. The value of acts of production, by which an end is indirectly satisfied, is not realized until the act of consumption, which the previous acts of production make possible, actually satisfies an end. Time preference determines how a person will arrange a sequence of acts of production over time into a structure of capital goods to produce consumer goods by which his most highly-valued ends will be satisfied. Because longer production processes render more or superior consumer goods or both, a person who made no distinction between a satisfaction sooner and the same satisfaction later would continually engage in acts of production, thereby lengthening out the capital structure, so that he could enjoy greater consumption satisfaction in the more distant future. Of course, such a person would act, but he would never consume because he would still prefer more goods to less goods and superior goods to inferior goods and he could, by entering into longer production processes, wind up in the more distant future with more and better consumer goods than he could have in the less distant future with shorter production processes. Mises (1998, pp. 479–480) wrote:
If acting men were not to pay heed to the length of the waiting time, they would never say that a goal is temporally so distant that one cannot consider aiming at it. Faced with the alternative of choosing between two processes of production which render different output with the same input, they would always prefer that process which renders the greater quantity of the same products or better products in the same quantity, even if this result could be attained only by lengthening the period of production. Increments in input which result in a more than proportionate increase in the product’s duration of serviceableness would unconditionally be deemed advantageous. The fact that men do not act this way evidences that they value fractions of time of the same length in a different way according as they are nearer or remoter from the instant of the actor’s decision.
Whether a person prefers sooner satisfaction of an end over later satisfaction or makes no distinction between sooner and later, he will act. But if a person makes no distinction between sooner and later satisfaction, his action will be production to the exclusion of consumption. Mises states the implication of time preference in terms of consumption instead of action in general to highlight the difference these two cases of inter-temporal valuation have on consumption and production. There is, logically, a third case of inter-temporal valuation. A person could prefer a satisfaction later to the same satisfaction sooner. If a person prefers later satisfaction of an end over sooner satisfaction, then he will not act at all. This is the case in the quote cited by Topan and Păun (2013, p. 305) from Huerta de Soto (2006, p. 271): “A world without time preference… would mean people always preferred the future to the present.” The quote cited by Topan and Păun (2013, p. 306) from Walter Block (1990, p. 199) can also be understood this way. Thus, we have three cases of inter-temporal valuation: a person preferring sooner over later both produces and consumes; a person making no distinction between sooner and later produces but does not consume; a person preferring later over sooner neither produces nor consumes. Mises deals exclusively with the case in which a person makes no distinction between sooner and later.The one possible exception is in the quote cited by Topan and Păun (2013, p. 304; Mises 1998, p. 481): “The very act of gratifying a desire implies that gratification at the present instant is preferred to that at a later instant.” Mises, however, goes on in the same passage: “If he were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants.” For this reason, he does not state the implication of a lack of time preference in terms of the elimination of action itself, but in terms of the elimination of consumption, i.e., receiving the satisfaction from the realization of the end.
In response to Fetter’s argument by which he concludes that the pure rate of interest can be isolated in inter-temporal trade of money but not in the inter-temporal trade of goods, Topan and Păun also operate under a misapprehension. They (Topan and Păun 2013, p. 312, italics original) write that Fetter’s argument makes two claims: “(1) that non-monetary goods always suffer from the timing problem while (2) money never suffers from the same.” The first assertion must be true, they (Topan and Păun 2013, p. 313, note 8) write, “otherwise inter-temporal exchanges in terms of other goods… could presumably also isolate pure… interest. And this undermines the case for the peculiar role of money in this respect.” In making these assertions, Topan and Păun rely on my summary statement of Fetter’s work instead of consulting Fetter’s extended explanation.My summary statement of Fetter’s views is found in Herbener (2011). Fetter (1915, p. 264) gave a succinct statement of his argument in his 1915 book, Economic Principles:
Now as money is the common price denominator, and the price of nearly all things whether they are sold for cash or on credit is expressed in money, it is the unit in which the comparison of goods is made when one chooses goods in different periods of time. It is not an absolute standard of value; a “dollar” is not necessarily of the same value-magnitude to any one person from year to year, much less to all persons together…. But money is taken as the objective standard in borrowing and lending to which the time preferences of men are adjusted, as value is adjusted to price.
Fetter’s argument is that money is chosen for inter-temporal exchange because money, as the general medium of exchange, provides the only unit that can serve as the basis of economic calculation. The unit of money performs the function of economic calculation both for present exchanges and inter-temporal exchanges. Fetter (1915, p. 312) wrote:
Money being at the same time the medium of exchange, the common denominator of prices and the standard of deferred payments, is the unit in which all these valuations are expressed. In one form preeminently, the interest contract, the rate of time preference comes to a definite arithmetic expression.
Fetter’s claim, then, would not be contradicted by an occasional instance of inter-temporal trade of a good any more than money’s status as the general medium of exchange would be contradicted by an occasional act of barter.
Fetter explicates his argument in his 1905 book, Principles of Economics. He (Fetter 1905, p. 104) wrote:
Money serves as a “common denominator,” for, as all other things can be expressed in terms of money, through it the value of other things can be compared. The other things can be expressed in money because they are constantly exchanged for it. All things being compared with money, can in turn be compared with each other.
Only the general medium of exchange performs the function of allowing each person to make comparisons of value among all the diverse circumstances of action, including different moments in time. Fetter argues that both timing aspects and the time preference aspect affect the value of goods at different moments in time. If it were not possible to eliminate the timing aspect from inter-temporal exchange, then interest, i.e., the time preference discount, could not appear unalloyed. Fetter (1905, p. 141) wrote:
Time value is the difference between the values of things at different times. Things differ in value according to form, place, quality of goods, and according to the feelings of men and—not the least important factor—according to time. The simplest and clearest case of time-value is the difference noticeable in the same thing at different moments. Is this good worth more now or next week? Shall this apple be eaten now or next winter? These questions can be answered only after comparing the marginal utilities which differ according to the varying conditions of the two periods.
The time preference aspect within time value can be isolated by finding a good of “equivalent value.” Fetter (1905, p. 141) wrote:
All the other cases of time-value can, by the practical device of substituting other goods of equivalent value, be reduced to the typical case of comparison of the same thing at different times. The comparison may be between very similar things, the one consumed being replaced by a duplicate. An apple borrowed now may be returned next year in the form of one of the same size and quality. The essential thing in this comparison is not physical identity, but equivalence in size, sort, and quality at the two periods. This is borrowing under the renting contract.
But no good, save money, will have equivalent value for each person at different moments in time across all persons. The “same thing” in which lending and borrowing are done is money because only money provides the unit of economic calculation. All the different goods and combinations of goods are bought with money and therefore, valued against the monetary unit. The monetary unit, therefore, is the basis for comparing all the different goods in all the different circumstance across all the different persons who are acting. Fetter (1905, pp. 141–142) wrote:
But two or more quite different things may be expressed in terms of another thing and so be made comparable. Money becomes the value-unit through which different things may be reduced to the same terms of comparison. With this mode of expressing the value-equivalence of various goods, the interest contract first becomes possible, money…being the thing exchanged…at two periods of time.
The “equivalent value” of each unit of money permits the comparison of the value of different things whether they are traded in the present or inter-temporally. What is being compared in the interest contract, fundamentally, are two satisfactions one available sooner and another available later. Fetter (1905, p. 142) wrote:
What is really compared are various gratifications which may be produced by very different material things or services. In its last analysis comparison of values at different periods of time must be comparison of psychic incomes, of two sums of gratification. The comparison of the value of a bushel of apples with that of a barrel of potatoes or a suit of clothes at the same moment appears simple enough. When all are expressed in terms of money, the comparison of each with its value-equivalent at a later date becomes easy.
For Fetter, the unit of economic calculation, i.e., the monetary unit, is the suitable unit for making comparisons of sooner satisfactions relative to later satisfactions. No other good renders equivalent value units for comparing different subjective values held by different persons in all the diverse circumstances of acting, including across time.Fetter (1905, p. 116) wrote, “In the interest contract for the loan of capital the interest always is and must be expressed in money; the capital sum must be expressed as value; and the interest rate expresses the relation between these two values.”
The “equivalent value” units of money, then, do not refer to the subjective value people place on money. Regardless of the differences in subjective valuations a person might have for different goods, different circumstances, different moments in time, etc. they can be compared using the monetary unit. The ability people have to use the monetary unit to make such comparisons inter-temporally would be lost if the item used as money no longer served as the medium of exchange in the future. As long as the item continues to serve as money, then people can express their comparison of sooner satisfactions to latter satisfactions through the monetary unit for the same reason they can express their satisfaction for one good relative to another good through the monetary unit in the present. Thus, Fetter’s argument does not imply, as Topan and Păun (2013, p. 312) write, that “the intuition that one needs money at certain moments for certain payments [is] completely absurd.” That a person has different subjective valuations for money at two moments in time is no more an argument against the unit of money being useful for inter-temporal economic calculation than that two persons at the same moment in time have different subjective valuations of money is an argument against the unit of money being useful for economic calculation at the present moment. When a person lends a unit of money in exchange for receiving a premium and another person borrows a unit of money in exchange for paying a premium, then their inter-temporal trade expresses their time preferences. Just as, when a person sells a good in exchange for receiving the money price and another person buys the good in exchange for paying the price, then their trade expresses their preferences.
What Fetter is stressing is that the interest rate does not have a necessary temporal value in it when money is traded inter-temporally as it would if goods were traded inter-temporally. If people traded goods inter-temporally, there would be a different “interest rate” for each of the different goods traded. Each one reflecting the combined effect of the two causes: time preference and timing. With money, the pure rate of interest is uniform. The pure rate of interest is the ratio of the premium of future money paid for present money lent. The unit of money in the numerator is compatible with the unit of money in the denominator, otherwise no ratio could be formed. The “equivalent value” of the unit of money inter-temporally permits the premium paid to express the different value placed on present satisfaction relative to future satisfaction. Mises (1998, p. 535) wrote:
It has been pointed out already that in the imaginary construction of the evenly rotating economy, the rate of originary interest is uniform. There prevails in the whole system only one rate of interest. The rate of interest on loans coincides with the rate of originary interest as manifested in the ratio between prices of present and of future goods.
Topan and Păun (2013, p. 314) miss the mark, then, when they cite Mises (1998, p. 531, italics added) who wrote, “originary interest can therefore in the changing economy never appear in a pure unalloyed form.” In the text preceding this quote, Mises explained that in a world without change, the market rate of interest would be the unalloyed pure rate. Mises (1998, p. 530) wrote:
Under the conditions of a market economy the rate of originary interest is, provided the assumptions involved in the imaginary construction of the evenly rotating economy are present, equal to the ratio of a definite amount of money available today and the amount available at a later date which is considered as its equivalent.
The monetary unit, for the purposes of economic calculation both in the present and inter-temporally, can be considered to have “equivalent value,” as Fetter would put it. It is this feature of the monetary unit that permits the isolation of time preference to be expressed in inter-temporal trade. Time preference is the only causal factor bringing about the pure rate of interest. In the actual market economy as opposed to the ERE, however, the pure rate of interest is not isolated from the entrepreneurial component and the price premium component in the gross market rate of interest (Mises 1998, pp. 535–542). Fetter (1905, pp. 132–133 and 150-151 and 1915, pp. 302–304), Mises (1998, pp. 535–542), and Rothbard (2004, pp. 550–552, 773–776, and 792–798) each hold the view that the gross market rate of interest consists of component elements, one of which is time preference, and that the time preference component is isolated in the pure rate of interest.
Finally, Topan and Păun (2013, p. 313) claim that money can suffer from the timing problem is built on the misapprehension that has been exposed by a careful review of Fetter’s argument. The timing problem is not referring to the different subjective value of either the goods that could be bought with a sum of money at different points in time or the holding of that sum of money at different points in time. It refers, instead, to the different circumstances at different moments in time that would make it impossible to have an “equivalent unit” of something for the purpose of inter-temporal economic calculation. The monetary unit, however, provides an “equivalent unit” for making inter-temporal exchange. In the ERE, time preference would generate the only component of the market rate of interest. The pure rate of interest would emerge. In the real world, the pure rate is intertwined with the other components making up the various gross market rates of interest.
Because I share the premise with Topan and Păun (2013, p. 315) that “correct theories must be defended by correct arguments,” I hope my attempt to ward off misapprehensions will open the door to further progress in developing the theory of interest.
REFERENCES
De Soto, Jesús Huerta. 2006. Money, Bank Credit, and Economic Cycles. Auburn, Ala.: Ludwig von Mises Institute.
Fetter, Frank. 1915. Economic Principles. New York: The Century Company.
Fetter, Frank. 1905. The Principles of Economics. New York: The Century Company.
Herbener, Jeffrey, ed. 2011. The Pure Time Preference Theory of Interest. Auburn, Ala.: Ludwig von Mises Institute.
Mises, Ludwig von. 1949. Human Action: A Treatise on Economics. Auburn, Ala.: Ludwig von Mises Institute, 1998.
Rothbard, Murray. 1962. Man, Economy, and State. Auburn, Ala.: Ludwig von Mises Institute, 2004.
Topan, Vlad, and Cristian Păun. 2013. “A Note on Two Erroneous Ways of Defending the PTPT of Interest.” Quarterly Journal of Austrian Economics 16, no. 3: 299-315.
Volume 1, Number 3 (Fall 1978)Professor Ludwig M. Lachmann, one of the most prominent members of the Austrian school, has centered his long and productive career around the importance of subjectivism in economics. From his early work on the role of expectations to his more recent endeavors in capital theory and the market process, Lachmann has been a tireless advocate of subjectivism and methodological individualism.
A collection of his essays, Capital, Expectations, and the Market Process, was recently published, and his Capital and Its Structure will soon be reprinted. Notable among his other contributions are the discussions of methodology and the significance of institutions in The Legacy of Max Weber and his trenchant attack on modern macroeconomics in his "Macroeconomic Thinking and the Market Economy."
Professor Lachmann was interviewed on November 18th, 1977, shortly before his return to South Africa and near the end of his three year appointment as Visiting Professor of Economics at NYU. This interview was conducted by Richard M. Ebeling and Gary G. Short.
AEN: Professor Lachmann, you have been one of the main contributors to the Austrian tradition for forty years. How did you get interested in the Austrian school?
Lachmann: Well, I grew up in the Berlin of the Weimar Republic where the official creed was a kind of revolutionary socialism. I didn't like it. So, naturally, I was looking around for something different. I had read Schumpeter and had been quite impressed. One day, I really don't know by what accident, I came across an article by Mises, who, you'll remember, started publishing methodological essays in the German journals in the late 1920's. I don' remember the first occasion on which I came across one of these articles, but I read it, and found it most interesting. In particular the Austrian economics Mises espoused seemed to be something rather different from what I knew from the textbooks. I got interested and read more Mises and that is how I became an Austrian.
AEN: Did you meet Mises while you were living in Germany?
Lachmann: I met him once in June, 1932, the year before Hitler came to power, there was a conference in Berlin, a "world economic conference," as it was called, that had been arranged by one of the big liberal newspapers in Berlin. Mises had been invited to it and I prevailed on someone in the financial editor's staff of that paper to introduce me to Mises. The meeting of course didn't last longer than two minutes, but I did meet Mises that way.
AEN: After you moved to England in 1933 you became a research assistant to Hayek. What type of topics were usually of interest in the famous Hayek-Robbins seminar.
Lachmann: In general, problems of the business cycle and of capital theory. I actually worked on secondary depressions. That is to say, what Hayek first used to call the process of secondary deflation, a word that had been coined by a German economist to denote that part of the process of depression which goes beyond any kind of primary maladjustment. That is to say, that kind of depression that would not be an adjustment process in the Hayekian sense. It was by then (1933) admitted that a depression of this kind could develop and I think everybody admitted that by 1933 the world was in a process of secondary depression.
AEN: You have talked a number of times about the importance of expectations in business cycle theory. What first drew your interest to expectations as far as the business cycle question was concerned
Lachmann: Talking to Paul Rosenstein-Rodan, who was then a lecturer at University College, London--not technically in the London School of Economics--but he gave a course on the history of economic thought to which all of us who were research students then went. It was Rosenstein-Rodan who in discussing Austrian trade cycle theory with me said, "Ah yes, but whatever happens in the business cycle is in the first place determined by expectations." And then he told me of the work that had been done in Sweden.
AEN: When you arrived in England you obviously must have seen the great concern that a lot of English economists were giving to the problem of the Great Depression. How did you perceive the English interpretation of the Great Depression?
Lachmann: Well, there was no English interpretation of it as such. There was the London School of Economics interpretation which of course was Hayek's interpretation and which you also find reflected in Lionel Robbins' book, The Great Depression, published in 1934. That was the London interpretation. I then realized that there was, in Cambridge, a different kind of interpretation. But at first it was something rather difficult to get hold of. I then realized that to some extent it was something I was already familiar with. I had first come to England for the summer term in 1931 and I had been in Cambridge for a few days, and thanks to an introduction that Schumpeter had given me I had met R. F. Kahn, who had told me about the multiplier that was then just being discovered. In fact, it was shortly before I met him that Kahn's famous article appeared in Economic Journal. So, n a way I knew about the multiplier, but I didn't know much more.
AEN: Were you involved a great deal with the debates between Cambridge and London? Was there constant contact between the parties, or were they isolated and not talking to each other?
Lachmann: No. There was no question of isolation. We did talk to each other. I may remind you that the Review of Economic Studies was started in the fall of 1933 as a joint venture by London, Cambridge and Oxford students. So there was contact. And the contact became even more intimate when in 1935 Abba Lerner, a product of the London School, went to Cambridge. After that there was for a few years a joint London, Cambridge and Oxford seminar, that is to say a joint seminar of the research students in economics at these three universities. Anyone from another university who was interested could join, of course, and it would meet one Sunday a month in one of the three towns, and discuss more or less Keynesian economics.
AEN: What type of reception did you notice was taken by economists when the General Theory appeared?
Lachmann: It was a big success, and immediately so; that I think I can say. Naturally, there was some discussion, not everybody understood the whole thing at once. I had some advantage or, we in London had some advantage because we had Lerner explaining what it all meant. And this was very good teaching indeed.
AEN: In 1938 you had written an article called "Investment and the Cost of Production" in which you raised the issue of "capital complementarity" in understanding expansionary monetary policies: that, in fact, expansionary policies may not bring forth greater output if some complementary factors are scarce. What first brought the importance of complementarity and substitutability in capital to your mind?
Lachmann: My attention was drawn to it by Hayek's paper, "Investment that Raise the Demand for Capital" which was published in 1937, in the Review of Economic Statistics. It had impressed me and it intrigued me to hear from Hayek that Keynes had said to him, "You know this is really quite an interesting idea, it had never occurred to me."
AEN: In the early 30's there had been great interest among the profession in the "Austrian" or Hayekian theory of the trade cycle. Yet as the 1930's progressed even those who had been adherents seemed to have given up their belief in its correctness. What reasons do you think were behind this?
Lachmann: Well, you presumably know about the two different letters to the London Times that appeared in October, 1932. This, of course, was before I came to London. In one of them, Keynes and some Cambridge economists who were not, in general, his friends, like Pigou and Dennis Robertson, demanded that the government should take steps against unemployment. And three days later, Hayek, Robbins and Arnold Plant sent another letter saying that anything the government did by way of public works or similar methods would only make things worse and would not have the affect that Keynes claimed it would have.
That is to say, the "Austrians" seemed to be committed to a policy of continuous deflation whatever happened. Yes, I'm quite sure that the apparent insistence of the "Austrians" that the depression must run its course in the sense that both prices and wages in general must fall seemed to make it increasingly difficult for most other economists to support it, because it was by then obvious that wages didn't fall, not in the Britain of the 1930's anyway. That is to say, there was an obvious difference between the point of view expressed by Hayek, Robbins and their letter of October, 1932, and their willingness to admit the following year that a secondary depression was possible.
AEN: Besides your work in capital theory, you've also written a book on Max Weber. What got you interested in doing a work on him?
Lachmann: Well, anyone who is interested in the methodology of the social sciences must take an interest in Max Weber. I had heard about Weber first at the University of Berlin from my teacher Werner Sombert, who had still known Weber personally, of course. It struck me that what Weber thought and what the Austrians said was more or less the same thing. As you know, Mises admitted that an impetus for his own Neo-Kantian interpretation of the logical part of economics came from Max Weber. In the early years in Johannesburg I read a good deal about Max Weber. And it struck me that his methodology was obviously the Austrian methodology.
AEN: You've been at New York University for about three years. In that period there has tended to be a revival of the Austrian school and there are now more graduate students who are interested in the Austrian tradition. What prospects do you see for Austrians now?
Lachmann: Well, the first steps in the Austrian revival have been taken. How quickly we get on now depends on the Austrians themselves. I think we have broken through the barrier of ignorance, that is to say that state of affairs in which very few economists had ever heard of Austrian economics. I think we are much better known than we were three years ago. From now on everything will depend on how good Austrian economists are, i.e., how readily or how well the Austrians tackle the problems they deal with.
AEN: What type of problems do you think Austrians will have to tackle and what are the important issues that could enable the Austrians to gain the initiative in the field of ideas?
Lachmann: I would agree with a view Hicks has expressed in his paper, "Some Questions of Time in Economics" in the Georgescu-Roegen essays. The most important problems are problems of market structure and certain problems of the effect of technical progress on the capital structure and on the economic structure as a whole. I suppose it doesn=t need any great emphasis that if Austrians stress the market process as the central economic process they should take some interest in the way in which the market functions in various parts of the system and in particular in the way in which different markets function. We have learned for instance that there is a difference between asset and commodity markets and that in some markets expectations are more important than in others. All this I think should be developed further, including, of course, the problem of the forward markets, which as it were, has been thrown at us by certain prominent neoclassical figures.
The other is the problem Hicks has been trying to deal with, questions of technical progress in an economy in which most capital goods are durable and where the effects of technical progress only begin to show themselves gradually and only at first in some sectors of the system but not in others. Now this might lead to some revision of the Austrian trade cycle theory, the subject on which I have become somewhat skeptical. It still seems to me that Wicksell's insistence that the trade cycle has something to do with the uneven rate of technical progress in different parts of the system was fundamentally a sound one. And I hope that Austrian economists somehow will find a way to incorporate such views in the Austrian trade cycle theory. As it stands, of course, there is no reference whatever to technical progress. But it is surely clear that in the real world it does matter.
Another problem Austrians should tackle is a critical examination of certain concepts that are used by other economists. The other day listening to Professor Tobin one learned that he thought that there was a good deal of excess capacity at the moment in the American economy. Now, how exactly would one go about measuring that? It seems to me that economists taking some interest in capital problems should take an interest in such matters as excess capacity.
AEN: How do you think the Austrians should relate to the recent work at Chicago?
Lachmann: In the first place we should distinguish between practical matters, theoretical matters and philosophical matters. Now, in practical matters, I take it we can agree. Personally, I am willing to go along with a good deal of the practical recommendations of Milton Friedman--how to combat inflation, for example. And it seems to me that on what he calls the "natural rate of unemployment," he has said a good deal that makes perfectly good sense. But this doesn't mean that we must necessarily agree on the theoretical level. For instance, is the natural rate of unemployment a minimum, which we could all accept, or is it, as it seems to me, both a minimum and a maximum? And there are certain other questions. But I think on the philosophical level a real abyss yawns between at least some of the Chicago thinkers and us.
My impression from reading certain recent Chicago publications such as the famous article, "De Gustibus Non Est Disputandum" (AER, March, 1977), is that these economists don't understand the difference between action and reaction. They seem unwilling to admit that there is such a thing as spontaneous action in the world. For if there is such a thing as spontaneous action, then it will also take place in the economic field. And if it does take place in the economic field, then it evidently cannot be predicted. Chicago economists seem wedded to the notion that prediction will make everything come true, it is by means of prediction and predictive tests that we are able to distinguish that which is true in the end from that which is not true. But in a world in which spontaneous action exists, such action evidently cannot be predicted, So, I do feel it is very difficult to see how we can possibly agree with them on such matters.
It seems to me to follow from the Austrian rejection of prediction as a test of theories that, again, contrary to the Chicagoans, we have to be very careful about what assumptions we are making because if we have made assumptions which are unrealistic, we will get results which are unrealistic. In Chicago they don't seem to be interested in what assumptions they make as long as they have the possibility of prediction. It seems to me that we must be very careful of the realism of our assumptions and Austrians should in general insist on precisely this.
AEN: How do you see the relationship of the Keynesians to the Austrians?
Lachmann: Now, this is a bit more difficult because the question arises, "Who now are the Keynesians?" I did notice that a certain economist whom I always thought was a Keynesian has described himself as a nonmonetarist. So, it seems to me, that Austrians and Keynesians have certain things in common. They have a common methodology, which in the case of the Austrians is laid down of course in Mises Human Action. And which I would say so far as Keynes was concerned is expressed as you know succinctly in the famous letter to Roy Harrod of July 16, 1938, that I have quoted several times: "Economics is not a natural science. It has to deal with human purposes." That as it were unites us with the Keynesians as against certain other economists, this kind of subjectivism. What also I take it we have in common is a general interest in the facts. After all, we are living in the same world, and it is assumed we accept that facts matter, a proposition which in Chicago doesn't seem to be so readily accepted. But if we admit that facts matter, then we should be able to establish those facts.
AEN: You mentioned the comment by Keynes in which he made a methodological statement. In fact most Keynesians, at least in the United States, follow a methodology that limits itself to a study of averages and aggregates. Is it possible to see this relationship when, in fact, they for the most part operate with a methodological holism?
Lachmann: I don't know what you have in mind, and then of course the question again arises who is a Keynesian? I would point out, for instance, that in a book like Paul Davidson's Money and the Real World, subjectivism is after all present. I wouldn't know any good examples of what you call methodological holism. The mere fact that someone deals with macroaggregates does not necessarily mean that he is not methodologically an individualist. This was, I think, brought out quite well by Frank Hahn, in his famous critique of Friedman. I would say the mere fact that some economists are interested in macroaggregates does not necessarily impair their methodological subjectivism. It still leaves the avenue open for explaining the phenomena pertaining to macroaggregates ultimately in terms of human motives, as, for instance, Keynes did himself when he tried to split up the demand for money (money as a macroaggregate) into the famous motives. That was an attempt at subjectivism, at least.
AEN: One theorist who has said that he comes out of a Keynesian tradition is Shackle, and he says that he is trying to develop the subjectivism that he sees in Keynes, in particular Keynes's thoughts on expectations. What relationship do you see between Shackle's work and that of the Austrians?
Lachmann: I can think of no one more distinguished or important to the fundamental Austrian ideas than Shackle. Whether he wishes to identify himself with Austrian economics or not, or whether he prefers to rather not be associated with any particular kind of school, is an attitude one certainly can appreciate. I regard Shackle as, in fact, an Austrian,
AEN: Did you have the opportunity to get to know Shackle well in your London school days?
Lachmann: Reasonably well, I would say. We were both research students under Hayek for two years between 1935 and 1937. We certainly talked very often. Also, these years include the crucial year 1936, in which The General Theory was published.
AEN: Professor Lachmann, the Austrians have always emphasized the importance of the price mechanism in disseminating information and as an allocative tool for efficient resource utilization in an economy. The western world is now facing the situation in which an important price is more and more inflexible downwards; i.e., wages, particularly in England. What types of policy recommendations or what types of theoretical insights can an Austrian give in a world in which wages are rigid downwards?
Lachmann: All one can say of course is that it would be better if wages were not as rigid as they are, and I think Austrian economists should tell everybody who is willing to listen to them that wages that are inflexible downwards are not in the interests of society and not in the interests of the workers concerned; that in a market economy it is not the path of wisdom never to reduce the price of what one has to sell.
AEN: A collection of your essays has recently been published. Perhaps you would like to say a word or two about it.
Lachmann: The collection of essays, Capital,Expectations and the Market Process, is of course a selection of articles I have written, the earliest from 1940, "A Reconsideration of the Austrian Theory of Industrial Fluctuations." I think that in general these articles reflect both my reaction to the Keynesian economics as well as my growing disenchantment with what was called orthodox or mainstream economics. I do take some pride in an article which will be included that originally came out in February, 1943, "The Role of Expectations in Economics as a Social Science." Before 1942 when I wrote the article it had not become clear to me that the introduction of expectations into economics would mean a major revision of economic theory. And this has been one of the themes on which I have written since 1943. That is to say, fundamentally, the incompatibility of a world in which spontaneous action exists and expectations are as subjective as preferences are.
AEN: What plans do you have for the near future? Do you have any books in particular that you are working on or will you just continue to write in this vein?
Lachmann: No, I just intend to write in this vein as long as I am permitted to.
Volume 17, Number 1 (Spring 1997)No living economist is as closely identified with the Austrian School as Israel M. Kirzner, professor of economics at New York University, a leader of the generation of Austrians after Mises and Hayek, and an adjunct scholar of the Mises Institute. He wrote his dissertation under Mises, later published as The Economic Point of View (1960), and broke new theoretical ground in his Competition and Entrepreneurship (1973). Kirzner is author of seven additional books, his newest on capital and interest from Edward Elgar (1997), and dozens of articles, including several in the Austrian Economics Newsletter and The Review of Austrian Economics. He was interviewed in his office at NYU following the weekly Austrian Colloquium.
AEN: You were Mises's assistant for some years.
KIRZNER: Yes, and in addition to attending his weekly lectures, I spent time in his office downtown being available for his students. He used to read my manuscripts, and I was honored to have him write the introduction to The Economic Point of View (1960). Otherwise, he didn't comment very much on my work, and we didn't have extensive discussions on the details.It was not easy to discuss matters of theory with Mises. He was always gracious, polite, and kind, but at the same time reserved. There was also a bit of a language barrier. He spoke English perfectly, but I think he still thought in German.I would never claim that my interpretations of Mises were given his personal approval. Most of what I understood of Mises was attained from diligently studying and thinking about passages in Human Action again and again.
AEN: Any other insights on Mises the man?
KIRZNER: He was a man of great integrity. I remember an episode after completing my master's degree in 1955. I was studying with Mises and was strongly under his influence. But I also applied for fellowships at other schools. I received an offer from Johns Hopkins. I went to ask Mises's advice on whether I should go. Even though he had very few students, he told me to accept the offer. He pointed out that Fritz Machlup teaches there, and that Johns Hopkins is a prestigious school. As it happens, I did not take his advice, but this says something about his concern for his students' interests. It was an extraordinary gesture on his part.
AEN: How were you first attracted to Mises?
KIRZNER: At first, I did not know who he was. But as I was looking around for programs and professors, I did happen to notice that Mises seemed to have more books than anyone else. I found that impressive, so began my studies with him. Eventually I was hooked.
AEN: Did you know you were getting involved in a school of thought that most of the profession regarded as old-fashioned?
KIRZNER: Not at first. But I eventually came to realize that the mainstream of the profession was headed in a different direction. In 1954, there was no Austrian movement. There was no Austrian School. There was Mises, and there was Hayek. They must have been seen as the last of their generation, and not too much of a threat.
Now, I don't regard my choice as heroic by any means. True, I was isolated as far as the profession was concerned. But I received my PhD, taught at New York University, did my work, and published my books. I was content with this, and had no great difficulties. Gradually, as the sixties wore on, I began to think I had an idea that might even have an impact on the profession. Indeed, Competition and Entrepreneurship interested some reviewers at the University of Chicago Press, which pleased me very much.
AEN: When you look at the Austrian School today, what do you think?
KIRZNER: Its sheer size is very pleasing, of course. To some extent, the fact that the profession at large has moved even further along in the technical-mathematical direction created an opening for the Austrian School among younger scholars. They began to see the sterility and aridity of the way the mainstream has gone. The Austrian School appears as a whole different way of approaching the discipline. And today, there is room out there for Austrians in the profession--however, not yet at the top of the profession.
AEN: In today's colloquium, and in your writings, you seem to be increasingly occupying what's sometimes called Austrian "middle ground."
KIRZNER: No question. This has been true ever since people have begun to take more extreme positions on the question of the uses of the equilibrium construct in economics. When they began to deny its relevance altogether, I began to realize that my position is not as extreme as theirs. The phrase "middle ground" was first used by Roger Garrison to describe a theoretical position that neither entirely spurns nor fully embraces a construct like equilibrium that is most often associated with neoclassical economic thought.
AEN: Is it excessive subjectivism that troubles you?
KIRZNER: I wouldn't say so. The argument that says we can't use equilibrium constructs at all is not a valid use of subjectivism. It takes economic theory in an entirely different direction.
AEN: What is the middle ground on the question of equilibrium?
KIRZNER: The two extremes, simply stated, are "equilibrium always" and "equilibrium never." The "equilibrium always" view is the strict neoclassical/Chicago perspective which never permits us to consider a world in which everything is not completely adjusted. The other extreme is one in which there are no systematic, overriding tendencies that could lead to regularity. I don't think an Austrian economist can be satisfied with either of these positions.
Austrian economics cannot be "equilibrium always," but neither can it be "anything goes." As Mises used to say, it was the great contribution of the classical economists to enunciate the concept of economic law. There are, indeed, systematic consequences to our actions. If one accepts that economics is the study of those systematic consequences, one cannot live with a perspective that sees the world as so open-ended that anything is possible. That's why I would disagree with the characterization of economics as essentially the study of the unfolding of an uncertain future.
AEN: Is Professor Mario Rizzo correct that Austrians must think in terms of non-equilibrium "real time" as versus some static variant?
KIRZNER: I think it is highly useful to think in non-equilibrium terms, to be open to the possibility of change and surprise. You certainly cannot do good economics without understanding the role of surprise. But if one pursues this to the point where the surprises tend to overwhelm the regularities, then I don't believe you have a science that reflects existing realities.
AEN: There's an impression out there that you believe entrepreneurship is always equilibrating. Is this a mischaracterization of your position?
KIRZNER: Yes. Entrepreneurship is not always equilibrating. The equilibrating features of the real world ought to be ascribed to entrepreneurship; it doesn't follow that all entrepreneurship is always equilibrating. Entrepreneurs make losses, and losses are not equilibrating.
The idea I reject is this: there is successful entrepreneurship, there is unsuccessful entrepreneurship, and it's a toss-up which is going to outweigh which in the end. That was Frank Knight's position, by the way, and I think that is a mistake.
The fundamental Misesian insight into human action is that it involves a tendency to be right rather than to be wrong. People have an interest in being right. They do not have an interest in being wrong. This definitely, distinctively weights the tendency of human action in the direction of being right.
This does not guarantee "equilibration always." And certainly a permanent equilibrium is out of the question. It would be incorrect even to imply that in any given time period, the changes we observe are necessarily equilibrating. But there are tendencies which tend to overwhelm disequilibrating forces in the market, most of the time.
AEN: Are there times when disequilibrium is a sure thing?
KIRZNER: Much depends on the nature of the exogenous changes we are experiencing. In a world in which change is of such a volatility that entrepreneurial activity and action are continually frustrated, we will find continual non-equilibration. There are historical circumstances in which chaos, violence, and uprisings do indeed overwhelm orderliness and evolution. Perhaps we can even point to such occasions. For equilibrium to be the regular tendency, we do need, empirically, a certain environment of stability.
AEN: Can you give an example of such volatility?
KIRZNER: Suppose people's tastes change every day, drastically. Sometimes they like the temperature inside to be 32 degrees; other times, they like it very hot. Sometimes people eat three times a day; sometimes only one. Sometimes they like to wear shoes; other times, they insist on going barefoot. Suppose that technology were to change drastically and in unexpected ways. This is extreme volatility. In these times, we have no guarantee whatsoever that a market theory can really provide a systematic understanding of change. In such a world there would be so little that is stable, I don't believe an economic theory would be of much help.
AEN: In these times, does economic law cease to exist?
KIRZNER: Not at all. It only becomes more difficult to take account of the pattern of change. For example, we can always predict that an increase in demand will increase the price. But under extreme volatility, demand changes and wobbles so quickly that the forces that would otherwise cause prices to rise will be swamped temporarily by forces that cause them to fall. We can't rule it out. But economic law still continues to be the underlying reality.
AEN: Do you regard Joseph Schumpeter's theory of entrepreneurship as an Austrian theory?
KIRZNER: There's a good deal of controversy about that. There was personal tension between Mises and Schumpeter, and most of what we would currently identify as key Austrian features were not accepted by Schumpeter. Walrasianism did dominate his thinking.
Yet I have defended Schumpeter as an Austrian in a very special way. He never really bought into the neoclassical view of "equilibrium always." Certainly his emphasis on the entrepreneur is consistent with that. He never forgot the lessons he learned from Austrians, even if he tried to forget them. The Austrian revival owes something to Schumpeter.
AEN: What is the relationship between his theory and yours?
KIRZNER: Let me recognize that in my 1973 book I was perhaps overeager to draw a distinction between Schumpeter and myself. In later writings I have pulled back somewhat from that. I have recognized that you can subsume the Schumpeterian entrepreneur under my own theory, if you like.
For Schumpeter, the entrepreneur was a disrupter. He breaks an existing, evenly-rotating system. Paul Samuelson has a metaphor for Schumpeter's view of the world. He said it's like a violin string. You pluck it, it vibrates, and finally settles down. I would say that Schumpeter saw the entrepreneur as the person who is doing the plucking from a taut position, generating the change. All the vibrations are attributed to his action.
Originally, I emphasized the other side of the issue. The entrepreneur generates a tendency to restore the evenly-rotating system to a new level or a new pattern. But it is the restoration, not the disruption, that is brought about by the entrepreneur.
AEN: How would his, and your, theory apply to a specific technological change?
KIRZNER: Imagine Victorian England, where everything is calm and still, with horse carriages and trains carrying people here and there. Along comes the entrepreneur who invents the automobile. The stillness is utterly shattered. People lose jobs and physical resources are shifted to new lines of production. All of this is to be ascribed to the entrepreneur in Schumpeter's view.
In one sense this is correct. But my 1973 book emphasizes a different point. We have to recognize that when the entrepreneur discovers the automobile, he is not simply disrupting the calm. He is identifying what was in fact waiting to be introduced. Technological knowledge was being misapplied. Resources were being wasted on trains, carriages, and bicycles, when, in fact, what was waiting to be put together was this new gadget called the automobile. A person who recognizes this is responding to a preexisting, gaping hole in the market.
Of course, the role of the entrepreneur can be understood as disrupting in a very down-to-earth sense. People had jobs and their jobs are destroyed. People had careers, and they are now gone. Granted. But what appear to be disruptions aren't disruptions at all. They are simply the revealing of misallocations that were there before.
Very often people object. "You say entrepreneurship is coordinating, but surely an entrepreneur who discovers new ways of doing things is putting people out of work and disrupting people's expectations."
Yes, he is, but in a more fundamental sense, he is correcting an already existing discoordination. He is redirecting resources that are already misplaced. People do not have to go on for years and years behaving in ways that are socially inefficient. The person who abruptly draws their attention to this inefficiency is assisting in the process of economic coordination. However, this does not reduce, in any way, the importance of Schumpeter's focus on the innovation of the entrepreneur. Nothing I have said should be interpreted to do so.
AEN: What do you mean in saying something is "waiting" to be discovered?
KIRZNER: Philosophically, people have objected to that. I do not mean to convey the idea that the future is a rolled-up tapestry, and we need only to be patient as the picture progressively unrolls itself before our eyes. In fact, the future may be a void. There may be nothing around the corner or in the tapestry. The future has to be created. Philosophically, all this may be so. But it doesn't matter for the sake of the metaphor I have chosen.
Ex post we have to recognize that when an innovator has discovered something new, that something was metaphorically waiting to be discovered. But from an everyday point-of-view, when a new gadget is invented, we all say, gee, I can see we needed that. It was just waiting to be discovered.
AEN: Consumer demand was there, resources were there, and the technology was there. . .
KIRZNER: Yes, so there was no reason why it wasn't being done. The entrepreneur is alert to this reality, to the profit opportunity it represents, and responds creatively to it.
AEN: Some have said your careful definition of the "pure" entrepreneur is excessively abstracted from that of the capitalist, and that in this respect your theory departs from Mises.
KIRZNER: I know that Murray Rothbard and Joe Salerno have suggested this, but I don't think it is correct. Frankly, I've always thought I picked up the idea of the "pure entrepreneur" from Mises. I've written a comment on this view in a book edited by Bruce Caldwell and Stephen Boehm [Austrian Economics: Tensions and New Directions, Boston: Kluwer, 1992]. I argue that it depends on your analytical purposes. We recognize that in the real world the pure entrepreneur never exists. A pure laborer never exists. A pure capitalist never exists. Yet it remains highly useful to speak of the pure entrepreneur.
AEN: In theory, then, if not in reality.
KIRZNER: Yes, but I have no difficulty in recognizing the theoretical meaning of the pure entrepreneur. The more difficult question is: can you have a capitalist who is not an entrepreneur? In a world of uncertainty, I don't believe so. If there is no pure capitalist, because every capitalist must also be an entrepreneur, then what does one gain by talking about the pure entrepreneur? It helps us to understand the precise nature of his contribution to the process of economic change.
Let's assume that all the uncertainty in the world is subsumed within the entrepreneur, and nobody else has any element of uncertainty. The actions of everyone else are not human actions; they are the movements of robots. Neither the laborers, nor the capitalists, nor the consumers are entrepreneurs. They are Robbinsian maximizers. In this world, the pure entrepreneur buys resources at prices which are known to the resource sellers, sells them at prices which are known to the buyers, and he's the one who sees the difference between the two.
In the real world, of course, no one performs a purely non-entrepreneurial function. The consumer is an entrepreneur, the capitalist is, and the laborer is too. They are all taking risks, taking leaps. They are all forgoing some opportunities for others. Granted. But that doesn't by itself preclude us from talking about the central entrepreneurial function of being alert to new opportunities, of discovering something that others have not seen.
AEN: And this understanding is consistent with your 1973 book?
KIRZNER: I don't believe I've made substantial revisions. I've made revisions from my earlier books. My Economic Point of View [1960], Market Theory and the Price System [1963], and Essay on Capital [1966] were not informed by the entrepreneurial insights, which I only gained later.
AEN: Market Theory and the Price System is said to have made a contribution to the Austrian view of efficiency.
KIRZNER: I sweated a great deal over that book. I put a tremendous amount of thought into trying to translate Misesian economics, as I understood it then, into terms that would be understandable to the profession at large and usable at the undergraduate level. It wasn't easy. It is probably the winner in a contest over having sold the least copies.
AEN: Do you regard your entrepreneurial insight as a bridge between the Austrian and neoclassical worlds?
KIRZNER: The word "bridge" is a diplomatic word. I've been accused of turning Austrian economics into a footnote of neoclassical economics. I think that is incorrect. But I would accept the word "bridge." It is a bridge in the best sense of the term.
Neoclassical economics in its modern version is an "equilibrium always" theory. It didn't used to be that way. Frank M. Machovec has written a book in which he points out that the great neoclassical thinkers from 1880 to 1930 did not really believe in a world built on equilibrium theory. They thought about the price system as a competitive process. It's the modern version of neoclassical economics that has been Walrasian--and Machovec goes further to argue that not even Walras believed in "equilibrium" always. I don't think I would go that far, but I see his main point.
The idea of the entrepreneur enables us to see how there might conceivably be an equilibrium system, or why an equilibrium system might be of any interest to us. Even if we deny that equilibrium is ever attained, we can look at neoclassical theory and understand it in relationship with Austrian theory.
When Mises talked about the evenly rotating economy as a model against which to understand equilibrating processes, he is doing exactly what should be done. We can understand market process theory by contrasting it with equilibrium states. How can a contrast be a bridge? It can by drawing attention to the role of equilibrium models in understanding the process. But I strongly disagree with those who have said that this theory of the entrepreneur merely restores neoclassical economics to its pristine glory.
AEN: But if a neoclassical economist told his class about Kirzner's theory of entrepreneurship, that would be an improvement.
KIRZNER: Certainly, given today's rigid environment. Once, however, I gave a talk on the Austrian view of the market process, and the late Abba Lerner was there. He said that what I was calling the Austrian view is precisely what he had been taught in school and had long accepted. I'm sure it's true. The perfectly competitive model was never dominant in neoclassical economics until E.H. Chamberlin and Joan Robinson brought us imperfect competition. Then, they retroactively attributed perfect competition to those that preceded them.
AEN: Prior to this, Mises even thought of himself as within the mainstream of thought.
KIRZNER: That's right. There's a passage which I've often quoted from a 1932 piece where Mises is saying that all modern schools of economics are basically saying the same thing. That is very revealing. What did he mean? He was noting that all schools have abandoned the German historical school. In short, vis-a-vis the common enemy, they are all saying the same thing.
Later on, the differences between the schools--Walrasian, Marshallian, Austrian--began to widen. Think of them like three parallel runners who start off close to each other but move progressively further apart as they proceed. By the time I came to study under Mises in 1957, I don't believe he would have subscribed to the view that all schools taught the same thing.
AEN: What in particular changed Mises's mind?
KIRZNER: I've made the argument, in The Review of Austrian Economics, that it was partly a result of the socialist calculation debate in the 1930s. This debate exposed deep differences between Austrians and others in the very conception of what the market is and how it works. I think it's true of Hayek too.
AEN: Congratulations on the new edition of An Essay on Capital, along with two additional essays, just out from Edward Elgar. How did that earlier book come about?
KIRZNER: When I wrote An Essay on Capital in 1966, I didn't believe I was breaking any new ground. After completing my 1963 book, I spent several years hoping to write a history of capital theory since the 1880s. I found myself getting deeper and deeper in what I found to be an endless muddle of ideas, confusion of purposes, and definitional ambiguities. I finally gave up. I found instead that it would be useful for me to write down in clear and simple terms a summary of what I got out of my research, in light of the Misesian framework.
AEN: Can you summarize the argument of this work?
KIRZNER: Usually, people look at capital as objects, usually highly valued objects. That tempts us to think that physical capital is itself the source of the flow of income. The view of capital I present relates directly to the purposes of individuals. I insist that Austrians see capital as the intermediate form in which plans are brought about.
I like to use the metaphor of the half-baked cake in an oven. This is a desk, and the person who made it was planning that I would use it to write on, put papers on, and so on. By itself, the desk is a half-baked cake, just as are cars, buildings, and machines.
It goes back to Eugen von Böhm-Bawerk's view of inchoate output. We must look at capital, not in objective terms, but as representing the plans of individuals and their forecasts of the future. There are overlapping, multi-period plans, of course, so that new cakes are going into the oven before old ones come out.
AEN: It is said sometimes that Hayek should not have spent so much time writing the treatise on capital that appeared in 1941.
KIRZNER: He expected that book to be followed by a subsequent volume, I believe. He stuck it out, and produced a very difficult book that is largely ignored today. I have some criticisms of that book too, and it is good that he moved on, but it was an honest and grand effort.
AEN: In those early years, did you have a goal of doing more macro-oriented work?
KIRZNER: No. I have never really seen myself as a macroeconomist. Of course I've taught macro for many years, yet I felt I never understood Keynesian economics. It assumes that decision making doesn't matter. All that matters are the relationships between totals. While I often pointed out what seemed to me gaping holes, I had no great desire to counter this with a separate macroeconomic theory of some sort.
AEN: You've never thought of providing a systematic critique of the Austrian business cycle theory, for instance?
KIRZNER: No, I've never had too much interest in the Austrian business cycle theory. I've never felt that the Hayekian business cycle theory was essentially Austrian. In fact, Mises, who was the originator of this whole idea in 1912, didn't see it as particularly Austrian either. There are passages where he notes that people call it the Austrian theory, but he says it's not really Austrian. It goes back to the Currency School and Knut Wicksell. It's certainly not historically Austrian. Further, I would claim that, as developed by Hayek, there are many aspects of it that are non-Austrian. I don't believe that to be an Austrian you have to buy into the Hayekian view of business cycles.
AEN: Are there any aspects of Hayek's business cycle theory that you regard as Austrian?
KIRZNER: I recently wrote a paper to accompany the facsimile German edition of Prices and Production. I identified what seemed to me to be elements of Hayek's later work on coordination, miscoordination, and knowledge. I argued that the germs of his later ideas can be traced to this volume, especially his description of the upswing stage of the cycle. This is a phase during which some decisions are out of sync with other decisions. Current investors are making decisions which anticipate the decisions of others down the road, which are in fact not there. Leaving the exact mechanism aside, that is the kind of thing Hayek taught us to look for in analyzing the market process. In that respect, it's Austrian.
AEN: And the rest of the theory?
KIRZNER: Otherwise, the Austrian theory of the business cycle is a macro theory. It's an equilibrium theory. And it treats capital in an objective sense rather than a subjective sense. It treats time as somehow embedded in the capital goods themselves. So I've always had a certain reserve about that particular theory, however brilliant it may be. I think the way Hayek developed it was not quite consistent with the way Mises laid it out in 1912.
AEN: Do you accept the idea that interest-rate manipulation by the central bank can cause distortions in the structure of production?
KIRZNER: Certainly the Austrian cycle theory showed brilliantly how this can happen. But it's one thing to develop a theory which could explain a downturn. It's quite another to claim that historically every downturn is to be attributed to that particular theory. That does not necessarily follow. If one were asked, does this theory necessarily explain each and every cycle, I would say no.
Mises used to poke fun at those who criticize the Austrian theory of the business cycle as being too simple. He said that still doesn't tell what's wrong with it. That's correct, as far as it goes. Perhaps many market aberrations are of this kind. But that can only be a question of historical understanding. We must be able to look at every case to see just what is happening.
AEN: Should Austrians insist that the scope of Austrian theory be limited to only praxeologically valid theorems?
KIRZNER: No, I'm not saying that Austrian economics should not deal with applications of praxeology. But it's one thing to explain what must necessarily follow under certain assumptions. It's another to take this and claim, without justification, that this therefore is the explanation for a particular empirical phenomenon. There's a danger in doing that.
AEN: In recent years, you've written about the implications of entrepreneurial discovery for matters of ethics and justice, and particularly the idea of "finders keepers."
KIRZNER: Let me be clear. Finders keepers is not necessarily my preferred ethical teaching. I am not proclaiming it should be followed. I'm not an ethicist; I'm an economist. I'm merely suggesting ways that people's own ethical conceptions can be applied to economic categories. I picked up the phrase "finders keepers" from Murray Rothbard, who got it from a book by Henry Oliver. I then linked the finders-keepers ethic to the idea of entrepreneurial discovery, which I discuss as a new kind of finding.
By "finding," I do not mean that someone is walking along the street and sees something in the gutter. I mean finding a new way of producing something, coming up with a new gadget, discovering some way of meeting an unmet need. Once you broaden the concept of finding, the finders-keepers ethic becomes immediately relevant. A theory of justice that considers the role of entrepreneurship will have a place for the finders-keepers ethic, an ethic that would not come into play in an equilibrium view of markets.
AEN: What is the most direct application of this concept?
KIRZNER: To the morality and justice of profits. People have great difficulty with justifying how someone can pocket money that is over and above what it costs to produce it. If someone buys something for $10, and sells it for $17, why does he get to keep the $7? It seems to many people that it's pure luck that you can sell it for a higher price, and the products of luck should probably belong to all mankind. Or it might seem to be a fraud or a con job.
Those are the obvious ethical problems. But those problems appear only insofar as we assume that everyone begins with potentially full and equal knowledge. In that case, this $7 profit might represent an attempt to deceive. But if people lack knowledge that someone else has, does taking advantage of that constitute fraud? I don't take a position qua ethicist. I am simply pointing out that the finders-keepers ethic may throw light on this problem. The entrepreneur, after all, found value in something.
AEN: And this is different from merely paying for expertise?
KIRZNER: I don't believe in defenses of profit that say we have to pay for people's know-how and skills. These items will have their own independent price on the market. Pure entrepreneurial profit rises above all of these costs, and it needs a separate defense. It is not a payment for something for which a price can be established; the entrepreneur is paid for overcoming ignorance through alertness. A person might say, you have no right to cash in on somebody else's ignorance. Now is everybody who makes a pure profit cashing in on somebody else's ignorance? In fact, yes. Full and equal knowledge is not a reality. If people could not cash in on other people's ignorance, there would be no such thing as pure profit.
AEN: Among the items integral or incidental to Austrian economics, where does the pure-time-preference theory of interest stand?
KIRZNER: I can imagine an Austrian economist who might not fully accept this theory of the origination of interest. I myself have never understood exactly what Mises meant by giving pure time preference an a priori basis. When I say I don't understand it, I mean literally that, and not that it's wrong. It is a very difficult chapter in Mises.
The pure-time-preference theory I've written about is not based on a priori reasoning. I've merely concluded that time preference is a reasonably universal empirical phenomenon. I ask my students: do you know anybody who is indifferent between receiving a paycheck now and receiving it in ten years? The answer is no. To me, that is enough to provide the basis of the theory.
AEN: You don't rule out the possible existence of negative rate of time preference?
KIRZNER: I would be surprised, but I don't rule it out apodictically. If there is a tax on bank balances that is sufficiently high, it would pay people to lend money at negative interest, provided the interest is less than the tax rate. Is that negative time preference? Probably not, but it does show that a positive rate of time preference can coexist with a negative rate of interest. That seems to be what Mises is denying, so my theory cannot claim to present the Misesian view.
AEN: Is it right to say you have adopted a Misesian rather than Rothbardian view of monopoly?
KIRZNER: That is correct. Mises had a view of monopoly in which he said that under certain exceptional circumstances, the pattern of resource ownership may fly in the face of the interest of consumers.
Ordinarily, the ownership of a resource provides value to its owner only to the extent he is prepared to put that resource to use in the service of the consuming public. The only possible exception is where the entire supply of a scarce resource, for which there are no substitutes, happens to be in the hands of a single seller. It may indeed be the case that the interests of the resource owner may be counter to that of consumers. In other words, the resource owner may discover an advantage in producing less of a product for consumers than consumers themselves desire.
This is a possible conflict of interest, and, for Mises, an extraordinary phenomenon. Here we see Mises's integrity. He was willing to recognize that it's not always true that a private-property system conduces to the well-being of the consuming public. He didn't think it was an important case, but he did draw attention to it. He did not use this exceptional case to argue for controls over monopolies.
I too think this point is interesting. I don't believe it is empirically important. It doesn't provide justification for monopoly regulation, or breaking companies, or anything like that. It simply points to a theoretical implication of certain patterns of resource ownership.
Others have disagreed. Rothbard used to say you can never really know if a producer is storing up resources in order to gain more profits or whether his doing so is even contrary to the interest of consumers. That's true. You never will know. But the theoretical possibility is still there.
AEN: A recent controversy has centered on the attempt to "de-homogenize" Mises and Hayek. Do you think this debate has been constructive?
KIRZNER: The short answer is no. Most definitely no. Such thinkers as complex as Mises and Hayek are not going to be identical at every point. There were differences between them, and these differences should be studied, developed, and their roots identified. Certainly. But for what I believe to be the major agenda of Austrian economics, the points of commonality between Mises and Hayek are far, far more important than what I consider to be the marginal differences. To draw a division between them is a major mistake, and possibly a tragic one.
AEN: Why do you say tragic?
KIRZNER: Tragic from the standpoint of the influence of Austrian economics on the profession in general. Moreover, if people believe they must choose between being Hayekians and being Misesians, they are going to say, well, Hayek was the Nobel Prize winner, so he must have done the better work; Mises will be neglected.
KIRZNER: How do you regard Ludwig Lachmann's contributions to the Austrian School?
AEN: Lachmann played a vital role in the revival of Austrian economics. He was a gadfly. He kept us honest. He had a personal link with Mises and Hayek that nobody else had. He was a bridge between the generations. He had deep respect for Mises and Hayek, even where he disagreed with them. He showed young students that you could be a respected economist even if you thought Mises was a great thinker.
Doctrinally, Lachmann was much closer to the extreme Shackelian position on choice, uncertainty, and time, and went much further than I am willing to go. At the same time, he was a circumspect scholar. He was careful to keep a lot of his ideas to himself. But I believe he was trying to steer Austrian economics in a more subjectivist direction.
AEN: And Murray Rothbard?
KIRZNER: Rothbard was unquestionably a genius. His History of Thought exemplifies his life-long ability to absorb an enormous amount of literature and write clearly. He played an important role in inspiring young scholars to take a careful look at the Austrian body of thought. Just as I have had disagreements with Lachmann, I've had them with Rothbard, in matters of style and in matters of substance. Some of his impact was deepened, and some of it qualified, by his ideological work in libertarian political theory.
AEN: What about Frank Fetter of Princeton?
KIRZNER: Yes, he too made valuable contributions. Rothbard did a fine job in drawing together his essays on interest. I don't believe that Fetter can be considered an Austrian except in this one narrow area, however.
AEN: What is your most overlooked contribution to Austrian economics?
KIRZNER: Chapter seven in my 1963 book, which I've often cited to students and colleagues. It's where I provide a scenario of the spread of knowledge in the market process, starting with a non-equilibrium state and building to a systematic process of learning. It provides, I think, a very useful framework.
AEN: Are you generally optimistic about the prospect for the Austrian School?
KIRZNER: Austrians never make forecasts in their role as scientists, but I will venture this. There is work for us to do. There is a generation open to these ideas. The developments of the last 20 years demonstrate this. So, yes, I am optimistic. That's a frame of mind, not a forecast.
Booms and busts are brewing in the real economy, but computers that can quickly solve math problems won’t tell you much about how business cycles work, writes Jonathan Newman. This audio Mises Daily is narrated by Allan Davis.
Volume 20, Number 4 (Winter 2000)Roger W. Garrison is interviewed on his contributions to Austrian Economics.
Volume 1, No. 2 (Summer 1998)As substantial as economist as Schumpeter could claim that interest is a disequilibrium phenomenon and fantasize about a long-run equilibrium where market forces have pushed the interest rate to zero. John Maynard Keynes imagined interest to be a purely monetary phenomenon. Creating what Hayek called a "mythology of capital," Frank Knight held that production and consumption occur simultaneously, that the period of production is irrelevant, and that the interest rate is wholly determined by technological considerations. F.A. Hayek found it necessary to repeat with Knight the debate that had earlier taken place between Böhm-Bawerk—and give timeless value to the critical assessment of the Austrian theory offered by Klaus Hennings.
Volume 21, Number 3 (Fall 2001)George Reisman is interviewed about his interest in Ludwig von Mises at a young age as well as his many encounters with him.
Taught by Professor Joseph T. Salerno, this course builds upon the basic analytic principles of Austrian economics including basic supply and demand analysis and the theories of entrepreneurship and factor pricing to present the fundamentals of Austrian macroeconomics.
The Austrian approach to macroeconomics was developed by the followers of Carl Menger, and in modern times included most notably Mises, Hayek, and Rothbard. Unlike mainstream macroeconomics, Austrian macroeconomics is not a body of theory separate from basic value and price theory that aims at analyzing the economy as a holistic entity apart from the individual households, firms and markets that constitute it. Austrian macroeconomics is only “macro” in the limited sense that it uses general economic theory to analyze specifically those phenomena that pervade individual exchanges throughout the market economy.
Although Frédéric Bastiat disproved it years ago, many still believe that natural disasters increase economic growth, writes Frank Hollenbeck. This audio Mises Daily is narrated by Allan Davis.
Easy money policy hurts most people, particularly workers and savers, and redistributes their wealth to the ruling elites, writes Mark Thornton. This audio Mises Daily is narrated by Keith Hocker.
Interviewed by host Tom Woods, Bob Murphy demonstrates that the author of a book on capital doesn't seem to know any capital theory.
Interviewed by host Alan Butler, Mark Thornton explains how crony capitalism lead to the banning of industrial hemp in the United States. Dr. Thornton also discusses several other relevant economic topics.
One of Carl Menger’s contributions was his primacy of the consumer in determining value and price, not only in the marketplace but in all economic activity, writes Christopher Westley.
This audio Mises Daily is narrated by Keith Hocker.
Interviewed by hosts Steve Floyd, Josh Bennett, and Aaron Bennett, on KFAR 660 AM Fairbanks, Mark Thornton discusses the state of the economy, Liberty, and the Skyscraper Index.
Keynes’s keynote book, The General Theory, is loaded with economic theory. There are only two pages of data in that book, and Keynes dismisses the scant data he cites as “improbable.” By contrast, Piketty’s new book, Capital in the Twenty-first Century, is stuffed with data. Indeed Piketty considers himself a successor to the economist whose data Keynes dismissed, Simon Kuznets. Almost everyone admits that Piketty’s theoretical case is weak — but, his supporters say, look at all this data. You can’t argue with this mass of historical evidence!
Piketty’s primary argument is that wealth (which tends to be concentrated in few hands) grows faster than the economy, so that those with a lot of wealth keep getting richer relative to everyone else. This is supposed to be an inescapable feature of capitalism. (If this sounds familiar, it should be. It echoes both Marx and Keynes, although we should remember that Keynes mocked most of what Marx said as “hocus-pocus.”)
So what then is the evidence that wealth has grown faster than the economy?
Let’s look at the chart below, adapted from Piketty’s book. The top line is return on capital and the bottom line is the economic growth rate. The top line is supposed to be how the rich are faring and the bottom line how the average person is faring. Note that the lines on the far right are just a projection of Piketty’s, and not actual history.
This chart is astonishing for many reasons. First of all, it suggests that capital earned a 4.5 percent or higher return for the years 0-1800 C.E. This is a crazy number. If the human race had started out with only $10 in year 1 and compounded it at 4.5 percent a year for any series of 1,800 years, by now we would have much, much more than a trillion times the entire world’s wealth today, which is estimated at $241 trillion by Credit Suisse.
The 4.5 percent or higher number is also crazy because Piketty is right that there was negligible economic growth prior to the industrial revolution, and such high returns for the rich are just not consistent with so little growth. The truth is that rich people for most of those years were interested in spending or hiding their wealth, not in investing it, because wealth out in the open was likely to be stolen, if not by bandits, then by government.
If you look closely at the more modern part of the chart and ignore the projection into an unknown future, you will see that the lines do not support Piketty’s thesis. His idea that the rich will always necessarily get richer relative to everyone else under capitalism is not supported by the data he presents.
The next chart shows the share of wealth of the 10 percent richest in Europe over time (dark-blue, top line), the share of wealth of the 10 percent richest Americans (the light-green, second line from top), the share of wealth of the top 1 percent Europeans (the light-blue, third line from top), and the share of wealth of the top 1 percent Americans (the dark-green, fourth line from top). This chart doesn’t support Piketty’s thesis either. Yes the share of the rich has grown since 1970, but only after falling previously.
The next chart is one that I have commented on in an earlier article. It shows the income of the top 10 percent in the US over time as a percent of all income. Income in this case includes capital gains which arguably are not true income, but rather the exchange of one asset for another, and excludes government transfer payments which make a considerable difference to the results. Even so, once again we do not see an inexorable rise in the income of higher earners over time, far from it.
What we actually see is two peaks for high earners, right before the crash of 1929 and again before the crash of 2008. These are the two great bubble eras in which government printed too much new money, which led to a false and unsustainable prosperity. These were also crony capitalist eras, as rich people with government connections used the new money to become even richer or benefited from other government favors.
Unfortunately world central banks have blown up yet another bubble in capital markets following the crash of 2008, which has again brought the high earners share back to 50 percent in 2012, based on data that became available after the book’s publication. This newest bubble too will eventually burst and bring the share back toward the 40 percent level of 1910, the start of the chart.
Perhaps the most astonishing claim in Piketty’s book is that government bureaucracies need to be reformed so that they can make most efficient use of all the new income and wealth taxes that are recommended. The assumption is that almost complete government control of the economy would be best, but that the machinery needs some fine tuning.
Economist Ludwig von Mises demonstrated almost 100 years ago that a state managed economy will simply not work, because among other problems it cannot set workable prices. Only a consumer run economy can do that. Socialists have been trying to disprove Mises’s thesis ever since, but have never succeeded. Piketty should at least read Mises.
Image source: iStockphoto
Interviewed by host John O’Donnell, Peter Klein discusses income inequality cause and effect, role of Fed intervention in capital markets, malinvestment in boom-bust cycles, and the 99% vs the 1% myth. Klein also discusses why boomers are working longer and the impact of youth joining the workplace.
Interviewed by host Alan Butler, Mark Thornton discusses inflation, deflation, and more.
Interviewed by Paul Molloy, Mark Thornton talks about socialism of the Nazi German pattern, the early progressive movement in the U.S., and the dangers of government control.
Interviewed by hosts Steve Floyd, Josh Bennett, and Aaron Bennett, on KFAR 660 AM Fairbanks, Mark Thornton talks about current topics in economics and freedom, and where the U.S. is headed.
Interviewed by host Jay Taylor, John Cochran explains how Keynes’ anti-free market interest rates are destroying life sustaining capitalism.
Interviewed by host Alan Butler, Mark Thornton talks about Keynesian deflation-phobia, as well as the Federal Income tax.
Interviewed by host Angel Clark, Mark Thornton explains and discusses the Skyscraper Index and what it can tell us about the economy.
Interviewed by host Alan Butler, Mark Thornton dispels the notion that a little bit of inflation is a good thing. He also discusses central banking and boom-bust cycles, and addresses the Keynesian contention that loose monetary policy can help lower unemployment.
Interviewed by host Marina Dzhashi, Mark Thornton discusses the U.S. government shutdown and its impact on the country's economy and image abroad.
Interviewed by host Alan Butler, Mark Thornton shoots down the notion of a flexible currency being good for the economy.
Host Alan Butler discusses inflation and fractional reserve banking with Mark Thornton.
Archived from the live Mises.tv broadcast, this lecture was presented by David Gordon at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 24 July 2013.
Archived from the live Mises.tv broadcast, this lecture was presented by Roger Garrison at the 2013 Mises University, hosted by the Mises Institute in Auburn, Alabama, on 22 July 2013.
Interviewed by guest host Tom Woods, Mark Thornton talks about price inflation and the American economy. Recorded 16 April 2013 on the Peter Schiff Show.
From the session on "Austrian Theory and Method," presented at the Austrian Economics Research Conference. Recorded 23 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "Foundations of Libertarian Political Philosophy," presented at the Austrian Economics Research Conference. Recorded 22 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "Applied Economics," presented at the Austrian Economics Research Conference. Recorded 22 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "Advances in the Theory of Entrepreneurship," presented at the Austrian Economics Research Conference. Recorded 21 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "Advances in the Theory of Entrepreneurship," presented at the Austrian Economics Research Conference. Recorded 21 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
Presented at the Mises Circle in Manhattan, hosted by the Ludwig von Mises Institute and sponsored by the Story Garschina Charitable Fund, and Anonymous Donor.
Recorded on Friday, 14 September 2012, at the Metropolitan Club in New York City.
Presented at the Mises Circle in Manhattan, hosted by the Ludwig von Mises Institute and sponsored by the Story Garschina Charitable Fund, and Anonymous Donor. Recorded on Friday, 14 September 2012, at the Metropolitan Club in New York City.
Presented at the Mises Circle in Manhattan, hosted by the Ludwig von Mises Institute and sponsored by the Story Garschina Charitable Fund, and Anonymous Donor.
Recorded on Friday, 14 September 2012, at the Metropolitan Club in New York City.
[Recent Literature on Interest (1903)]
During this entire period the exploitation theory has occupied much space in literary discussions. These have been especially excited and animated on account of a peculiar personal turn that they have taken and sometimes also on account of a kind of dramatic tension. Of all socialistic writers Karl Marx — not perhaps without an unjust depreciation of others, and especially of Rodbertus, whose scientific rank was high — had gained the greatest influence over his partisans. His work represented, so to speak, the official doctrine of contemporary socialism. It therefore occupied the center of attack and defense. The polemical literature of the time became a literature on Marx. The circumstances also were of unusual interest. Marx had died before he had brought his work on capital to an end. The unfinished parts were found in manuscript among his belongings in an almost complete form. These were expected to furnish the explanation of a problem that had been the chief cause of the attack against the exploitation theory and that, according to the expectations of both the contending parties, would furnish the deciding test of the tenableness or untenableness of the Marxian system, the problem, namely, of harmonizing and connecting the rate of profits, which experience shows tends toward equality in all forms of investment, with the law of value and the theory of exploitation that Marx had developed in his first volume.See "Geschichte und Kritik der Capital zins-Theorien," 2d ed., Section XII, p. 530 sq.
The publication of the third volume, in which this theme was treated, was delayed until 1894, 11 years after the death of Marx. The interest in the question regarding what Marx himself might have had to say on this most delicate point of his theory showed itself in a sort of prophetic literature that had for its object the development of Marx's probable opinion on the subject of the average rate of profit from the premises given in his first volume. This prophetic literature fills the decade from 1885–1894, and presents a stately array of more or less extensive publications. I have given a compilation of these on another occasion (in an essay "Zum Abschluss des Marx'schen Systems," in the "Festgaben für Carl Knies," 1896, p. 6). It comprises: Lexis, Jahrbücher für Nationalökonomie, 1885, ν.F., Vol. XI, pp. 452–465; Schmidt, "Die Durchschnittsprofitrate auf Grund des Marx'schen Wertgesetzes," Stuttgart, 1889; an examination of this latter paper by myself in the Tübinger Zeitschrift f d. ges. Staatstv., 1890, p. 590 sq., and by Loria in the Jahrbücher für Nationalökonomie, N.F., Vol. XX (1890), p. 272 sq.; Stiebeling, "Das Wertgesetz und die Profitrate," New York, 1890; Wolf, "Das Räthsel der Durchschnittsprofitrate bei Marx," Jahrbücher für Nationalökonomie, III F., Vol. 2 (1891), p. 352 sq.; again Schmidt, Nene Zeit, 1892–1893, Nos. 4 and 5; Lande, ibid., Nos. 19 and 20; Firenjan, "Kritik der Marx'schen Werttheorie," Jahrbücher für Nationalökonomie, III F., Vol. 3 (1892), p. 793 sq.; finally, Lafargue, Soldi, Coletti, and Graziadei, in the Critica Sociale, from July to November, 1894. Of the other literature of this period on Marx, we may refer to Georg Adler, "Die Grundlagen der Karl Marx'schen Kritik der bestehenden Volkswirtschaft," Tübingen, 1887. The second act and at the same time the climax of the dramatic development was reached in 1894 by Engels's publication of the posthumous third volume. And then follows as a third act an exceedingly animated literary discussion on the critical estimate of this third volume, its relation to the point of departure taken by Marx in the systematic development of his theories, and the future prospects of Marxism, a discussion that is not likely soon to reach a conclusion.Of the writings on this subject that have hitherto appeared may be mentioned: numerous essays in the Neue Zeit, especially by Engels (XIV Jahrgang, .Vol. ι, Nos. ι and 2), Bernstein, and Kautsky; then Loria, "L'opera posthuma di Carlo Marx" (Nuova Antologia, February, 1895); Sombart, "Zur Kritik des Ökonomischen Systems, von K. Marx" (Archivfür soc. Gesetzgebung und Statistik, Vol. VII, Pt. 4); the above-mentioned essay by myself, "Zum Abschluss des Marx'schen Systems," 1896; Komorzynsky, "Der dritte Band von Carl Marx, 'das Kapital,'" in the Zeitschr. für Volkswirtschaft, Socialpoli-tik und Verwaltung, Bd. VI, p. 242 sq.; Wenkstern, "Marx," Leipzig, 1896; Diehl, "Ueber das Verhältnis von Wert und Preis im Ökonomischen System von Carl Marx" (in the "Festschrift zur Feier des 25 jährigen Bestehens des staatsw. Seminars in Halle," Jena, 1898); Labriola, "La teoria del valore di Carl Marx," Milan, 1899; Graziadei, "La produzione capitalistica," Turin, 1899; Bernstein, "Die Voraussetzungen des Socialismus und die Aufgaben der Socialdemokratie," Stuttgart, 1899; Masaryk, "Die philosophischen und sociologischen Grundlagen des Marxismus," Vienna, 1899; Weisengrün, "Das Ende des Marxismus," Leipzig, 1899.
I can content myself here with a mere registration of these events, because in an earlier part of this work I have described their scientific content and subjected them to a critical analysis. Nor have I withheld my opinion that the great test has been decidedly against Marx and his theories of value and surplus value, and that for these the beginning of the end seems to be at hand.
But the period under discussion presents us with another very peculiar theoretical development that must be mentioned in this connection, and which I have called in another place the vulgär-ökonomischen branch of the socialistic theory of exploitation."Einige strittige Fragen der Capitalstheorie," Vienna, 1900, p. III. (Also printed in Vol. VIII of the Zeitschrift für Volkswirtschaft, Socialpolitik und Verwaltung.) This peculiar phenomenon may be described as follows: Various eminent theorists of a nonsocialistic tendency, who do not even recognize the theoretical value-premises of the socialistic exploitation theory, have yet adopted a general view of interest that in its essence is identical with the exploitation theory and differs from it only in its more moderate, more reserved, or less consistent form.
The most characteristic expressions of this kind come from Dietzel and Lexis. Dietzel confesses it to be his opinion that in its essence the exploitation theory is undeniable, and maintains that he is obliged to accept the view that the interest phenomenon is a historical product that is rooted in the commercial law of the present time, and that it is one of those kinds of income that in a form of society like the present are justly blamed as necessarily opposed to the maxim suum cuique.Göttinger Gelehrte Anzeigen, No. 23, 1891, pp. 935, 943. Lexis expresses the opinion that the normal profit on capital is connected with the relations of power brought about by the possession or nonpossession of capital. The source of the slave-holder's profits is unmistakable, and the same may be said of the profits of the "sweater." In the normal relation of the employer to the workman there exists no exploitation of this kind, but an economic dependence of the workman that undoubtedly influences the division of the product of labor. The share of the workman in the yield of production is conditioned by the circumstance, unfavorable to him, that he cannot utilize his working power independently, but is compelled to sell it, resigning his claim to the product for a more or less adequate means of subsistence. Schmoller's Jahrbuch Vol. XIX, p. 335 sq.On another occasion Lexis still more clearly explains this opinion of his on the origin of interest by saying that the capitalistic seller, the producer of raw material, the manufacturer, the wholesale dealer, the retailer, make profits in their business by selling at a higher price than they buy, thereby raising the cost price of their goods by a certain percent. The laborer alone is unable to get a similar advance of price. On account of his unfavorable situation with reference to the capitalist he is compelled to sell his labor at the price that it costs himself, namely, the necessary means of subsistence. Thus, even if capitalists by buying goods at a higher price lose again a part of what they win as sellers, these advanced prices retain their full significance for the wage-earner who buys, and effects the transfer of part of the value of the total product to the capitalist class.Conrad's Jahrbücher, N.F., Vol. XI (1885), p. 453
In all these statements the idea is unmistakably expressed that profits — and not merely some excessive portion acquired under especially burdensome circumstances, but ordinary, normal profits as such — arise from the pressure the possessing classes exert on the nonpossessing by availing themselves of the stronger position that they hold in the struggle for price, an idea that is essentially the same as that which forms the essence of the socialistic theory of exploitation.
In order to characterize these statements, attention should be called to two circumstances that may bear some relation to each other. The first is that up to the present time they have been presented as occasional statements only, and have been made on occasions that prompted the authors to a confession of their own opinions on the interest problem, but did not force them to a systematic defense and explanation of their views, namely, on the occasion of a critical review of other people's theories (Marx's and my own). The second circumstance is that these statements have presented themselves hitherto only as simple expressions of opinion, as confessions of faith of the authors, for which a connected, theoretically tenable foundation has neither been given nor attempted. Dietzel does not add a word in support of his statements, and the brief remarksNamely, that, even under the full pressure of competition, — which is the condition necessary to the levelling of profits to the normal rate, — capitalistic sellers are yet able permanently to maintain a surplus of value above prime costs, and that this is the peculiar fact that requires an explanation such as will be compatible with the laws of value and price, or such as may be plausibly deduced from them. Yet there is nothing in what Lexis says to suggest the existence of these facts. Consult the exhaustive treatment of this subject in my above-mentioned essay, "Einige strittige Fragen der Capitalstheorie," Vienna, 1900, p. 110 sq. with which Lexis accompanies the expression of his opinion are so vague and leave the problem so plainly unexplained that the author himself will hardly claim that they contain, even in general outlines, a really adequate explanation.
In view of the fact that the theoretical grounds on which the views of the exploitation theorists are usually based, namely, the socialistic theories of value and surplus value, are not laid down by these authors as a basis for their allied theory of interest, and in view of the fact that until now no other tenable foundation has been laid for it, as a historian of doctrines I have merely to register the fact that these opinions exist, and that for the present, at least, they exist merely as unproved nontheoretical statements. We must wait to see whether an earnest attempt will be made to elevate these confessions of faith to real theories based on some kind of a foundation, or whether they will die out as mere expressions of feeling to which the tendency of the time inclines without any attempt to bring them into connection with tenable scientific premises.Namely, that, even under the full pressure of competition, — which is the condition necessary to the levelling of profits to the normal rate, — capitalistic sellers are yet able permanently to maintain a surplus of value above prime costs, and that this is the peculiar fact that requires an explanation such as will be compatible with the laws of value and price, or such as may be plausibly deduced from them. Yet there is nothing in what Lexis says to suggest the existence of these facts. Consult the exhaustive treatment of this subject in my above-mentioned essay, "Einige strittige Fragen der Capitalstheorie," Vienna, 1900, p. 110 sq.
This lecture by Walter Block was presented at the 2012 Mises University in Auburn, Alabama. Includes an introduction by Mark Thornton.
This lecture by Roger Garrison was presented at the 2012 Mises University in Auburn, Alabama. Includes an introduction my Mark Thornton.
This lecture by Jeffrey Herbener was presented at the 2012 Mises University in Auburn, Alabama. Includes an introduction my Mark Thornton.
Fascism cartelizes the private sector and denies fundamental rights and liberties to individuals. This describes mainstream politics, writes Llewellyn H. Rockwell Jr.
This audio Mises Daily is narrated by Harold Fritsche.
[Originally published in the Freeman, November 1964, this article is included in Free Market Economics: A Basic Reader, edited by Bettina Bien Greaves.]
Although every businessman aims to earn a "profit," he usually knows very little about the economic nature of his objective. He may even succeed in earning a profit, and yet be unable to explain this excess of proceeds that accrues to him after all expenses are paid.
The same can be said about tax collectors who search for "profits" and aim to seize parts thereof for the state. And the accountants who reveal the "profits" by comparing the business revenue with the expenses. They all look at the totality of net income without any distinction of its various component parts.
The economist who analyzes the economic nature of "profits" actually perceives three entirely different sources of income.
Most proprietors and partners of small businesses who think they are reaping "profits" actually earn what economists call managerial remuneration. They are earning an income through their own managerial labor, supervising their employees, serving customers, working with salesmen, accountants, and auditors. Obviously, their services are very valuable in the labor market. They would earn a good salary if they were to work for the A&P or a 5&10¢ store. Therefore, that part of a businessman's income that is earned through his own labor exertion is a kind of wage or salary, and as such, totally unrelated to economic profits.
Most small businessmen with incomes up to $20,000 and $25,000 fall in this category. In the managerial labor market they would earn this income for services rendered to customers, for buying and selling, supervision of personnel, bookkeeping and accounting, and many other business activities.
But the majority of American enterprises earn an income in excess of managerial remuneration. The economist who dissects this residuum finds yet two other heterogeneous parts. By far the largest part, which is earned by the majority of American enterprises, is interest on the owners or stockholders invested capital. It accrues to the owner on account of the time-consuming nature of the production process.
InterestWhoever refrains from spending his income and wealth and, instead, invests them in time-consuming production can expect a return. For without it no one would relinquish his savings to provide capital for production. Interest ultimately flows from human nature. Men of all ages and races value their present cash more highly than a claim payable in the future. Therefore, in order to induce an investor to relinquish his cash for production, which will yield its fruits in the future, a premium, called originary interest, must be paid. In other words, the businessman who invests in his own enterprise should hope to earn on his investment the same kind of income as the lender who extends a loan to a borrower.
This basic interest return of some 4 percent must accrue to business lest it withdraw its capital from production. As labor will leave an industry that pays low wages, so will capital shun an industry that does not yield a market return. If the government should tax it away or if labor unions should succeed in wresting this interest income from businessmen, production will necessarily contract and ultimately fall into deep depression. No additional capital will be placed at the disposal of an industry whose interest accrual is distributed to workers instead of owners. In fact, the liquid capital of that industry will even be withdrawn and turned to other employment where interest can still accrue. Capital consumption may even destroy what many generations before have built and accumulated.
It is difficult to ascertain the precise rate of originary interest which businessmen earn on account of the time-consuming nature of production. For reasons of comparison we cannot even use the market rate of interest applicable to loan funds because the market rate itself is a gross rate consisting of originary interest, an entrepreneurial profit component that flows from the risks of the individual loan, and finally, a risk premium that flows from the dangers of monetary depreciation wherever inflation is practiced. But for reasons of simple illustration of the originary interest rate, we may use the rate the US government must pay for the use of funds. If we assume that the lender of funds to the US government bears no debtors risk and that inflation does not affect the loan value, we arrive at an interest rate that may constitute the originary rate, which is the rate businessmen should hope to earn as a basic interest return on their invested capital.
Suppose your net worth of business, stated in present value, amounts to $100,000. Originary interest on that amount would come to $4,000 a year, which you would earn even in such riskless investments as US Treasury bonds or savings-banks deposits. As a basis for this interest calculation you would take the estimated present market value of your net worth, for only the present value of your assets, and not the arbitrary book value reflecting past valuations or tax considerations, is meaningful for individual motivation and action.
A merchant with a business net worth of $100,000, spending long days in his shop serving customers, supervising his help, and otherwise managing the business may thus earn $4,000 interest and $20,000 managerial remuneration without actually reaping any profits.
Pure Profits — Temporary Response to Changing Market ConditionsFinally, there are enterprises that do earn pure profits. Through correct anticipation of future economic conditions, businessmen may earn what economists call entrepreneurial profits. For instance, through buying at a time when prices are low and selling when prices are higher, they may earn inventory profits. After interest allowance is made for the time of investment, stock market profits are pure profits. Of course, such profits are connected with risk on account of the uncertainty of the future. Instead of reaping profits, many businessmen suffer losses.
Contrary to popular belief, pure profits are only short-lived. Whenever a change in demand, supply, fashion, or technology opens up an opportunity for pure profits, the early producer reaps high returns. But immediately he will be imitated by competitors and newcomers. They will produce the same good, render identical services, apply similar methods of production, and thus depress prices until the pure profit disappears. The first hula-hoop manufacturer undoubtedly reaped pure profits. But as soon as dozens of competitors had retooled their factories the market was flooded with hula hoops. Prices dropped rapidly until the pure profits had vanished. When the American people suddenly discovered their need for compact cars, American Motors, who was the early manufacturer, temporarily earned pure profits. After General Motors, Chrysler, and Ford invaded the field, American Motors profits returned to the market rate of interest or even changed to losses.
Pure profits are very elusive. But opportunities for profits will emerge as long as there are changes in demand, supply, fashion, population, technology, or even the weather. As all life is change, and economic adjustments need to be made continuously, opportunities for profits will arise again and again.
And yet, in spite of the competitive forces that work incessantly in a free economy to wipe out pure profits, we may observe numerous enterprises that succeed in earning them over lengthy periods of time. The reason must be sought not only in the superior management of some enterprises in which gifted entrepreneurs direct the speculative aspects of business, but also in the different degrees of risk connected with the various industries.
Industries that work with a minimum of risk in stable markets and with stagnant technology must expect to earn the lowest profits. When completely adjusted to consumer demand and without any anticipation of risk, pure profits would indeed be completely eliminated and only the originary interest return would remain. But as even a completely adjusted industry may face future risks, economic or political, and as the risk factor cannot be eliminated entirely from any productive investment, some remnant of pure profit is usually earned by the successful enterprises. This is the reason why even apparently riskless industries continue to earn a little more than the 4 percent originary interest. The successful public utility, for instance, which may bear little investment risk, may earn 6 or 7 percent, which consists of 4 percent interest and 2 to 3 percent pure profit. But the presence of risk also explains why some enterprises in the same industry only earn the interest return or even suffer loss.
On the other hand, the successful enterprises that continuously face high degrees of risk tend to earn higher profits. For several years during the cold-war rearmament, the manufacture of aircraft and parts was exceptionally profitable. According to some statistics, a few aircraft manufacturers earned more than 20 percent of net worth. Even if we bear in mind that corporate net worth is usually understated when compared with present values, and earnings ratios therefore are considerably overstated, we must admit that exceptionally high profits were earned by the most successful enterprises. In short, economic activity that involves a great deal of risk must yield exceptionally high profits to the successful enterprise in order to attract the necessary capital. It is obvious that the aircraft industry that continuously faces a great many imponderables, and often has suffered heavy losses, could not attract the needed capital if no more could be expected than a one percent profit above the originary interest. Or, oil exploration and drilling which entail great financial risks would not be carried on without high rewards for success.
Interference with ProfitsTaxation of these high rewards, or their arbitrary distribution to workers, would eliminate the incentive for risk-taking. Why should a man risk his capital in production if he can only suffer losses? In that case he would shun every productive investment, and search for riskless employment of his funds. The economy thus becomes rigid and inflexible, and unable to adjust to changes in demand, supply, and technology. Expansion and modernization are severely hampered. A confiscatory taxation of pure profits, maliciously called "excess profits," destroys the vitality and dynamism of the market economy. (For an excellent discussion of profit and loss see Ludwig von Mises, Planning for Freedom.)
And what are the effects of taxes levied on the 4 percent basic interest return? As described above, interest is the payment for the use of capital over time. Without it capital cannot be invested and production must come to a standstill. When the government levies its confiscatory taxes on this basic income component, the market must fall into severe depression. In fact, the "multiplier" economists who usually apply their calculations to government spending would do much better calculating the depressive effects of this taxation. Let us assume, for instance, that the government imposes a tax of $1 billion on the interest return of business. At 4 percent this interest constitutes the yield of $25 billion capital invested. And without this yield these $25 billion of business capital will be withdrawn from production, at least as far as it is liquid and can be withdrawn without heavy losses. For why should the owner keep his capital invested without a return?
The Great Depression gave dramatic proof of the depressive effects of confiscatory corporate taxation. And today, we can observe similar stagnating effects whenever the federal or state governments raise their basic levies on business, such as the social-security taxes and unemployment taxes which fall on every business regardless of its profitability.
And, finally, what are the economic effects of taxes that fall on the first-mentioned component, the managerial remuneration? Why should a merchant spend 12 to 16 hours daily in his store if he cannot earn an income that is comparable with the salaries earned by other managers? If profit taxes encroach upon this income the independent businessman will be tempted to sell out to his big competitor and rather earn a salary as a branch manager than to face confiscatory profit taxes.
In economic life it is rather difficult to ascertain the impact of profit taxation. The same tax in some cases may fall on pure profits, in others on basic interest, and yet others on managerial remuneration. The effects, therefore, do vary. In some cases the tax merely prevents risky undertakings, in others it causes depressive restrictions of production, and in yet others it may cause the liquidation of small and medium-sized enterprises.
Addendum on Profit-SharingFor many people, profit-sharing is thought to provide the solution to our labor problems. It is said to hold the key to industrial peace and represent the ideal of industrial democracy. According to a Senate committee report, profit-sharing is "essential to the ultimate maintenance of the capitalistic system." Even some businessmen praise it for giving employees a sense of partnership in the enterprise, raising worker morale, avoiding strikes, reducing turnover, increasing efficiency, and so on. In fact, profit-sharing is said to afford workers a stake in our capitalistic system.
These people do not seem to realize that the market economy is a sharing system. Although hampered and mutilated, American business continues to deliver ever more and better goods. Wages continue to rise on account of improved technology and increased capital investments, not because we work ever harder and longer hours. Competition forces investors and businessmen to share the fruits of their investments with their customers through lower prices and with their workers through higher wages.
But in popular terminology "profit-sharing" proposes to give the workers more than higher wages through competition in the labor market. It means an additional distribution of a businessman's earnings to his employees. Some proposals depend on government or union coercion, others aim at voluntary sharing. Most sharing firms are rather small in size and employment.
The economist who analyzes this supplementary sharing must ask a pointed question. Which part of the business surplus commonly called "profit" is to be divided between businessmen and workers? Is it the "managerial remuneration" which businessmen earn through their own managerial services? Why should independent businessmen yield their labor income while managers and supervisors in the service of large corporations continue to earn a market wage?
Is it the "pure profit" which businessmen are urged to share? Only a small percentage of American enterprises actually earn pure profits. Now, are the fortunate workers who found employment in profitable enterprises to earn more than their fellow workers in average firms? Should an accountant who serves a brilliant stockbroker earn $100,000 per year while his equally competent fellow accountants labor at $5,000 or $6,000? What is to determine his remuneration? But, whatever the sharing plan should provide, it introduces a dubious wage principle: a man's labor income is determined by the ability of his employer. I doubt that this is the matrix for human cooperation, the key to industrial peace. On the contrary, it would create new sources of conflict. Most workers who receive wages only would probably demand "equal pay" from their profitless employers, which would aggravate rather than alleviate the labor situation.
Many people fail to realize that industry doesn't have much profit to share. According to Claude Robinson's excellent analysis, 45 percent of all companies, on the average, are reporting no profits. The average annual earnings for all manufacturing companies amount to 8.6 cents per dollar of investment. "If we allow five cents as a form of interest," Robinson concludes, "the remaining three and six-tenths cents is left for entrepreneurial risk-taking. Should the three and six-tenths cents entrepreneurial fee be shared, it could at best mean an insignificant wage increase, and would surely decrease the willingness of owners to take the investment risks involved in providing better tools for workers. Sharing the entrepreneurial fee, therefore, would likely do the wage-earner more harm than good." (Claude Robinson, Understanding Profits. Princeton, N. J.: D. Van Nostrand, 1961, p. 315.)
Interest on InvestmentAnd finally, there is the "interest" which capitalists usually earn on their invested funds. But, a forced reduction of this basic yield not only prevents capital formation but also causes its withdrawal and consumption. Such profit-sharing on a large scale causes stagnation and depression as the economic history of the past 35 years has repeatedly demonstrated.
Improvements in labor productivity and standards of living largely depend on the increased use of capital. Saving is a fundamental prerequisite of economic progress. It is hard to understand how anyone who has human betterment at heart can urge us to reduce the award of saving by sharing it with those who did not earn it but propose to consume it.
The friends of profit-sharing sometimes argue that if all companies would share their profits, labor productivity would rise greatly and everyone would benefit. But in this case, competition would again reduce prices and profits until there would be no excess profits to share. The benefits of rising productivity would thus accrue to consumers through lower prices and to workers through rising wages. Competition would not tolerate the existence of permanent profits to share. Therefore, profit-sharing can remain only a limited industrial practice.
In many cases even this limited sharing is sailing under false colors. Where labor actually becomes more productive through greater effort and application, its market value rises accordingly. Competition among businessmen will cause wages to rise. A businessman who then proposes to share his profits with his workers may merely be using this means to pay higher market wages. But instead of making payments every Friday, he may hold off paying for six months or a year, and call this profit-sharing. It is my opinion that most of the seemingly successful profit-sharing plans merely constitute plans for delayed payment of that part of wages that is earned through special effort and application.
In all such cases the workers would be well advised to insist on payment of higher wages rather than expose their earnings to the risks of business. Workers may even lose their delayed wages in case the business should lose money through poor management decisions.
From a speech to business executives, Dallas, Texas, April 23, 1965, this article is included in Free Market Economics: A Basic Reader, edited by Bettina Bien Greaves.
The Role of Interest RatesIn our economic system, times of good business commonly alternate more or less regularly with times of bad business. Decline follows economic upswing, upswing follows decline, and so on. The attention of economic theory has quite understandably been greatly stimulated by this problem of cyclical changes in business conditions. In the beginning, several hypotheses were set forth, which could not stand up under critical examination. However, a theory of cyclical fluctuations was finally developed which fulfilled the demands legitimately expected from a scientific solution to the problem. This is the circulation-credit theory, usually called the monetary theory of the trade cycle. This theory is generally recognized by science. All cyclical policy measures, which are taken seriously, proceed from the reasoning which lies at the root of this theory.
According to the circulation-credit theory (monetary theory of the trade cycle), cyclical changes in business conditions stem from attempts to reduce artificially the interest rates on loans through measures of banking policy — expansion of bank credit by the issue or creation of additional fiduciary media (that is, banknotes and/or checking deposits not covered 100 percent by gold). On a market, which is not disturbed by the interference of such an "inflationist" banking policy, interest rates develop at which the means are available to carry out all the plans and enterprises that are initiated. Such unhampered market interest rates are known as "natural" or "static" interest rates. If these interest rates were adhered to, then economic development would proceed without interruption — except for the influence of natural cataclysms or political acts such as war, revolution, and the like. The fact that economic development follows a wavy pattern must be attributed to the intervention of the banks through their interest rate policy.
The point of view prevails generally among politicians, business people, the press and public opinion that reducing the interest rates below those developed by market conditions is a worthy goal for economic policy, and that the simplest way to reach this goal is through expanding bank credit. Under the influence of this view, the attempt is undertaken, again and again, to spark an economic upswing through granting additional loans. At first, to be sure, the result of such credit expansion comes up to expectations. Business is revived. An upswing develops. However, the stimulating effect emanating from the credit expansion cannot continue forever. Sooner or later, a business boom created in this way must collapse.
At the interest rates which developed on the market, before any interference by the banks through the creation of additional circulation credit, only those enterprises and businesses appeared profitable for which the needed factors of production were available in the economy. The interest rates are reduced through the expansion of credit, and then some businesses, which did not previously seem profitable, appear to be profitable. It is precisely the fact that such businesses are undertaken that initiates the upswing. However, the economy is not wealthy enough for them. The resources they need for completion are not available. The resources they need must first be withdrawn from other enterprises. If the means had been available, then the credit expansion would not have been necessary to make the new projects appear possible.
The Sequel of Credit ExpansionCredit expansion cannot increase the supply of real goods. It merely brings about a rearrangement. It diverts capital investment away from the course prescribed by the state of economic wealth and market conditions. It causes production to pursue paths which it would not follow unless the economy were to acquire an increase in material goods. As a result, the upswing lacks a solid base. It is not real prosperity. It is illusory prosperity. It did not develop from an increase in economic wealth. Rather, it arose because the credit expansion created the illusion of such an increase. Sooner or later it must become apparent that this economic situation is built on sand.
Sooner or later, credit expansion, through the creation of additional fiduciary media, must come to a standstill. Even if the banks wanted to, they could not carry on this policy indefinitely, not even if they were being forced to do so by the strongest pressure from outside. The continuing increase in the quantity of fiduciary media leads to continual price increases. Inflation can continue only so long as the opinion persists that it will stop in the foreseeable future. However, once the conviction gains a foothold that the inflation will not come to a halt, then a panic breaks out. In evaluating money and commodities, the public takes anticipated price increases into account in advance. As a consequence, prices race erratically upward out of all bounds. People turn away from using money which is compromised by the increase in fiduciary media. They "flee" to foreign money, metal bars, "real values," barter. In short, the currency breaks down.
The policy of expanding credit is usually abandoned well before this critical point is reached. It is discontinued because of the situation which develops in international trade relations and also, especially, because of experiences in previous crises, which have frequently led to legal limitations on the right of the central banks to issue notes and create credit. In any event, the policy of expanding credit must come to an end — if not sooner due to a turnabout by the banks, then later in a catastrophic breakdown. The sooner the credit expansion policy is brought to a stop, the less harm will have been done by the misdirection of entrepreneurial activity, the milder the crisis and the shorter the following period of economic stagnation and general depression.
The appearance of periodically recurring economic crises is the necessary consequence of repeatedly renewed attempts to reduce the "natural" rates of interest on the market by means of banking policy. The crises will never disappear so long as men have not learned to avoid such pump-priming, because an artificially stimulated boom must inevitably lead to crisis and depression.
This article is excerpted from The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, chapter 3, part II, "Cyclical Changes in Business Conditions."
[The Austrian School of Economics: A History of Its Ideas, Ambassadors, and Institutions (2011)]
The up-and-coming Austrian School received support from abroad even during the Methodenstreit. Léon Walras mentioned already well-known supporters of the new value theory from among the Romance countries in the preface to his Théorie de la monnaie (1886). In English publications, the subjectivist theory of value was gaining increased acceptance as well (cf. Böhm-Bawerk 1889b). The fact alone that it had been discovered at almost the same time by three authors (Walras, Menger, and Jevons) was considered by Böhm-Bawerk to be substantive evidence of its veracity (Böhm-Bawerk 1891/1930, p. 132 n. 1). In contrast, Gustav Cohn (1840–1919), an advocate of the Historical School, interpreted this brisk publishing activity to mean that the discovery of the marginal utility constituted a "meager morsel" that would have to be shared by "a number of like-minded discoverers" (Cohn 1889, p. 23).
Yet within months, the derisive phrase "meager morsel" was impressively refuted. In 1889 alone, members of the Austrian School published a notable number of monographs offering productive suggestions for further development: Böhm-Bawerk, Positive Theorie des Kapitales (Positive Theory of Capital); Zuckerkandl, Zur Theorie des Preises ("On the Theory of Price"); Wieser, Der natürliche Wert (Natural Value); Schullern zu Schrattenhofen, Untersuchungen über Begriff und Wesen der Grundrente ("Analyses of the Concept and the Essence of the Ground Rent"); Sax, Neueste Fortschritte in der nationalökonomischen Theorie ("Recent Advancements in the Theory of Economics"); and Komorzynski, Der Wert in der isolirten Wirtschaft ("The Value in the Isolated Economy"). Böhm-Bawerk achieved the most lasting impact by far. With his Positive Theory, he not only laid the foundations for an "Austrian" theory of capital and interest, but made a critical contribution to the international reputation of the Austrian School. He became one of the most discussed and quoted economists of his time.
During a seminar led by Carl Gustav Adolf Knies (1821–1898) at the University of Heidelberg, Böhm-Bawerk, as a scholarship recipient, had already thoroughly considered the relationship between the present and the future by posing the question: why is a debtor prepared to pay the creditor interest for a loan on top of paying back the amount of the loan itself? He answered this by explaining that future goods have a lower value than present goods, and the result is a difference in value between the present and the future: between loan and repayment. Payment and return are deemed equivalent when the difference in value has been balanced by a "quantitative plus," namely, interest. Without specifying further, he argued that a "self-induced creation of capital value" (cited after Yagi 1983, p. 32), would make repayment of such amounts economically feasible for a debtor.
The publication of Positive Theory was preceded by a wide-ranging, virtually complete collection and appraisal of all the established theories of capital and interest. Böhm-Bawerk dealt with more than 150 authors and laid out an exemplary history of dogma, whose structure suggests that he had already put together a complete draft of Positive Theory (cf. Tomo 1994, p. 92). Die Geschichte und Kritik der Kapitalzinstheorien (1884) (History and Critique of Theories of Interest) would give the further development of the Austrian School direction in two ways in particular: first, Böhm-Bawerk subjected the socialist labor theories of value by Johann Karl Rodbertus (1805–1875) and Karl Marx (1818–1883) to a detailed and consistently deprecatory criticism, thus laying the foundation for the critique of Marxism in the Austrian School's tradition (Böhm-Bawerk 1890/1884, pp. 328–392). Second, he dismissed Carl Menger's utility theory, according to which capital rent is the remuneration for the hired use of capital. Böhm-Bawerk's objection was that Menger considered a "good" and the "disposal over goods" to be two separate value repositories, and would lead to an incorrect double count (ibid., p. 260). This was simply the logical outcome of his definition of the term "good," which differed from Menger's, and which Böhm-Bawerk had already presented in his revised postdoctoral thesis (cf. Böhm-Bawerk 1881/2006, pp. 16–17; and Menger 1950/2007, pp. 52–53). This divergence and its consequences resulted in the founder of the Austrian School's taking a detached view of its definitive theory of capital and interest throughout his life.
In his Positive Theory, the publication of which was held up for years, Böhm-Bawerk defined "capital" as "a group of products destined to serve towards further production" or as "a group of intermediate products" (Böhm-Bawerk 1891/1930, p. 38). Based on this notion of capital, three kinds of capital yield were conceivable: revenue from a loan, revenue from renting out a durable good, or revenue from a production process. All three types of revenue could ultimately be explained by the subjectivist value theory. The starting point had been the observation that in general, present goods were valued more highly than future goods of equal kind and number. Two reasons can be cited. First, the ratio between demand and supply varies at different points in time because personal circumstances and future expectations are constantly changing (ibid., p. 249). Second, we systematically underrate our "future needs" as well as the "means to meet them." The causes of this misjudgment are our hazy picture of the future, our weakness of will, and our "consideration of the brevity and incertitude of life" (ibid., pp. 253–256; cf. Menger 1950/2007, pp. 150–152). Böhm-Bawerk concluded from all this that "we look at the marginal utility of future goods diminished, as it were, in perspective" and that thus "[t]he agio on present goods moves upwards." (Böhm-Bawerk 1891/1930, pp. 258–259).
There is a third reason for the upward pressure on this agio ("premium"), however, which does not reside in the sphere of the consumer but in that of the producer. According to Böhm-Bawerk, it is in the nature of capitalist production that the elementary economic productive forces — labor and land use, possibly also in combination with natural forces — are combined in such a way that consumer goods are created either directly or indirectly. As a general rule, such "indirect production" would also lead to a greater result in output. Thus one could use nothing but one's hands to break stones out of a rock face, or one could first extract iron, then use it to make hammer and chisel, and then get to work. An even greater and more time-consuming form of indirect production would be to take sulfur and sodium nitrate to manufacture gun powder, fill it into drilled holes and thus blast out the rocks. An operation like this would increase the result in output many times over (ibid., p. 19). However, this rule would only apply for a "wisely chosen capitalist process" (ibid., p. 82). With increasing diversity in production, the additional revenue would then decrease again after a certain point (ibid., pp. 85–86).Böhm-Bawerk borrowed the concept of "productive diversion" and its "additional revenue" from a number of predecessors, whose ideas he developed and formulated more stringently. Later it would turn out that John Rae (1796–1872), a Scotsman who had emigrated to Canada and fallen into oblivion, had already pre-empted the Positive Theory on key points in 1834. cf. Böhm-Bawerk 1890/1959, pp. 208–240.
Interest, according to Böhm-Bawerk, thus has psychological and productive–technical causes. It also exists independently of the prevailing economic and social system. A difference in value would exist between present and future goods even in a "socialist state." The "interest principle" can therefore in no way be conceived as "exploitation" because it is not a "historico-legal," category, "but an economic category, which springs from elementary economic causes" (ibid., pp. 367, 371; italics in the original).
Böhm-Bawerk, who considered the basic principles of his theory of capital and interest to be "unusually simple and natural" (Böhm-Bawerk 1891/1930, p. xxvi), had to supplement and expand his work considerably in order to combine the subjectivist value theory with his capital theory. He thus made a clear distinction between the reasons for the origin of interest and those which were responsible for the specific interest rate. Furthermore, as he had combined heterogeneous intermediate products and their variously long, indirect production paths under the term "capital," he had to introduce the term "average period." This was illustrated with a simple diagram of figures (ibid., p. 89). Moreover, he adopted Stanley Jevons's concept of "wage funds" (cf. Jevons 1871/1970, chap. 8) because the laborers involved in indirect production paths had to be supported for the duration of the production process (Böhm-Bawerk 1891/1930, pp. 318–319). Finally, the subjectivist value theory had to be reconciled with the law of costs, which states that in the long term, the market price of reproducible goods will equal the production costs (ibid., pp. 223–234). These and other "additions" meant that the basically elegant theoretical structure appeared more and more contrived and overburdened.
Nevertheless, Böhm-Bawerk's Positive Theory had an enormous impact internationally. It was translated into English as early as 1891, and into French soon afterward. In 1892, Swedish economist Knut Wicksell (1851– 1926) saw to its mathematical reformulation. By the turn of the century, Böhm-Bawerk was counted among the world's most famous and talked about economists (cf. Kurz 1994, p. 151). A second edition was published in 1900, and it contained a heftily expanded criticism of Marx. A third was published in 1913. Both editions included excursuses in which responses were given to objections that had been raised (cf. Böhm-Bawerk 1921, vol. 3). Finally, Friedrich von Wieser arranged for a fourth publication in 1921 — a complete edition in three volumes that was to be published under the title Kapital und Kapitalzins (Capital and Interest).
Menger, whose notion of capital fundamentally differed from Böhm-Bawerk's, took up an extremely critical stance. In small circles he even went so far as to call Böhm-Bawerk's theory "one of the greatest errors ever committed" (Schumpeter 1954, p. 847 n. 8). There has been much speculation as to what might have led to Menger's stern rejection. It could hardly have been Böhm-Bawerk's insufficiently consistent subjectivism, as even Menger's definitions of value theory contained some residual objectivism (cf. Gloria-Palermo 1999, pp. 39–50; Mises 1960/2003, pp. 177, 183–185). A distinctive dividing line, however, were their differing methodological approaches. Menger took Böhm-Bawerk to task for the "obvious artificiality" of some of his theories (Menger 1915/1970, pp. 11, 16). Böhm-Bawerk did indeed demonstrate an almost unconcerned, pragmatic-eclectic attitude when it came to methodological questions. Characteristic of this attitude was his rejection of the use of mathematics in economics. This was not for fundamental epistemological reasons, as was the case with Menger, but because he, along with most of his faculty colleagues, utterly lacked the necessary mathematical skills (cf. Böhm-Bawerk 1894c, pp. 163–165). Furthermore, Positive Theory seems in some respects to point in the direction of modern macroeconomics. Unlike other key works of the "Austrians," it contains an unmistakable tendency to create highly abstract aggregates, and demonstrates a hearty propensity to quantify, albeit in the modest guise of simple forms of calculation.
Böhm-Bawerk's theory was also met with reservation, or even rejection, by the successive generations of the Austrian School. The twenty-eight-year-old Joseph A. Schumpeter (1883–1953) developed his own "dynamic theory of interest" (Schumpeter 1912/1934/1961, pp. 157–211), which must have appeared to Böhm-Bawerk as a defamation of middle-class economic morality and a heralding of inflationist daredevil policies. Böhm-Bawerk rejected it with rare forcefulness (Böhm-Bawerk 1913a; Böhm-Bawerk 1913b). Schumpeter's response was accordingly subdued (Schumpeter 1913, pp. 599–639). In the context of Böhm-Bawerk's seminars, Ludwig von Mises (1881–1973) also made the criticism that his theory of capital and interest had proceeded on the assumption of a "neutrality of money." According to Mises, Böhm-Bawerk moved far beyond his published theories by the end of his life (cf. Mises 1978/2009, p. 47; also Elster 1923, p. 164).
It was finally Emil Sax who, in Der Kapitalzins (1916) ("Interest on Capital"), presented the first comprehensive critique of Böhm-Bawerk and compiled all of the arguments that future authors would raise against him. Böhm-Bawerk's theory of capital and interest was "a chain of thought too elaborately spun out, and, owing to its unevenness, unable to withstand a tensile test" (Sax 1916, p. 229). Above all, Sax believed he could prove that each of three reasons for a value difference between present and future goods was questionable, that durable goods (fixed capital) as such could not yield any interest, that the term "average roundabout production process" ("durchschnittlicher Produktionsumweg") was too indeterminate, and that the Positive Theory did not account for compound interest. Thus, Der Kapitalzins documented just another step in the drifting apart of the Austrian School at the height of its international eminence. External events such as Menger's permanent withdrawal from university activity, Böhm-Bawerk's death in 1914, and the outbreak of the war, however, scarcely allowed this internal split to come to the surface (cf. Elster 1923, p. 163).
In the last analysis, no economist of note agreed with Böhm-Bawerk on every point. But for decades his work continued to have an unusually inspiring and fruitful impact (cf. Schumpeter 1954, p. 930; Kurz 2000, p. 153). Among the representatives of the Austrian School, Böhm-Bawerk was always revered as one of the greats. The generation of academics who came after World War I felt compelled to qualify his work and make manifold changes or other shifts in emphasis. But this did little or no harm to the remarkable fascination with which Böhm-Bawerk's theory of capital and interest is treated to this very day. This undiminished appeal might be due to the fact that Böhm-Bawerk's monumental theory reveals a glimpse of the "hidden logic" or the "grammar of economic phenomena" (Orosel 1986, pp. 127–128).
This article is excerpted from The Austrian School of Economics: A History of Its Ideas, Ambassadors, and Institutions (2011), chapter 6: "Time Is Money: The Austrian Theory of Capital and Interest."
Consumers and entrepreneurs often speak of "the cost of money" when referring to interest rates. Modern lenders also refer to the interest they charge as "loan pricing." Viewed this way, interest is viewed as if it were any other good. The cheaper a good the more affordable it is. And so the lower the interest rate, the more affordable. By dictating key interest rates, modern central bankers are believed to be alchemists, lowering interest rates to magically transform scarcity into prosperity.
As the world struggles to deleverage, with the market constantly forced to clear malinvestments of a continuous string of asset bubbles and crashes, central bankers continue their faith in the ancient tradition. All the economy needs is more monetary elixir. If the patient hasn't yet responded, it must mean larger doses are needed: Interest rates must be too high.
The mainstream view has devolved to the belief that zero is too high. In the spring of 2009, Harvard economist, and former adviser to President George W. Bush, N. Gregory Mankiw seriously wrote in the New York Times, "It May Be Time for the Fed to Go Negative." But who would lend money to only receive less in return?
Mankiw approvingly cites German economist Silvio Gesell's argument for a tax on holding money, an idea John Maynard Keynes himself approved of. Crazier still is Mankiw's idea that one of his graduate students floated, of turning interest-rate policy into an absurd game of chance.
Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.
Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn't a flaw — it's a benefit.N. Gregory Mankiw, "It May Be Time for the Fed to Go Negative," New York Times, April 18, 2009.
Mankiw recognizes that the idea of negative interest rates is nonsense to most people. But he writes, "Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace."
However there is nothing new about the idea of the state juicing up an economy with low interest rates. John Law's monetary theory for an ailing France in the early 1700s was built on a foundation of low interest rates. The Scottish economist and policy maker believed interest rates were derived from
(1) the quantity of money, (2) the quality of the government, and (3) the security of the state's debt. If the quantity of money increased relative to the demand for it, the government of the country was good, and the state debt secure, then, interest rates would fall.Antoin E. Murphy, John Law: Economic Theorist and Policymaker (Oxford: Oxford University Press, 1997), p. 65.
The result of Law's monetary experiment was the famous Mississippi Bubble that devastated the French economy. The continuous injections of new money that Law flooded into the market not only rushed into Mississippi Company shares, but into commodities as well, while money wages for the French working class never caught up.
And so it goes today.
However, Keynesians are undeterred in their belief that low interest rates put people back to work and solve all economic woes, albeit with nagging liquidity-trap apprehension. Keynes believed the rate of interest is "the reward for parting with liquidity for a specific period … is a measure of the unwillingness of those who possess money to part with their liquid control over it."John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and Company, 1936), p. 167.
Keynes believed that those who hold cash for the speculative motive to be wicked. And it is up to central bankers to stop this evil. However, Henry Hazlitt explained in The Failure of the "New Economics," holding cash balances
is usually most indulged in after a boom has cracked. The best way to prevent it is not to have a Monetary Authority so manipulate things as to force the purchase of investments or of goods, but to prevent an inflationary boom in the first place. Henry Hazlitt, The Failure of the "New Economics" (Princeton, N.J.: D. Van Nostrand,1959), p. 190.
Keynes thought money to be barren as a store of wealth while investments yielded returns, writing "Why should anyone outside a lunatic asylum wish to use money as a store of wealth?"
If liquidity preference determined the rate of interest, rates would be lowest during a recovery and at the peak of booms, with confidence high, everyone would be seeking to trade their liquidity for investments in things. "But it is precisely in a recovery and at the peak of a boom that short-term interest rates are highest," Hazlitt writes.
Time is what Keynesians leave out of their calculus. While lenders may think they are lending money, they are really lending time. Present goods are more valuable than future goods. Borrowers buy the use of time. Hazlitt reminds us that the old word for interest was usury, "etymologically more descriptive than its modern substitute."
Borrowers pay interest in order to buy present assets. It is time preference that determines interest: the discount of future goods as against present goods. Most importantly, this ratio is outside the reach of the monetary authorities. It is determined subjectively by the actions of millions of market participants.
Central bank manipulation of interest rates can never fix an ailing economy. It is impossible for the monetary authorities to dictate the proper interest rate. Interest rates determined by command and control bear no relation to the collective time preference of economic actors. The result of central bank intervention can only be distortions and chaos.
Those pushing the monetary buttons are naïve in believing they can steer the economy by setting interest policy when, in fact, they don't understand what interest is or how the rate of interest is determined.
The following essays parse through the uniquely Austrian insight of the pure time-preference theory of interest, but more importantly go to the core of why modern central bank monetary engineering leaves the economy further from recovery while at the same time providing a Petri dish for speculation and malinvestment.