Saturday, January 12, 2008

Credit Expansion, Economic Inequality, and Stagnant Wages

Capital in the form of credit is normally and, certainly, properly, extended out of previously accumulated savings. In sharpest contrast, credit expansion is the creation of new and additional money out of thin air, which money is then lent to business firms and individuals as though it were a supply of new and additional saved up capital funds. Its existence serves to reduce interest rates and to enable loans to be made and debts to be incurred which otherwise would not have been made or incurred. Always and everywhere, to the extent that private banks participate in the process of credit expansion, they do so with the sanction and generally with the active encouragement of the government.

Economists, above all Ludwig von Mises, have shown how credit expansion is responsible for the boom-bust business cycle and how its existence depends on deliberate government policy. Nevertheless, public opinion believes that the business cycle is an inherent feature of capitalism and that the role of government is not that of causing the phenomenon but of combating it. Indeed, as Mises observed, “Nothing harmed the cause of liberalism [capitalism] more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy.”

The truth is that credit expansion is responsible not only for the boom-bust cycle but also for another major negative phenomenon for which public opinion mistakenly blames capitalism. Namely, sharply increased economic inequality, in which the wealthier strata of the population appear to increase their wealth dramatically relative to the rest of the population and for no good reason.

It is not accidental that the two leading periods of credit expansion in history—the 1920s and the period since the mid 1990s—have been characterized by a major increase in economic inequality. Both in the 1920s and in the more recent period, a major cause of the increased economic inequality is that the new and additional funds created in credit expansion show up very soon in the financial markets, where they drive up the prices of securities, above all, common stocks. The owners of common stock are preponderantly wealthy individuals, who now find themselves the beneficiaries of substantial capital gains. These gains are the greater the larger and more prolonged the credit expansion is and the higher it drives the prices of shares. In the process of new and additional money pouring into the financial markets, investment bankers and stock speculators are in a position to reap especially great gains.

Since it’s so important, the main point just made needs to be repeated: credit expansion creates an artificial economic inequality by showing up in the stock market and driving up stock prices. Since the stocks are owned mainly by wealthy people, they are the main beneficiaries of the process. The more substantial and the more prolonged the credit expansion is, the larger are the gains enjoyed by wealthy people more than anyone else.

The new and additional funds injected into the economic system also soon show up in an additional demand for capital goods, such as business inventories and plant and equipment, and in an additional demand for consumers’ durable goods, such as houses and automobiles. The purchase of these latter goods, like the capital goods purchased by business firms, depends largely on credit and is encouraged by lower interest rates. It is also fed by the capital gains being reaped by wealthy individuals, which results in an especially pronounced increase in the demand for luxury housing and for luxury goods in general.

The additional demand for capital goods and consumers’ durable goods serves to increase business sales revenues and thus business profits across a wide spectrum of the economic system. Credit expansion increases profits in the economic system because the expenditure of the new and additional money in buying capital goods and labor increases the sales revenues of business firms immediately, while it increases the costs they must deduct from those sales revenues only with a time lag. This is also true to an extent of inflation that enters the economic system by means of its creators simply spending the new and additional money rather than lending it out—“simple inflation,” as Mises calls it. What is present in both kinds of inflation—credit expansion and simple inflation—is the fact that sales revenues rise as soon as new and additional money is spent, but the costs deducted from the sales revenues of any given year largely reflect outlays of money made in previous years. In those previous years the quantity of money and volume of spending of virtually all types was smaller, including the spending that shows up in the present year as costs in business income statements.

Credit expansion boosts profits more than does simple inflation because the reduction in interest rates it brings about serves to increase the time lag between the making of expenditures for capital goods and labor and their subsequent appearance as costs in business income statements. The low interest rates encourage the purchase of such things as durable machinery and the undertaking of construction projects. The kind of increase that this must bring about in economy-wide profits can be seen in the following examples.

Thus in one case, imagine that a business firm uses newly created money that has come into its hands to increase its newspaper advertising, say. Its additional expenditure will be equivalent additional sales revenue to the newspaper. It will also most likely be an equivalent immediate additional cost to it—a cost that it must deduct from its sales revenues in its very next income statement. Thus, in the same accounting period that the newspaper records additional sales revenues equal to the firm’s additional expenditure, the firm itself must record an equal additional cost of production to deduct from its own sales revenues. Obviously, in this case there is no increase in the economy-wide aggregate amount of profit. This is because economy-wide, aggregate sales revenues and economy-wide aggregate costs have both increased to the same extent.

But now imagine that the firm spends the same amount of money in buying durable machinery that will be depreciated over a ten-year period. Once again, a seller, this time the seller of the machinery, will immediately have additional sales revenues equal to our firm’s additional expenditure. But in this case, our firm will certainly not have an equally large additional cost of production to report in its next income statement. If its expenditure for the machinery was $1 million, say, then while the seller has $1 million of additional sales revenues in his next annual income statement, our firm will probably have merely $100 thousand of additional costs to report in its next annual income statement. This is because the purchase price of the machine is not charged off all at once, but only gradually, over its depreciable life. The implication of this example is that in the current year there will be an addition of $900,000 to economy-wide, aggregate profits. If our firm’s $1 million were part of an investment in the construction of a building with a forty-year depreciable life, the implied addition to economy-wide, aggregate profits would be even greater.

Such boosts to profits go hand in glove with the rise in common-stock prices and greatly reinforce them. Of course, once credit expansion comes to an end, the stimulus it gave to profits and to the stock market both disappear and at that point profits plunge and capital gains turn into capital losses. And at that point, the enemies of capitalism turn to attacking capitalism for causing depressions.

Now as the new and additional money created in credit expansion works its way through the economic system, one would expect the demand for labor and thus wage rates also to rise. This certainly does tend to happen and in the 1920s wages increased substantially in terms both of money and real buying power. They simply did not increase to nearly the same extent as the incomes of the wealthier strata of the population, nor, of course, to the extent that business profits increased.

In addition to the special stimulus given to profits, a second reason for the failure of wages to keep pace with the rise in profits, is that the encouragement given by credit expansion to the purchase of durable capital goods, particularly plant and equipment, tends to take place at the expense of funds that otherwise would be devoted to the purchase of labor services. As a result, the rise in wages is retarded at the same time that profits sharply advance. For this reason too it does not keep pace with the rise in profits.

Despite any appearances to the contrary, the rise in real wages in the 1920s was not the result of credit expansion but of rising production. Credit expansion actually operated to retard the rise in production insofar as it caused the wasteful investment of capital, i.e., what Mises calls malinvestment.

The rise in production is what prevented the prices of goods and services from rising as rapidly as credit expansion raised wage rates in terms of money. The rise in production, in turn, was based on a high degree of availability of capital funds provided by actual savings, as opposed to credit expansion, together with rapid scientific and technological progress. It was this that increased real wages, i.e., the goods and services that wage earners could actually buy with their wages.

In contrast to the experience of the 1920s, in the two great recent credit expansions, i.e., the bubble of 1995-2001 and its successor the presently collapsing housing bubble that began not long thereafter, there has been very little, if any, rise in real wages. Most commentators appear to attribute this to nothing more than the unrestrained greed of businessmen and capitalists. They apparently go on the theory that if there is anything in the economic system that breathes or moves other than at the command of the government, or other than with the active supervision and control of the government, it is proof that we live in an era of “laissez-faire.” For example, in The New York Times of December 30, 2007, in an article titled “The Free Market: A False Idol After All?,” Times columnist Peter Goodman writes:

For more than a quarter-century, the dominant idea guiding economic policy in the United States and much of the globe has been that the market is unfailingly wise. So wise that the proper role for government is to steer clear and not mess with the gusher of wealth that will flow, trickling down to the [sic] every level of society, if only the market is left to do its magic.

That notion has carried the day as industries have been unshackled from regulation, and as taxes have been rolled back, along with the oversight powers of government.
This alleged laissez-faire environment, such writers pretend, has enabled businessmen and capitalists shamelessly to enrich themselves at the expense of increasingly impoverished wage earners, to whom nothing any longer even “trickles down.” Increased free trade and “globalization,” of course, are attacked as part of the process and as greatly contributing to the stagnation or outright decline in real wages.

In sharpest contrast to such blather, in the real world there are innumerable rules and regulations enacted by the Federal Government to control virtually every aspect of economic activity. They are contained in the more than 70,000 pages of The Federal Register. The overwhelming mass of government interference described therein, and in its counterparts at the state and local level, is a glaring refutation of claims about the existence of any kind of laissez faire in the present-day world. The very description of such interference, in tens of thousands of pages of official text, is a refutation of such size and literal weight as to render any claims about laissez faire or insufficient government controls or regulations utterly nonsensical.

This truly massive body of material also suggests that the actual explanation of the stagnation in real wages is precisely an ever growing burden of government intervention in the economic system. The intervention is in the form of policies that undermine genuine saving and in numerous other ways undermine capital accumulation and the rise in the productivity of labor. Personal and corporate income taxes, the inheritance tax, the capital gains tax, and government budget deficits—all entail the taking away of funds that if left in the hands of their owners would have been heavily spent, indeed, overwhelmingly spent, in the purchase of capital goods and labor services. Instead, those funds are diverted into financing the consumption of the government and those to whom the government gives money.

Inflation and credit expansion greatly exacerbate this diversion of funds, because their effect is artificially to increase the incomes subject to these taxes and to thus to deprive business firms of the funds required to replace assets at prices made higher by the same process that increases their taxable incomes. The progressive aspect of income and inheritance taxes also worsens their effects, because incomes tend to be saved and invested the more heavily the larger they are; at the same time, substantial inheritances are more likely to be retained in the form of accumulated savings and capital than are modest inheritances.

Because of the reduced demand for labor that results from the taxation of funds that would otherwise have been used in employing labor and in buying capital goods, wages are substantially less than they otherwise would have been. At the same time, the buying power of those reduced wages is also sharply reduced in comparison with what it would otherwise have been.

It is worth pointing out that totally apart from the effect of social security in undermining the incentive to save, the sheer rise in tax rates since 1965 to pay for the system has taken away fully eight additional percentage points of the income of every wage earner whose earnings are equal to or less than the amount subject to such taxation. In 1965 the combined social security tax on wage earners and their employers was 7.25 percent, which applied to a maximum annual income of $4800. Today, the combined rate is 15.3 percent, which includes 2.9 percent for Medicare. The 15.3 percent rate currently, i.e., in 2008, applies to all wages and salaries up to a maximum of $102,000 per year. The effect of these major increases both in social security tax rates and in the amount of income
subject to them has been to reduce the take-home wages of many workers by considerably more than 8 percent.

The social security contribution of employers is a loss to wage earners, because it is a cost of employment no different than the payment of take-home wages. Financially, it is a matter of indifference to employers whether they pay this sum to the government or to their employees. The cost to them is the same. It is money that the employees could and would have had, if the government had not taken it from the employers.

The same is true of all other costs borne by employers on behalf of their workers, whether it is health insurance, day care, family leave, or whatever. The costs in question are all costs of employment, which, in the absence of such government interference, the wage earners could and would have had in their own pockets. Compelling employers to pay the costs of such things is at the expense of the workers’ take-home wages. The more such costs are imposed, the lower are take-home wages in comparison with what they otherwise would have been. The increase in such costs over time has correspondingly held down any rise in take-home wages.

Government intervention, as I’ve said, not only holds down the demand for labor and thus wages, particularly take-home wages, but it also reduces the buying power of wages. This is because the supply of capital goods is less, thanks to the diversion of funds from their purchase. The absence of these capital goods prevents the productivity of labor from being increased as much as it otherwise would have been. This in turn holds down the production both of consumers’ goods and of further capital goods. The consequence of a lesser supply of consumers’ goods is prices of consumers’ goods that are higher than they otherwise would have been and thus a buying power of wages that is correspondingly lower than it otherwise would have been.

The consequent absence of further capital goods compounds the negative effect on production, in a process that can be repeated over and over again, with each passing year. What this means is that because fewer capital goods in the form of factories and machines are available this year, the ability to produce capital goods in the form of factories and machines for the following year is reduced, because capital goods in the form of factories and machines are the means of producing further capital goods in the form of factories and machines no less than they are of producing consumers’ goods.

The buying power of wages is also reduced by all of the other laws and regulations that hold down the production and supply of goods in general and thus keep up prices. And again, there is a compounding effect. Environmental legislation deserves an especially prominent place in any list of such laws and regulations. Already, because of the restrictions it has imposed on the production of oil, coal, natural gas, and atomic power, it has served to raise the price of energy to unprecedented levels and to deprive many wage earners of the ability to buy gasoline for their cars or trucks and heating oil for their homes. To the extent that wage earners are able to pay energy prices reflecting a $100- per-barrel price of oil, their ability to buy other goods is correspondingly reduced. If the environmental movement’s agenda of radical reductions (up to 90 percent) in carbon dioxide emissions is imposed, meeting it will require absolutely crippling cutbacks in the production and use of oil, coal, and natural gas which must result in corresponding reductions in production, increases in prices, and absolute devastation for real wages.

The negative effect on production here is again a cumulative one, inasmuch as lack of energy supplies hampers the ability to find and exploit further supplies of energy. The more abundant and cheaper energy is, the greater is man’s ability to move masses of earth and to process them, thereby developing further energy supplies. Thus, government intervention that reduces energy supplies reduces the ability to find and exploit further energy supplies.

Other examples of laws and regulations holding down production are minimum-wage, prounion, and licensing legislation. These cause higher costs, higher prices, the diversion of labor from more productive pursuits to less productive pursuits, and, finally, unemployment. Subsidies of all kinds, tariffs, and consumer-product safety legislation also serve to hold down the production and supply of things and to keep up or add to their costs and prices. Again, to whatever extent production in general is curtailed, so too is the production of capital goods, with a consequent cumulative negative effect on subsequent production.

It should be clear that the resumption of an era of high and progressively rising real wages requires a radical reduction of government intervention into the economic system and the reestablishment of economic freedom.

What we have seen is that credit expansion is responsible not only for the boom-bust business cycle, as Mises showed, but also that it is a major source of artificial economic inequality and sharply increases profits relative to wages. These are processes that come to an end and are actually thrown into reverse as soon as credit expansion stops and the recession/depression that is its ultimate consequence begins. In wasting capital through malinvestment, it undermines the rise in production and accompanying rise in real wages. Despite credit expansion, real wages could still rise through most of American history, because of the substantial economic freedom enjoyed in the United States and did so even in the midst of credit expansion, as in the 1920s. In the last two episodes of major credit expansion, however, and over the last several decades as a whole, real wages have largely stagnated. This stagnation is the result of massive government intervention into the economic system that undermines capital accumulation and both the demand for labor and the productivity of labor. It is not the result of economic inequality, the profit motive, or any other aspect of the capitalist system.

I have explained all of the essential matters discussed in this article in full detail, with all of their presuppositions and implications, in my book Capitalism: A Treatise on Economics.

Copyright © 2007, by George Reisman. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is

Labels: , , , , , , , , ,

Monday, November 05, 2007


November 5, 2007*

Calling falling prices per se “deflation” is one of the most serious errors one can make in economics. It’s tantamount to confusing becoming richer with becoming poorer. It leads people to believe that increases in production, which are the foundation of enrichment, but which also operate to make prices fall, are at the same time the source of depression and impoverishment.

To get matters straight, we need to clarify some things.

Prices can fall either because of more supply (i.e., more goods and services being produced and sold) or because of less demand (i.e., less money in existence and/or less overall spending of money in the purchase of goods and services).

A depression is characterized not only by falling prices, but also by a plunge in business profits (which may even become negative in the aggregate) and by a sharply increased difficulty of repaying debt. It is also characterized by mass unemployment.

While a gold standard very definitely can and probably will be accompanied by falling prices, it is not accompanied by plunging profits, a greater difficulty of repaying debt, or mass unemployment. The conjunction of these latter with falling prices is the result of a decrease in the quantity of money and volume of spending. A decrease in the quantity of money and volume of spending is the result not of a gold standard but of the incompleteness of a gold standard. It is the result of a fractional-reserve gold standard, in which gold represents only a portion of the money supply while the rest is based on debt. In such circumstances, the failure of debtors is capable of causing bank failures, which serves to reduce the quantity of money and volume of spending.

Under a full, i.e., 100-percent reserve gold standard, new and additional gold continues to be mined, and at a rate faster than gold is physically lost, e.g., in such things as shipwrecks and the burial of people with gold dental fillings in their mouths. Thus the quantity of money and volume of spending under a full gold standard increases. However, it does so at a modest rate. Prices fall under a full gold standard to the extent that the increase in the production and supply of goods and services other than gold outstrips the increase in the quantity of gold and the spending of gold.

Despite the fall in prices, the increase in the quantity of gold money and spending under a full gold standard serves to increase the economy-wide average rate of profit and interest. It does so for the simple reason that in the nature of the case there tends to be more money and spending in the economy at the time when products are sold than there was at the earlier points in time when money was expended for the means of producing those products. Thus the margin by which sales revenues outstrip costs is correspondingly increased.

Furthermore, despite the accompanying fall in prices caused by the more rapid increase in the production and supply of goods and services other than gold, the increase in the quantity of gold and the volume of spending in terms of gold serves to make the repayment of debt somewhat easier. For example, suppose that sales revenues in the economic system are rising at a two percent rate because of increases in the supply and spending of gold, but that prices are falling at a three percent rate because the supply of goods and services other than gold is increasing five percent per year. The average seller in this case will have five percent more goods to sell at prices that are only three percent less. His sales revenues will rise by two percent. He will be able to earn progressively increasing sales revenues and income despite the fall in his selling prices, because the increase in the supply of goods and services he has available to sell outstrips the fall in his selling prices to the extent of the increase in the quantity of gold money and spending.

The modest elevation of the rate of profit resulting from the increase in the quantity of gold is the opposite of what happens in a depression. So too is the greater ease rather than greater difficulty of repaying debt.

Thus, the truth is that a full gold standard, with its falling prices, is as much the enemy of deflation as it is of inflation.

As for mass unemployment: If there is a deflation, in the correct sense of a decrease in the quantity of money and/or volume of spending, then falling prices, so far from being the cause of deflation/depression are the way out of it. In such circumstances, a fall in wage rates and prices is precisely what’s needed to allow a reduced quantity of money and volume of spending to buy all that a previously larger quantity of money and volume of spending bought. If, for example, as in 1929, there was originally roughly $50 billion in payrolls employing 50 million workers at an average annual wage of $1,000 per year and now, because of deflation, there are only $40 billion of payrolls employing 40 million workers, full employment could be restored if the average wage rate fell from $1,000 to $800 per year. In that case, $40 billion could employ as many workers as $50 billion had done.

Viewing the fall in wage rates and prices that is needed to recover from deflation as itself being deflation and thus preventing the fall in wage rates and prices, as occurred under Hoover and the New Deal, serves only to perpetuate the unemployment and depression.

Confused concepts result in catastrophic consequences.


P.S. For elaboration of the points made in this discussion, see my article "
The Goal of Monetary Reform," The Quarterly Journal of Austrian Economics, Fall 2000, vol. 3, no. 3, pp. 3–18, and my book Capitalism: A Treatise on Economics, pp. 544–46, 557–59, 573–80, 809–20. See also my Daily Article "The Anatomy of Deflation," August 22, 2003

*This essay was originally a posting to the Ludwig von Mises Institute’s discussion list.

Copyright © 2007, by George Reisman. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is

Labels: , , ,