GENERAL MOTORS, RIP

June 2nd, 2009

General Motors was once not only the world’s greatest and most prosperous automobile company but the world’s greatest and most prosperous manufacturing company, indeed, the world’s greatest and most prosperous company of any kind. Its success, wealth, and economic power, were symbolic of the success, wealth, and economic power of the United States.

 

General Motors has now perished, brought down by a kind of philosophical and economic tapeworm that consumed the company from within. The economic tapeworm was the United Automobile Workers union, which transformed the company into a carcass upon which it could feed while tying GM’s hands and feet with arbitrary work rules that prevented it from competing and providing any addition to what was to be consumed by the UAW’s vultures. The philosophical tapeworm lay within the minds of those running the company. For decades, it led them never to take a stand on principle and forcefully resist the UAW. Always the present cost of a major strike was allowed to outweigh the prospect of the ultimate destruction of the company, which was never considered fully real because it lay in the future.

 

In its last years, the company was reduced to the status of a “benefits” company, a company existing primarily for the purpose of paying the pensions, medical benefits, and exorbitant wages of the UAW members. In its last year, the company was reduced to the status of a beggar-benefits company, as it repeatedly turned to the Federal government for the billions of dollars that were needed to keep it in existence for just the next few months, in the hope that in that time a miracle would appear that would allow it to survive.

 

Now the company is gone, along with the billions of dollars of “bailout” money needlessly spent to “rescue” it. It would have been far simpler not to have given any bailout money and to have allowed the bankruptcy to occur last fall. That would not only have saved billions of dollars, but it would have avoided the United States Government becoming the major stockholder in the company that will control many or most of the remaining assets of GM.

 

General Motors was destroyed by operating under the ignorance, stupidity, and irrational greed of a labor union. From this point on, it is to operate under the ignorance, stupidity, and irrational greed of government officials acting in combination with that same labor union. It will survive only if fresh billions continue to be thrown at it. It if survives, instead of being a source of wealth, it will be a continuing drain of wealth.

 

What has happened to General Motors is symbolic of what is happening to the United States. The United States is being destroyed economically and culturally by irrational theories and policies. The standard of living of its people is falling. Government officials are preparing to accelerate the fall by means of the imposition of insane policies designed to curtail energy consumption and roll back the production of wealth. The American people have elected a President who has expressed regret that the Supreme Court “never entered into the issues of redistribution of wealth” because it “didn’t break free from the essential constraints that were placed by the Founding Fathers in the Constitution.”

 

If a company as great and as economically powerful as General Motors once was can collapse into a shadow of its former self, so too can every other company in the United States. So too can the United States itself.

 

Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen.

 

Google Relents—Finally

May 31st, 2009

At last Google has withdrawn its repeated description of this blog as “spam” and its accompanying threats to delete it.

 

                     

Google seems to be a company that belongs somewhere in a world that might have been imagined by Franz Kafka, in that when dealing with it in a situation of this kind, a person is placed in a position in which he must confront a beast that is deaf, blind, and destructive, utterly impervious to all reason. The company has no email address that belongs to a live human being, or at least none that I could find. It has two listed phone numbers in its headquarters city of Mountain View, California. One of them offers five or six menu options none of which  lead to a  human being or any way to contact a human being. The second number does reach a human being, but that human being has no way to contact any executive and cannot deal with any such matter as a blog being threatened with deletion. Yes, it also has an 800 number, which duplicates the first of the Mountain View numbers.

 

 

A communication from the company promised an investigation by a human being “within two business days.” But no such investigation ever occurred. Between May 2 and May 21, in response to my requests to unlock my blog, I received the following three replies, all of them identical but for the date cited for the requests.

 

 

 

 

“Your blog is marked as spam

 

 

“Blogger’s spam-prevention robots have detected that your blog has characteristics of a spam blog. (What’s a spam blog?) Since you’re an actual person reading this, your blog is probably not a spam blog. Automated spam detection is inherently fuzzy, and we sincerely apologize for this false positive.

 

 

 “We received your unlock request on May 2, 2009. On behalf of the robots, we apologize for locking your non-spam blog. Please be patient while we take a look at your blog and verify that it is not spam.

 

 

 

“Your blog is marked as spam

 

 

“Blogger’s spam-prevention robots have detected that your blog has characteristics of a spam blog. (What’s a spam blog?) Since you’re an actual person reading this, your blog is probably not a spam blog. Automated spam detection is inherently fuzzy, and we sincerely apologize for this false positive.

 

 

 

“We received your unlock request on May 11, 2009. On behalf of the robots, we apologize for locking your non-spam blog. Please be patient while we take a look at your blog and verify that it is not spam.

 

 

 

“Your blog is marked as spam

 

“Blogger’s spam-prevention robots have detected that your blog has characteristics of a spam blog. (What’s a spam blog?) Since you’re an actual person reading this, your blog is probably not a spam blog. Automated spam detection is inherently fuzzy, and we sincerely apologize for this false positive.

 

 

 

“We received your unlock request on May 21, 2009. On behalf of the robots, we apologize for locking your non-spam blog. Please be patient while we take a look at your blog and verify that it is not spam.”

 

 

 

 

At least a dozen of the readers of this blog went to the trouble of writing directly to the President of Google. One of them went to the trouble of also informing an extensive list of pro-free-market news commentators and bloggers about what Google was doing. It’s difficult to be sure what effect this had. To my knowledge, none of those who wrote to the president of Google ever received a reply. Nevertheless, I must assume that Google finally unlocked my blog in response to the strong reaction from these readers. I want to thank them publicly, for their support.

 

 

 

What this experience has taught me is that I never again want to be dependent on Google. Accordingly, I’ve spent much of the past few weeks reconstructing this blog in Word Press. The reconstruction is complete for 2009 and 2008, but has only just begun for 2007 and 2006. I invite readers to visit this new blog at www.georgereisman.com/blogWP/. (Please note that the last two letters must be capitalized in order to bring up the blog.)

 

 

 

It seems incomprehensible to me that Google, a company with possibly the most advanced search technology in the world, would somehow lack the technical expertise required for its robots to distinguish my blog, which has been in existence for over three years and has more than 140 postings on it, from a spam blog. It is equally  incomprehensible to me why, if such is the case, and they know that their ability to identify spam blogs is “inherently fuzzy,” they would not have a  human being spend five minutes looking at a blog they know is very likely a “false positive” for spam, and make a rational judgment about the matter in short order. And why they would not have a readily accessible system whereby they could be easily contacted and “false positives” for spam speedily corrected by that route.

 

 

 

Whatever the explanation, Google in this case has shown itself to be incompetent, grossly irresponsible, and cowardly. It apparently does not care about the consequences of its actions or show any readiness to correct them or willingness even to hear about them. Nothing less than a public campaign is required to get its attention. This is not a good performance for a company whose motto is supposedly, “Don’t Be Evil.” What Google has done in this case is evil.

 

 

***

 

 

If any reader knows how to port over links from Google’s Blogger to Word Press, I hope he will share his knowledge with me. The abundance of links to many of the postings on the Google version of my blog serve to keep me tied to Google. Please write to me at georgereisman@georgereisman.com.

 

Letter to Krugman

May 4th, 2009

Dear Prof. Krugman: 

In your NY Times column of today you write, “But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.” You overlook the fact that the major benefit of a fall in wage rates is not any competitive advantage that it might give to one firm over another, but the fact that it allows the same total payment of wages in the economic system to employ more labor and the same total expenditure for consumers’ goods to buy more consumers’ goods at the lower prices resulting from lower wage rates. 

You also write, “Things get even worse if businesses and consumers expect wages to fall further in the future.” That’s true, and because it is, the implication is that when wage rates fall to the level to which they’ve been expected to fall, there will be a substantial increase in the quantity of labor demanded and in total wage payments and consumer spending. 

If you are open to a serious, detailed development of ideas on deflation and unemployment that are sharply at variance with your own, I’d like to recommend for your consideration two on-line articles of mine: “Falling Prices Are Not Deflation But the Antidote to Deflation” and “Standing Keynesianism on Its Head: as Employment Increases in Response to a Fall in Wage Rates, the Rate of Profit Rises, Not Falls.” 

In the latter article, you can learn of the profound contradiction that exists between Keynes’ statement of the basis of the IS-LM analysis on p. 261 of The General Theory and his statement of the basis of the declining mec doctrine on p. 136 of The General Theory. The net upshot is that a fall in wage rates does in fact result in an increase in employment, in part because it is accompanied by a rise in the “mec” rather than the fall assumed by Keynes. 

Cordially,

George Reisman, Ph.D.

Pepperdine University Professor Emeritus of Economics

Author of Capitalism: A Treatise on Economics

Web site: www.capitalism.net

Blog: www.georgereisman.com/blog/

Fallout from Declaring CO2 a Pollutant (A Potential News Dispatch from a World Going Mad)

April 24th, 2009

New York—Now that carbon dioxide has been declared a pollutant by the EPA, numerous local jurisdictions around the country, whose finances have been badly hammered by the current recession, are considering the imposition of “Exhalation Taxes.”

Among the task-force’s assignments are determining the extent to which people might use the oxygen they breath in more efficiently (oxygen-efficiency option), so that they would be able to correspondingly reduce their exhalations of CO2. Another potential solution under study is the possibility of sequestering the exhalations in jars and various other containers, so as to reduce the overall release of CO2 into the atmosphere (CO2 sequestration option).

New York’s Mayor Michael Bloomberg and California’s Governor Arnold Schwarzenegger are reportedly preparing a joint statement citing the legitimacy and inevitability of taxes on CO2 emissions in general and on human exhalations of CO2 in particular. Humans emit CO2 into the atmosphere and thus contribute to global warming every time they exhale, in other words, every time they let out their breath. Some studies have estimated that taking all human beings together their exhalations account for as much as 8 per cent of all human-caused CO2 emissions. This is more than the proportion emitted by all privately owned aircraft in the world and is thus an important and fruitful target for reduction.

The Obama Administration has until now preferred a system of “cap and trade” as the means of limiting CO2 emissions, rather than any direct tax on emissions. Under that system, the Federal Government will limit the overall total amount of permissible emissions but allow individuals to emit as much they wish by buying the emission rights of others. A high official in the New York City government, who spoke on condition of anonymity, said that the Mayor and the Governor have arranged for a joint task force, financed at the Mayor’s expense, out of his personal fortune, to study the feasibility of adapting this system to human exhalations. A particularly troubling aspect of any adaptation, the source explained, is how to combine it with plans by the Federal Government gradually to reduce the overall total of permissible emissions.

No official estimates have been released as to what the average person might expect to have to pay in order to exhale in compliance with the law, but some insiders place it initially as working out to as little as 50 cents per day. According to polls conducted among individuals who identify themselves as environmentalists or as political moderates, the general consensus is that “we can live with that” and “it’s a small price to pay, to keep the planet safe.”

Support for higher exhalation taxes and/or more stringent cap-and-trade limitations is indicated by the reported brisk sale of bumper stickers urging “polluters” to stop exhaling altogether. The stickers say, “Stop Exhaling, You God-Damned Polluting Bastards.” It is unclear whether the drivers of the vehicles which carry the stickers count themselves as polluters too.

In contrast to the extremist position expressed in such bumper stickers, key Obama Administration officials and Congressional leaders are reportedly prepared to guarantee that “no American will ever be allowed to be in a position in which he cannot afford to pay for all of his reasonably necessary exhalations.” The Federal Government, they say, will provide whatever financial subsidies as may be necessary to assure everyone’s right to exhale on terms that he can afford.

 Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/.

Green Jobs

April 21st, 2009

President Obama has proposed combining stimuli to promote employment with the fight against alleged man-made global warming, which allegedly results mainly from the burning of fossil fuels. Hundreds of thousands if not millions of new “green” jobs will supposedly be created by replacing power from fossil fuels with power from windmills and solar panels. They will be created in the construction of the windmills and in the production and installation of the solar panels, and also in the construction of a new power grid to carry all the electricity that is supposed to result.

A rather serious problem, which seems largely to have been ignored by those urging a race to build windmills and solar panels, is the fact that the wind does not always blow, nor does the sun always shine. And as yet there is no large-scale economical method of storing electricity for later use. This would seem to imply a need to retain the present system of power production alongside the new system that is to be based on wind and sun, or else to grow accustomed to protracted periods without power.

Or is it the case perhaps that this problem is to be taken as an opportunity for even greater gains in employment in connection with wind and solar power? These might be achieved if, in all those times when the wind does not blow or the sun does not shine, human beings were employed in rotating copper-clad generator shafts, in a manner similar to that of rotating a grindstone in a gristmill, only in the presence of surrounding magnets, so that electricity could be produced by the rotation. (I don’t know how much, if any, electricity might actually be produced in this way. But it would keep people employed in the attempt.)

Indeed, advancing the goals of environmentalism is capable of creating a virtually limitless number of jobs. Big-rig trucks and their “polluting” emissions might be done away with by replacing them with human porters who would carry freight on their backs. Ocean-going ships and their emissions might be done away with by replacing their “dirty engines” with the clean labor of banks of oarsmen. (Sails would be a substitute too, but they are no match for oarsmen when it comes to the number of workers needed.) Automobiles and their emissions might be replaced by sedan chairs and teams of litter bearers.

And if all that is not enough, then think of the jobs that might be created in making coal in the ground absolutely safe. At present there are outcries over the release of trace amounts of mercury, arsenic, and other heavy metals from above-ground accumulations of coal sludge. Yet these metals are found in nature-given, below-ground deposits of coal as well, and could not appear in coal sludge if it they had not first been present in below-ground coal. While perhaps a smaller threat to human health so long as they are locked in below-ground coal, they must undoubtedly represent some threat, if only at the level of parts per billion or parts per trillion.

Since one can never be too safe, it follows that if job creation is the goal, an environmentalist case can be made for extracting all known coal deposits and then, instead of using any of that coal for such environmentally “destructive” purposes as producing electricity or heating homes, simply reburying it. But this time in repositories lined so as to prevent any possible leakage of heavy metals into the surrounding environment.

And finally, think of all of the jobs that a program of environmental “stewardship” might make available. Thus each patch of desert, each rock formation, each clump of grass, and each tree stump, might have assigned to it one or more “stewards” whose job would be to watch over it, protect it, and “preserve it for future generations.” To carry out this valuable work, there could be a whole corps of “stewards.” They could be dressed in special uniforms displaying various ranks and medals, all gained in “service to the environment” and the defense of nature and its resources against the humans.

Indeed, once we put our minds to it, nothing is easier than to think of things that would require the performance of virtually unlimited labor in order to accomplish virtually zero result. Such is the nature of all job-creation programs. Such is the nature of environmentalism. Such is thought to be the path to economic recovery by most of today’s intellectual establishment.

 

***

 

Postscript: I want to note that my book Capitalism: A Treatise on Economics provides further, in-depth treatment of the substantive material discussed in this article and of practically all related aspects of economics. Of special note here is the fact that Chapter 3 of the book is a thorough-going critique of environmentalism. The critique is coupled with a positive demonstration of the fact that under capitalism and its economic freedom the supply of economically useable, accessible natural resources is capable of continuing further increase as man expands his knowledge of and physical power over nature. It is also joined by a demonstration that such increase in man’s knowledge and power at the same time serves progressively to improve his environment, understood as his external physical surroundings, deriving its value from its contribution to human life and well-being. In addition, Chapter 13 of Capitalism provides a critique of all variants of the notion that a problem of economic life is the creation of work rather than wealth.

 

*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen. The book provides further, in-depth treatment of the substantive material discussed in this article and of practically all related aspects of economics.

 

Standing Keynesianism on Its Head: as Employment Increases in Response to a Fall in Wage Rates, the Rate of Profit Rises, Not Falls

April 15th, 2009

 

This is the third in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity. (The first was “Falling Prices Are Not Deflation But the Antidote to Deflation.” The second was “Economic Recovery Requires Capital Accumulation Not Government ‘Stimulus Packages.’”)


With his usual astuteness, Mises observed that it is common for one and the same doctrine to circulate in more than one version, typically, in its original, scholarly version and then also in a greatly simplified version designed for popular consumption. He illustrated how this applied to doctrines as diverse as Catholicism, Darwinism, and Freudianism. (Money, Method, and the Market Process, pp. 301f.)

 

Not surprisingly, his observation also applies to Keynesianism and its claim that a free economy is incapable of eliminating unemployment, because its method of doing so, namely, a fall in wage rates, is allegedly unable to increase the quantity of labor demanded.

 

Popular Keynesianism

 

The popular version of the Keynesian doctrine, which is championed above all by the labor unions, is simply that a fall in wage rates, in reducing the incomes of wage earners, causes a fall in consumer spending, which allegedly serves to worsen the problem of unemployment. This doctrine can be disposed of fairly simply, before proceeding to the scholarly version of Keynesianism, which is known as the IS-LM doctrine.

 

First of all, it overlooks the fact that at lower wage rates more workers will be employed. The effect of this is to enable total wage payments and consumer spending in the economic system to remain the same or even increase while the wages of the individual worker decline. For example, 10 workers each employed at 90 percent of the wages earn the same total wages and can spend just as much in buying consumers’ goods as could 9 workers each earning the original wage. (It’s as simple as the fact that 10 times .9 equals 9 times 1.) And, of course, more than 10 workers employed at 90 percent of the wage per worker would earn more collectively and spend more for consumers’ goods collectively than was possible before.

 

The popular version of the Keynesian doctrine also overlooks the fact that even if total wage payments and consumer spending did decline, business sales revenues would not decline insofar as reduced wage payments made possible increased expenditures for capital goods. Indeed, to the extent that additional spending for capital goods took the place of wage payments and the consumer spending supported by wage payments, not only would sales revenues in the economic system remain the same, but, what is particularly important for the process of economic recovery, the amount of profit earned on those same total sales revenues would actually increase.[1]

 

This result follows because wage payments as a rule show up fairly quickly—usually within a matter of weeks or months—as equivalent costs that must be deducted from sales revenues in calculating profits. In contrast, expenditures for machinery will not show up as equivalent costs deducted from sales revenues for several years or more, in accordance with the depreciable life of the machines. And expenditures for construction materials and the services of construction equipment will not show up as equivalent costs deducted from sales revenues for several decades, in accordance with the still longer depreciable lives of buildings and other highly durable assets.

 

Because of these considerations, if a sum such as $100 billion, say, could be shifted away from wage payments in the economic system and to the purchase of machinery and plant, profits in the economic system might well increase on the order of $90 to $95 billion dollars in the year in which this shift of spending occurred. This is because the $100 billion of spending for capital goods that would now take place would represent fully as much spending for goods, and thus fully as much business sales revenues, as the $100 billion of spending for consumers’ goods that the wage earners would otherwise have made. At the same time, while $100 billion of wage payments would have shown up in the same year as $100 billion of costs to be deducted from sales revenues, $100 billion of spending for capital goods with a depreciable life ranging from several years to several decades, may well show up perhaps as a mere $5 to $10 billion of depreciation cost in any given year. The replacement of $100 billion in wage costs with $5 to $10 billion of depreciation cost, implies a rise in economy-wide profits of $90 to $95 billion.

 

Spending for Capital Goods Can Rise at the Same Time that Spending for Consumers’ Goods Falls

 

Some readers may wonder how it is possible for more to be spent for capital goods at the same time that less is spent for consumers’ goods. Less spending for consumers’ goods, it would seem, should imply less spending for the capital goods required to produce the consumers’ goods. The answer lies in the fact that while this may well be true, the spending for capital goods  to produce consumers’ goods declines in a lesser degree than does the spending to buy consumers’ goods. This means that it now stands in a higher proportion to the spending for consumers’ goods. In turn, the spending to buy the capital goods to produce those capital goods comes to stand in a compounded higher proportion to the spending for consumers’ goods, and so on, with the spending for capital goods further compounded at every succeeding stage of production.

 

The following series of numbers will help to illustrate what is involved. Thus imagine that initially spending for consumers’ goods in the economic system was 500 units of money, the spending for the capital goods to produce those consumers’ goods was 250 units of money, the spending for the capital goods to produce those capital goods, 125 units of money, and so on, with each succeeding amount of spending for capital goods being half of the spending for the capital goods it helps to produce.

 

Now imagine that spending for consumers’ goods falls from 500 to 400 units of money. Here is how at the same time spending for capital goods can increase from 500 (i.e., the sum of 250 + 125 + 62.50 +…) to 600 units of money. The mechanism is that the spending for the capital goods required to produce consumers’ goods falls from .5 x 500 to .6 x 400, i.e., from 250 to 240. The spending to produce the capital goods required to produce those capital goods will now be .6 x 240 rather than .5 times 250. Inasmuch as .6 x 240 = 144, while .5 x 250 = 125, the spending for capital goods at this stage has actually risen. Its rise will be relatively greater at each succeeding stage, e.g. 86.4 versus 62.50, 51.84 versus 31.25, and so on.

 

Hoarding and the Rate of Profit

 

Finally, it should also be realized that the effect even of a decline in total wage payments that was not accompanied by any increase in spending for capital goods, would soon be very positive for profits. It would not increase profits in absolute amount, but it would increase them as a percentage of sales revenues and costs.

 

Here it must be kept in mind that wage payments are not only a source of funds for wage earners to spend in buying consumers goods, but they also show up equivalently as business costs, which must be deducted from sales revenues in computing profits, and do so fairly soon. Thus a decline in wage payments would quickly result in equal reductions in sales revenues and costs. To whatever extent sales revenues were greater than costs to begin with, the amount of that excess would remain unchanged, because equals subtracted from unequals do not affect the amount of the inequality. However, the same amount of inequality, i.e., of profit, would now represent a larger percentage of the reduced sales revenues and costs.

 

The same amount of profit in the economic system would also represent a rise in the rate of return on capital invested in the economic system. This would be the result not only of the monetary value of the capital invested shrinking in consequence of reduced spending for labor (and capital goods), but also, and far more immediately, of the write-down of the value of existing capital assets to correspond with their lower level of replacement costs made possible by widespread declines in wage rates and prices. In addition, purchases of assets at fire-sale prices following bankruptcies contribute to the same result.

                       

What this implies is that to the extent that savings in the economic system might be unduly held in the form of cash, i.e., “hoarded,” the effect is to raise the rate of return on capital invested and thus to provide a greater incentive for savings being invested rather than being hoarded. In other words, “hoarding” is always a self-limiting phenomenon.

 

It follows that even if a decline in wage rates was initially accompanied not only by a fall in total wage payments but also by a fall in total business spending for labor and capital goods combined, the subsequent rise in the rate of return on capital would operate to restore total wage payments and the spending for capital goods. Consequently, once the underlying aspects of a process of financial contraction have come to an end, a fall in wage rates operates at least fairly soon to increase the quantity of labor demanded.

 

100 Percent Hoarding and an Infinite Rate of Profit

 

An implication of this discussion that may appear startling to many readers is that if it were ever the case that people kept all of their savings in the form of cash holdings and spent absolutely nothing for labor or capital goods, the rate of profit and interest in the economic system would become infinitely high. This is because while there would still be some amount of sales revenues in the economic system, resulting from consumption expenditures by those who possessed money, there would be no money costs of production to deduct from those sales revenues, since no expenditures giving rise to money costs would have been made. Thus the amount of profit in the economic system would equal 100 percent of the sales revenues generated by whatever consumer spending existed. At the same time it would equal an infinite percentage of the zero money costs of production and an infinite percentage of the zero money value of capital invested.

 

These conclusions are confirmed by the fact that the rate of profit and interest is far higher in countries that lack the security of property and developed financial markets and institutions and where, as a result, a far larger portion of savings takes the form of precious metals and gems rather than investments in business.

 

More on Hoarding and the Rate of Profit

 

“Hoarding,” or more precisely an increase in the demand for money for cash holding, has two effects on the rate of profit. One is its longer-run effect, which can take place within a period as short as a few months, and which is to raise the rate of proFfit, as I have just shown.

 

Its other, more immediate effect, however, is to reduce the rate of profit, even to the point of wiping it out entirely and replacing profits with losses throughout the economic system. This is the effect with which everyone is familiar and in the name of which they desire to do everything possible to avoid reductions in spending of any kind.

 

The reason that hoarding first reduces profits is merely the fact that reductions in spending for labor and capital goods exert their effect on business sales revenues to a more or less substantial extent before they exert their effect on the business costs deducted from sales revenues in arriving at profits. Business sales revenues decline immediately when spending for capital goods declines: for example, less spending for steel sheet by an automobile company is less sales revenues for steel companies at the very same moment. Sales revenues decline almost immediately when spending to employ labor declines, i.e., as soon as reduced wage payments show up in reduced consumer spending.

 

Now some costs deducted from sales revenues also decline immediately in response to reduced business spending, notably, such costs as typically come under the heading of selling, general, or administrative expenses.  But other costs, namely, those which come under the headings of “cost of goods sold” and “depreciation cost” are not immediately affected by declines in current business spending. They are determined historically, that is, by business spending for inventories and plant and equipment that has taken place in the past, and which cannot retroactively be reduced.

 

Current spending on account of inventories and plant and equipment shows up as costs to be deducted from sales revenues only in the future, a future that ranges from days to decades. Of course, in a major recession or depression, long-term investment spending falls to a far greater extent than spending required to carry on current operations, and as a result, further declines in business spending, notably for labor and materials, almost all show up fairly quickly as declines in costs deducted from sales revenues.

 

Long-term investment spending falls disproportionately in large part because the wage rates of construction workers and of workers producing construction materials and the various kinds of machinery have not fallen or have not fallen to the point to which it is believed they will fall. In that case, it pays to postpone such investments and hold cash instead, because they would be at a major disadvantage in competition with investments made in the future. And when these wage rates and prices do finally fall, permitting current long-term investment to be worthwhile once again, the monetary value of existing plant and equipment can be written down commensurately, as previously indicated. The effect of the write-downs is to reduce depreciation cost on existing plant and equipment. (For example, the annual depreciation charge on plant with an asset value of $1 billion and a remaining depreciable life of 20 years is $50 million. But if the value of that plant and equipment were written down to $500 million, the annual depreciation charge incurred would also fall by half, to $25 million.)

 

Along with a fall in wage rates and prices, an essential condition of economic recovery from a major recession or depression is simply the end of further financial contraction, i.e., further economy-wide declines in spending. Further financial contraction stops when bank failures and their accompanying declines in the quantity of money stop (or, better still, do not start in the first place) and when the demand for money for cash holding has risen sufficiently to satisfy the need to operate without access to loans created on a foundation of credit expansion.

 

The additional demand for money for cash holding also includes whatever temporary further component may be necessary to allow for a failure of wage rates and prices to fall and the consequent postponement of long-term investments. At this point, the short-run negative effect of less spending on the amount and rate of profit begins to come to an end. Its final end is greatly accelerated by the write-downs of assets that accompany reductions in wage rates and prices and hence in the replacement cost of existing business assets. (As indicated, purchases of assets at fire-sale prices following bankruptcies contribute to the same result.)

 

These write-downs not only serve to reduce costs deducted from sales revenues earned with existing assets, thereby increasing current profits, but also serve to reduce the money value of the capital invested, thereby further increasing the rate of profit on existing assets in the economic system. In effect, they serve to increase the size of the profit numerator while reducing the size of the capital-invested denominator. More profit earned on less capital is a two-sided increase in the rate of return on capital.

 

In this environment, reductions in wage rates not yet accompanied by the employment of more workers or by the purchase of more capital goods quickly result in improvement in the rate of profit. They do so not only by reducing costs as much as sales revenues, but by reducing them by more than sales revenues when the effect of write-downs is taken into account. The write downs, as just shown, also raise the rate of profit by reducing the money value of the capital invested in the economic system.

 

This rise in the rate of profit, and consequently also in the rate of  interest, operates to reduce the demand for money for cash holding, by virtue of making the investment of money relatively more attractive in comparison with the holding of money. The reduction in the demand for money for cash holding is greatly furthered by the restoration of the profitability of long-term investment that accompanies the necessary fall in wage rates and prices and also by the rise in the rate of profit that takes place pursuant to the putting of funds into longer-term investments.

 

The net upshot is that the necessary fall in wage rates and prices serves to increase the quantity of labor demanded disproportionately, by virtue of calling back into the market funds that had been withheld in anticipation of the fall in wage rates and prices. At the same time, the increase in the quantity of labor demanded and the corresponding movement of the economic system toward “full employment” is accompanied by a rise in the rate of profit in the economic system.

 

The Keynesian IS-LM Doctrine

 

The doctrine of Keynes himself is far more complex than the popular variant. It is so complex that it calls to mind a popular song from years ago called “Collarbone” that described the connection of one bone to another, from toe to head. The song went, “Toe bone connected to the ankle bone, ankle bone connected to the shin bone, shin bone connected to the knee bone…neck bone connected to the head bone.”

 

My reason for associating Keynesian economics with this song is that just as one bone is connected to another in the song, so in textbooks expounding the Keynesian system, each separate but connected piece of the anatomy of that system—a bone, if you will—is presented in a series of successively connected diagrams totaling as many as eleven  in all. Each one of the diagrams repeats an axis of the one before it. Thus, in the Keynesian system, the “production function” is connected to the “IS curve”;  the “IS curve” is connected to the “saving function”; the “saving function” is connected to the “saving-equals-investment line”; the “saving-equals-investment line” is connected to the “marginal efficiency of capital schedule”; the “marginal efficiency of capital schedule” is connected back to the “IS curve”; the “IS curve” is  connected to the “aggregate demand curve.…” The diagram below, which is from the first edition of Joseph P. McKenna’s Aggregate Economic Analysis, depicts all the various relationships involved.

Anatomy of the Keynesian System

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Just as in the case of the highly simplified labor-union version, the ultimate conclusion drawn from this extensive series of connections is that full employment cannot be achieved in a free market, because, once again, a fall in wage rates allegedly turns out to be incapable of increasing the quantity of labor demanded.

 

Even though the two versions of Keynesianism reach the same conclusion, they differ profoundly in the complexity of their explanations. And as a result, they require separate critiques. 

 

In the textbook version, the reason that a fall in wage rates allegedly cannot reduce unemployment is not that it automatically reduces spending in the economic system. Keynes is willing to concede that initially spending might remain the same or even increase and that at the lower wage rates it would in fact employ additional workers. He writes:

 

Perhaps it will help to rebut the crude conclusion that a reduction in money-wages will increase employment “because it reduces the cost of production”, if we follow up the course of events on the hypothesis most favourable to this view, namely that at the outset entrepreneurs expect the reduction in money-wages to have this effect. It is indeed not unlikely that the individual entrepreneur, seeing his own costs reduced, will overlook at the outset the repercussions on the demand for his product and will act on the assumption that he will be able to sell at a profit a larger output than before. (General Theory, p. 261.)

 

The basic problem, Keynes contends, lies in what would happen next, if the fall in wage rates did in fact manage to increase the volume of employment. Continuing in the very same paragraph, he argues that the effect of the greater employment would be a fall in the rate of profit (which he usually calls “the marginal efficiency of capital”) below the lowest rate that is sufficient to induce investment. This would serve to make the employment of additional workers no longer worthwhile and result in employment being pushed back to its previous figure. In his words (to which I’ve taken the liberty of adding explanatory comments, which appear in brackets):

 

If, then, entrepreneurs generally act on this expectation, will they in fact succeed in increasing their profits? Only if the community’s marginal propensity to consume is equal to unity, so that there is no gap between the increment of income and the increment of consumption [i.e., there is no additional saving]; or if there is an increase in investment, corresponding to the gap between the increment of income and the increment of consumption, which will only occur if the schedule of marginal efficiencies of capital has increased relatively to the rate of interest [i.e., either the mec schedule must somehow move to the right, which there is allegedly no reason for its doing, or the rate of interest must fall, which it can’t do, because it is allegedly already at its lowest acceptable rate, which is usually assumed to be 2 percent]. Thus the proceeds realised from the increased output will disappoint the entrepreneurs and employment will fall back again to its previous figure, unless the marginal propensity to consume is equal to unity [i.e., there is no additional saving] or the reduction in money-wages has had the effect of increasing the schedule of marginal efficiencies of capital relatively to the rate of interest and hence the amount of investment [Keynes means, of course, increase the amount of investment that is worthwhile—i.e., yields 2 percent or more]. For if entrepreneurs offer employment on a scale which, if they could sell their output at the expected price, would provide the public with incomes out of which they would save more than the amount of current investment, entrepreneurs are bound to make a loss equal to the difference; and this will be the case absolutely irrespective of the level of money wages.

 

I have italicized the last sentence because if any single sentence of Keynes can express the theoretical substance of his doctrine, that is the one.

 

Here is the line of argument Keynes is presenting in the passage above and which is depicted in the graphical analysis. The employment of more workers results in more production, which at the same time means more real income. By a process of equivocation, which I note here, but will not make a major issue of, real income suddenly becomes interchangeable with money income, out of which saving and cash hoarding can potentially take place.

 

Saving, according to Keynes and his followers, is a mathematical function of income, such that more income results in more saving, e.g., 20 percent of each additional dollar of income is saved, while 80 percent of each additional dollar of income is consumed. The extra saving relative to extra income is called “the marginal propensity to save,” while the extra consumption relative to extra income is called “the marginal propensity to consume.” The names of the full mathematical functions are “the saving function” and “the consumption function.”

 

As the quotation indicates, the existence of saving allegedly creates a problem. If there were no additional saving as employment and income increased, there would be nothing to stop the additional employment achieved as the result of a fall in wage rates from being maintained. But saving creates the potential for cash hoarding.

 

Cash hoarding, in the Keynesian system need not automatically and necessarily occur every time there is saving. Potentially, additional saving might be offset by equivalent additional investment. If it were, that would put the money saved back into the spending stream. In this case too, the additional employment achieved as the result of a fall in wage rates could be maintained.

 

The problem that arises, according to Keynes and his followers, is that the additional investment required is the cause of a fall in the “marginal efficiency of capital,” i.e., the rate of profit or rate of return on capital. The effect of achieving full employment, believe the Keynesians, would be an increase in the volume of saving to such an extent that it would require an offsetting increase in the volume of investment of such a magnitude that the rate of return on capital would allegedly be driven to an unacceptably low level. (Below 2 percent is the figure usually assumed.)

 

In response to a rate of return less than the minimum acceptable rate, funds would be withdrawn from investment and hoarded. This would reduce spending throughout the economic system and cause the return of unemployment.

 

The fundamental problem, say the Keynesians, is that the existence of full employment would impose an unacceptably low rate of return on capital and therefore could not be maintained if it were achieved. The return of unemployment would be necessary because by reducing output/income, it would reduce the volume of saving, since less income results in less saving. With saving reduced, less investment is required to offset it in order to prevent hoarding. And with less investment, the rate of return on capital will be higher.

 

Keynes’s whole argument depends on the rate of profit falling as the end result of the increase in employment and output. If the rate of profit did not fall, if it stayed the same or rose as employment and output increased on the foundation of a fall in wage rates and prices, there would be absolutely nothing standing in the way of the achievement of full employment by means of a fall in wages and prices.

 

Clearly, it is essential to examine Keynes’s argument that the rate of profit (mec) declines as investment increases. For his whole analysis depends on it. In explaining it, he writes:

 

 

If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase.… Thus for each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the schedule of the marginal efficiency of capital. (General Theory, p. 136.) 

 

Keynes’s reference to the prospective yield on capital falling is usually divided into two related aspects: a decline in the prospective selling prices of products as stepped up investment increases their supply, and also a decline in the physical amount of additional product produced per successive equal increment of additional investment. Thus, for example, each additional $10 billion of investment in the economic system might be imagined to result in increments of product that would sell for less and less because of increases in the supply of products and that would also bring in less and less because the physical size of the increases was smaller and smaller. Thus the first $10 billion of additional investment might be imagined to result in 1 million units of additional product that would sell at a price of $100 each. The second $10 billion, however, would supposedly result only in an additional 900 thousand units of product, which would sell at a price of, say, $95 each. By the same token, the third $10 billion of additional investment might result in only 800 thousand units of additional product that would sell for $90 per unit, and so on. Clearly, the extra revenue accompanying equal extra increments of investment would fall under these conditions. And since that extra revenue is the source of the profit on the investment, it seems to follow that the rate of profit would decline as investment increased.

 

In addition, of course, Keynes refers to a rising “supply price” for the various types of capital goods as their production expands in response to the additional demand constituted by additional investment. Thus, in his view, the rate of profit declines as investment increases because more investment both raises the prices of capital goods and at the same time operates to reduce their yields in terms of revenue.

 

Keynes’s Bait and Switch

 

When Keynes’s explanation of the falling “marginal efficiency of capital,” just quoted, is taken in conjunction with his previously quoted explanation of why a fall in wage rates allegedly cannot succeed in overcoming unemployment, it turns out that what is present is something similar to the technique of a dishonest salesmen who begins by appearing to offer something that is very different from what he actually ends up offering, i.e., the technique known as “bait and switch.”

 

When Keynes tries to explain the alleged impossibility of full employment being achieved by virtue of a fall in wage rates, he is clearly talking about the alleged impossibility of a fall in wage rates achieving full employment. But when all is said and done, what this alleged impossibility turns out to rest upon is not at all consistent with a fall in wage rates.  To the contrary, in the last analysis Keynes’s argument against the ability of a fall in wage rates to achieve full employment depends on the absence of a fall in wage rates, indeed, on their rise.

 

The fall in the “marginal efficiency of capital”/rate of profit that supposedly results from investment having to be pushed beyond its worthwhile limit in order to offset all of the saving taking place out of the level of income resulting from full employment, and which allegedly prevents full employment from being achieved more than very temporarily—that fall turns out to depend on wage rates not falling, indeed, rising.

 

Consider. Why should a fall in the selling prices of products serve to reduce profitability if that fall has been preceded by a fall in wage rates and in the prices of existing capital goods, i.e., in the costs of production, which is the situation under discussion? It would be reasonable to argue that a fall in selling prices serves to reduce profits if it were not preceded by a fall in wage rates and the prices of existing capital goods, but not when it is so preceded. What Keynes has done here is to substitute the effects of a fall in selling prices on the rate of profit in the absence of a preceding fall in wage rates and the prices of existing capital goods for its alleged effect in the presence of such a preceding fall.

 

The same point applies even more strongly to the alleged decline in yields based on declines in physical increments of product accompanying additional increments of investment. Here Keynes and his followers take for granted the supply of labor and consider the effects on output merely of successive equal increments of investment. But this too is a total contradiction of the situation under discussion.

 

That situation, recall, is whether or not the re-employment of masses of previously unemployed workers can be maintained following a fall in wage rates and the prices of existing capital goods. Keynes and his followers say no, in part because of alleged diminishing physical returns to additional increments of capital investment. Here they ignore the fact that the situation under discussion implies an increase in the supply of labor employed far in excess of any secondary, derivative increase in the supply of capital goods that might come about as the result of additional saving taking place as the by-product of full employment.

 

Going from a state of mass unemployment to full employment implies a correspondingly large reduction in the ratio of accumulated capital to labor. The supply of existing capital goods is what it is. But going from, say, an unemployment rate of 25 percent, such as existed in the depths of the Great Depression of the 1930s, to full employment, implies an increase in the supply of labor employed in the ratio of 4:3. This, in turn, implies a fall in the ratio of capital to labor to ¾ of its previous level. Thus, if in the state of mass unemployment there were 12 units of capital in existence for every 3 workers employed, giving a ratio of capital to labor of 4:1, now, with the employment of 4 workers for every 3 previously employed, the ratio of capital to labor falls to 3:1. With capital now less abundant relative to labor, i.e., scarcer relative to labor, successive equal increments of investment should have substantially higher physical yields than they did in the state of mass unemployment. Thus, if it were the case that physical increments of output accompanying increments of investment had a connection with the rate of profit, the rate of profit would have to be expected to rise as the accompaniment of the economic system going from a state of mass unemployment to full employment.

 

Even if at some point, after many years of full employment and accompanying additional saving, the ratio of capital to labor ultimately came to surpass what it had been in the period of mass unemployment, it would still be far less than it would be in the face of fresh mass unemployment. Always, the employment of more labor serves to reduce the ratio of capital to labor and to have a correspondingly positive effect on physical yields to capital, all other things being equal.

 

The third alleged reason for the rate of profit falling as employment increases turns out to be no less bizarre and contradictory. This is Keynes’s claim that pressure on the facilities for producing capital “will cause its supply price to increase.” Since when do the prices of capital goods rise on a foundation of falling wage rates and costs of production? They would rise in a situation of rising wage rates and costs of production, but not falling wage rates and costs of production. This is just another aspect of the switch Keynes has pulled off.

 

 

Further Problems with Keynesianism

 

The Keynesian argument is actually absurd on its face. If one looks at its so-called IS curve, one sees a relationship purporting to show that as output and, implicitly, employment increase along the horizontal axis, the “marginal efficiency of capital”/rate of profit falls on the vertical axis. The economic system is allegedly locked into a state of permanent mass unemployment because the rate of return is already as low as it is possible for it to go consistent with investment being worthwhile, while full employment would result in an even lower rate of return. What this means is that the economic system cannot achieve full employment and recovery, because if it did, the rate of profit would be lower in the recovery than it is in the depths of the depression.

 

There is another problem. A leading doctrine of the Keynesians is the “investment multiplier.” According to this doctrine, every additional dollar of investment results in an induced rise in consumption spending and thus in substantially more than a dollar of additional spending overall, perhaps $2 or $3. This additional spending is held to be synonymous with additional national income. While national income is composed essentially of profits and wages, the Keynesians seem to overlook the fact that additional national income implies additional profits. If profits were just 10 percent of national income, and the multiplier were just 2, every additional dollar of investment would imply 20 cents of additional profits in the economic system. What this in turn implies is that the rate of profit in the economic system must be rising in the direction of 20 percent, i.e., that more investment has a powerful positive effect on the rate of profit.

 

In a Recovery, Investment and Profits Move Together

 

The Keynesian claim is that the additional investment that accompanies additional employment reduces the rate of profit. The strongest argument against this claim is the fact that in the context of a business cycle, investment and profits move together, virtually dollar for dollar. Profit in the economic system is the totality of business sales revenues minus the totality of the costs deducted from those sales revenues. Net investment is the totality of business productive expenditure, i.e., wage payments plus purchases of newly produced capital goods, minus the very same costs that are deducted from sales revenues in arriving at profits. Since productive expenditure is the source of the great bulk of the sales revenues of the economic system, the only difference between net investment and profits in the economic system is the extent to which sales revenues exceed productive expenditure.

 

The reason that net investment equals productive expenditure minus costs is that productive expenditure represents additions to the value of accumulated assets, while costs represent subtractions from the value of accumulated assets. For example, productive expenditures on account of inventory are added to the value of inventory accounts on the balance sheets of the firms making the expenditures. Productive expenditures on account of plant and equipment are added to the gross plant accounts on the balance sheets of the firms making the expenditures. In these ways, productive expenditures increase the value of accumulated assets on the books of business firms.

 

By the same token, when firms make sales out of inventory, the value of inventory accounts is reduced by the cost value of the goods sold, which cost value enters into the income statements of firms, under the heading “cost of goods sold.” Similarly, as time passes, plant and equipment undergo depreciation. Depreciation allowances are accumulated in depreciation reserves, which are subtracted from the gross plant accounts, leaving net plant accounts. The same amount of depreciation that is deducted from gross plant and thereby reduces net plant, enters into the income statements of firms as depreciation cost.

 

If “cost of goods sold,” is subtracted from productive expenditure for inventory, the difference is the net change, i.e., the net investment, in inventory. If depreciation cost is subtracted from productive expenditure on account of plant and equipment, the difference is the net change, i.e., the net investment, in net plant and equipment.

 

There is a third major component of productive expenditure and costs, namely, productive expenditures that are not additions to any asset account and which are thus costs deducted from sales revenues in the very instant in which they are made; selling, general, and administrative expenses can be taken as examples. When productive expenditures that constitute selling, general, or administrative expenses are added to the productive expenditures on account of inventory and plant, the result is total productive expenditure. When these productive expenditures are added as costs to cost of goods sold and depreciation cost, the result is the total costs deducted from sales revenues in calculating profits. Since this is a matter of equals being added to unequals, the amount of net investment equals the totality of productive expenditure minus the totality of business costs.

 

In the context of recovery from a depression, a rise in productive expenditure should be expected to constitute a virtually equivalent rise in business sales revenues. If costs in the economic system remained the same, profits and net investment would obviously rise to exactly the same extent. The additional productive expenditure in its capacity as the source of additional sales revenues would raise profits equivalently. In its capacity simply as additional productive expenditure, it would raise net investment equivalently. Thus the rise in profits and the rise in net investment would be equal.

 

Insofar as total business costs might increase at the same time that productive expenditure and sales revenue rose, the rise both in net investment and profits would be equivalently diminished. In any event profits and net investment would increase together, dollar for dollar. The implication of this is that the economy-wide average rate of profit rises in the direction of 100 percent. This is the ratio found by dividing equal additions to profits and to capital invested. Capital invested rises to the exact same extent as net investment and additional net investment.  

 

In the same way, as was shown very early in this article, if costs in the economic system could be made to fall, say, by virtue of productive expenditure being shifted from wage payments to purchases of durable capital goods, profits and net investment would both rise equally.

 

The upshot is that to the extent that additional net investment accompanies the additional employment made possible by a fall in wage rates, the rate of profit increases, and increases the more, the greater is the increase in net investment. Keynes and his followers simply could not be more wrong about this subject.

 

In a Depression, Saving and Net Investment Are Negative

 

Closely related to the above, is another major error. This is the belief of Keynes and his followers that in the depths of depression and its accompanying mass unemployment, saving and investment are at their maximum tolerable limits. Allegedly, they are already as great as it is possible for them to be consistent with the rate of return on capital still being high enough to make investment worthwhile. The problem, say the Keynesians, is that full employment would result in still more saving, which would require still more investment to offset it, and which in turn would drive the already barely acceptable rate of return still lower, below the minimum acceptable rate.

 

Contrary to Keynes and his followers, the truth is that so far removed are saving and investment from being at their maximum tolerable limits in the conditions of depression and mass unemployment, that in reality they are both negative. For example, in the Great Depression of the 1930s, corporate saving (undistributed corporate profits) was negative in every year from 1930 to 1936 and again in 1938; personal saving was negative in 1932 and 1933 and barely more than zero in 1934; net investment was negative in the years 1931 to 1935 and again in 1938.

 

There should be nothing surprising in this. In a depression, business firms suffer widespread losses. What they are losing is a portion of their accumulated savings. Even many firms that manage to earn profits consume accumulated savings in a depression. This is the case to the extent that their profits are insufficient to cover the dividends they pay. Similarly, unemployed wage earners deplete their previously accumulated savings in consuming without the benefit of wages to provide the necessary funds.

 

Net investment becomes negative as the result of the exact same process that wipes out profits, namely, a sharp decline in productive expenditure, which results from the need to rebuild cash holdings in the aftermath of the end of the credit expansion of the preceding boom. The decline in productive expenditure wipes out profits insofar as it serves to reduce business sales revenues in the face of depreciation costs and costs of goods sold that reflect the higher levels of productive expenditure of the past. The decline in productive expenditure in the face of those same depreciation costs and costs of goods sold equivalently reduces net investment.

 

As explained previously, the demand for money for cash holding is also increased by a failure of wage rates to fall. And the decline in productive expenditure becomes greater still insofar as banks fail and the quantity of money is reduced. The effect is to further reduce productive expenditure, sales revenues, profits, and net investment.

 

In the light of such knowledge, it is difficult to imagine a theory that is more at odds with economic principles and obvious facts of reality than Keynesianism.

 

Conclusion

 

The essential conclusion to be drawn from this lengthy analysis is that once the process of financial contraction in a depression comes to an end, and existing business assets have been re-priced to reflect the deflationary aftermath of credit expansion—once this has occurred, a fall in wage rates will in fact serve to achieve the reemployment of the unemployed. Moreover, it will do so in a such way that the increase in employment is more than proportionate to the fall in wage rates. At the same time, as part of the same process, the decrease in the demand for money for cash holding that occurs in response to the necessary fall in wage rates, manifests itself in a rise in productive expenditure not only for labor but also for capital goods. As the result of the rise in productive expenditure, sales revenues, profits, and net investment in the economic system all rise together.

 

The fall in wage rates thus serves as an essential component of a full and complete economic recovery, one that entails full employment and the achievement of a substantially increased rate of profit that will be more than sufficient to make investment worthwhile.

 

The economic policy that is implied by these findings of economic theory is one of a fully free labor market. That is, a labor market free of coercive labor-union interference, free of minimum-wage laws, and free of all other laws that mandate expenditures by employers on behalf of the workers they employ. All legal obstacles in the way of wage rates falling, counting as part of wages the cost of so-called fringe benefits, must be swept aside. This is the policy that will allow the cost of employing labor to fall and thus the quantity of labor demanded to increase, and will thereby achieve the employment of everyone able and willing to work, i.e., full employment.

 

Beyond Keynesianism: Marxism

 

While essential, the overthrow of Keynesianism is insufficient for being able to implement the policy of a free labor market. It is insufficient because Keynesianism constitutes merely the outer ring of the defenses of the policy of government interference in the labor market. The inner ring, which Keynesianism has served to protect up to now, is the errors and contradictions of Marxism.

 

Marxism holds that a free market in labor is a vehicle for the exploitation of labor. It claims that in the absence of government intervention in the form of pro-union and minimum-wage and maximum-hours legislation, employers would be free to drive wage rates to or even below the level of minimum subsistence, while lengthening the hours of work beyond the limits of human endurance, and imposing conditions of work that are nightmarish.

 

Because of Keynesianism, the immense majority of economists have been able to avoid having to confront Marxism. They have been able to hide behind the Keynesian doctrine that even if a free market in labor existed, it would not be able to eliminate mass unemployment. And thus they have been able to believe that there is simply no point in fighting for a free market in labor.

 

Being able to believe this, I’m convinced, has been a source of great comfort and relief for most economists and thus a major source of their readiness to accept Keynesianism despite the obviously absurd nature of some of its claims, such as that “Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.” (General Theory, p. 129.) Keynesianism has spared them from having to do battle with practically the entire rest of the intellectual world, which has accepted Marxism as constituting a full and accurate description of what happens under laissez-faire capitalism.

 

In the absence of Keynesianism, economists who understood such elementary propositions as that quantity demanded rises as price falls would be obliged to argue for the repeal of pro-union and minimum-wage legislation. They would perceive such interferences as causing and perpetuating mass unemployment. But to do this, they themselves would have to understand why laissez-faire capitalism does not in fact result in any exploitation of labor and how, indeed, it is the foundation of progressively rising real wages, shortening of hours, and improvement in working conditions.

 

The immense majority of today’s economists, and those of the past several generations, have lacked both this essential knowledge and any will, or even mere willingness, to acquire it. They lack the will because they have no philosophical commitment to the value of individual rights and individual freedom and thus no basis for being prepared to challenge claims that these must be sacrificed for the sake of avoiding poverty. They are light years from understanding that it is precisely respect for individual rights and individual freedom that is the essential foundation of prosperity, including, as leading examples, full employment and high and progressively rising real wages.   

 

Keynesianism has been a refuge for masses of economists badly deficient in understanding of economics and equally lacking in essential aspects of moral character, namely, in abhorrence of the use of physical force for any purpose but that of self-defense, and in an equal abhorrence of blatant irrationalism, such as manifested in Keynes’s claims about the economic value of wars and earthquakes. Content with the unchecked growing use of physical force by government in all aspect of the life of the individual, and often taking delight in the ability to confuse the minds of students by convincing them that the absurd is true, they are completely at home in Keynesianism.

 

Hopefully, the overthrow of Keynesianism will set the stage for the appearance of a body of intellectuals with a far better understanding of economics than that of today’s economists, an understanding which they will join to a philosophical commitment to the values of Freedom and Reason. Thus armed, there will be a group of intellectuals able to take on the rest of the intellectual world and start to overcome the ideas that have made today’s colleges and universities more into centers of civilization-destroying intellectual disease than centers of knowledge and education.

 

 

*Copyright © 2009, by George Reisman. George Reisman, Ph.D.  is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen. The book provides a deeper and more comprehensive treatment of all aspects of the material discussed in this article.

 

[1]In this article “profit” is to be understood as inclusive of any interest paid on borrowed capital, and the rate of profit as reflecting the division of the sum of profits plus interest by the totality of the capital invested, i.e., as the rate of return on capital.

 

The Fundamental Obstacles to Economic Recovery: Marxism and Keynesianism

March 29th, 2009

In a previous article, I explained how falling prices, far from being deflation, are actually the antidote to deflation. They are the antidote, I explained, because they enable the reduced amount of spending that deflation entails to buy as much as did the previously larger amount of spending that took place in the economic system prior to the deflation.Capitalism: A Treatise on Economics, in the 269 pages that comprise Chapters 11, 13-15, and 18, which are respectively titled “The Division of Labor and the Concept of Productive Activity,” “Productionism, Say’s Law, and Unemployment,” “The Productivity Theory of Wages,” “Aggregate Production, Aggregate Spending, and the Role of Saving in Spending,” and “Keynesianism: a Critique.”

Despite the fact that the freedom of prices and wages to fall is the simple and obvious way to achieve economic recovery, two fundamental obstacles stand in the way. One is the exploitation theory of Karl Marx. The other is the doctrine of unemployment equilibrium, which was propounded by Lord Keynes.

According to Marxism, any freedom of wages to fall is a freedom for capitalists to intensify the exploitation of labor and to drive wages to or even below the level of minimum subsistence. This dire outcome can allegedly be prevented only by government interference in the form of minimum-wage and pro-union legislation. Such legislation, of course, makes reductions in wages simply illegal in all those instances in which the legal minimum wage would have to be breached. It also makes reductions in wages illegal in all those cases in which carrying them out depends on the ability to replace union workers with non-union workers in defiance of existing laws or government regulations. The influence of labor unions on wages pervades the economic system, with government protection of labor unions serving to prevent wages from falling even in companies and industries in which there are no unions. This is because non-union employers must pay wages fairly close to what union workers receive lest their workers too decide to unionize. In that case, the firms would be faced not only with having to pay union wages but also with all of the inefficiencies caused by union work rules.

The Keynesian unemployment equilibrium doctrine claims that it would make no difference even if wages and prices were totally free to fall. In that case, say the Keynesians, all that would happen is that total spending in the economic system would fall in proportion to the fall in wages and prices.

Thus, say the Keynesians, if, in response to an economy-wide fall in total spending of, say, 10 percent, wages and prices also fell by 10 percent, then instead of 90 percent of the original total spending now buying as much as did the original spending, total spending would fall by a further 10 percent. As a result, say the Keynesians, no additional goods or services whatever would be bought; all that would allegedly be accomplished is to make the deflation worse than before, as sales revenues and incomes throughout the economic system fell still further.

In sum, while the influence of Marxism stands directly in the path of a fall in wage rates and prices, by blocking its way with laws and threats, Keynesianism aims to prevent any attempt to overcome these obstacles by allegedly demonstrating the futility and harm of doing so.

Both doctrines are fundamental obstacles in the way of economic recovery and must be deprived of influence over public opinion in order for economic recovery to take place. The prerequisite of this necessary change in public opinion is the existence of a powerful, demonstration of the utter fallaciousness of these doctrines that at the same time proves that a free market is the foundation both of full employment and of progressively rising real wages.

Happily, this demonstration already exists, in full detail. It can be found in my book

Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen.

“Change” Under Obama: From Dumb to Dumber and From Bad to Worse

March 7th, 2009

A recent article in The New York Times quotes President Obama as saying, “I don’t buy the argument that providing workers with collective-bargaining rights somehow weakens the economy or worsens the business environment. If you’ve got workers who have decent pay and benefits, they’re also customers for business.” (March 2, 2009, p. B3.) This statement makes about as much sense as declaring that people who are successful at sticking up gas stations are also customers of gas stations.

The President’s statement reveals a great deal about his understanding or, more correctly, lack of understanding of economics.

Collective bargaining is the joining together, typically through the instrumentality of a labor union, of all workers in a given occupation or industry for the purpose of acting as a single unit in seeking pay and benefits. It is an attempt to compel employers to deal with just one party—i.e., the labor union—and to come to terms agreeable to that party or to be unable to obtain labor.

The imposition and maintenance of collective bargaining necessarily depends on compulsion and coercion, i.e., on the use of physical force against both employers and unemployed workers. This coercion is necessitated, in substantial measure, precisely by the seeming success that collective bargaining can achieve.

That success is measured in terms of the rise in wage rates that it achieves. That rise in wage rates is all that labor union leaders and their ignorant supporters are aware of.

Precisely this “success,” however, is the cause of major problems. The first is that higher wage rates reduce the quantity of labor that any given amount of capital funds can employ. For example, at a wage of $20,000 per year, $1 million of payroll funds can employ 50 workers for a year. But at a wage of $25,000 per year, it can employ only 40 workers for a year. With every further rise in the wage, correspondingly fewer workers are able to be employed.

Higher wage rates also serve to raise costs of production and thus the selling prices of the products that the higher-paid workers are producing. These higher selling prices reduce the quantities of the products that buyers are able and willing to buy. And thus, whether as the result of the reduced purchasing power of capital funds in the face of higher wage rates or the reduced quantities of products demanded by customers in the face of higher product prices, the effect of collective bargaining is a reduced quantity of labor employed, i.e., unemployment.

It is shocking, indeed, frightening, that the President of the United States, whose main concern at the moment is supposedly with overcoming mass unemployment and preventing its getting worse, does not understand that any policy that drives up wage rates drives up unemployment.

The unemployment that collective bargaining causes is what explains why it is necessary to resort to coercion against wage earners in order to maintain the system. The self-interest of the unemployed is to find work, and to accept lower wage rates as the means of doing so. And taking advantage of that fact is to the self-interest of employers. Thus there are two parties, unemployed workers and employers, whose self-interest lies with a reduction in the higher wage rates achieved by collective bargaining.

If these parties are free to act in their self-interest, the system of collective bargaining must break down. How are they to be prevented from acting in their self-interest?

The answer is physical force. Stepping outside the system of collective bargaining must be made illegal if the system is not to break down. That means employers and unemployed workers must be threatened with fines or imprisonment for acting in their self-interest and withdrawing from the system of collective bargaining. In the last analysis, they must be threatened with the specter of armed officers ready to cart them off to jail if they disobey the requirements of the system, and to club and shoot them should they physically resist being carted off to jail. (It is not always necessary that the physical force that imposes and maintains collective bargaining come directly from the government. It can often come from labor unions that the government chooses not to prosecute when their members physically assault strikebreakers, surround factories and refuse to allow entry or exit, start fires, set off stink bombs, shoot out tires, and perform other acts of vandalism and intimidation.)

In saying, “I don’t buy the argument that providing workers with collective-bargaining rights somehow weakens the economy or worsens the business environment,” President Obama confesses to not knowing that collective bargaining raises prices and causes unemployment. He confesses to not knowing that it raises costs and prices not only through the imposition of artificially high wage rates, but also in imposing on employers the use of unnecessary labor, sometimes as many as four or five workers to do the job that just one could do.

(A classic example of this is the insistence on the use of a carpenter, plumber, electrician, tile setter, and drywaller to make a simple repair in a bathroom, merely because the separate labor unions involved claim each operation as belonging to their respective members exclusively, i.e., claim a monopoly on that type of operation.) He confesses to not knowing how the enormous difficulties that labor unions put in the way of firing incompetent workers are responsible for such phenomena as so-called Monday-morning automobiles. That is, automobiles poorly made for no other reason than because they happened to be made on a day when too few workers showed up, or too few showed up sober, to do the jobs they were paid to do. The automobiles companies were unable to fire such workers without precipitating a crippling strike, to which the system of compulsory collective bargaining gave them no alternative.

Collective bargaining, with its imposition of higher costs and prices and lower product quality, is at the root of the destruction of the American automobile industry and many other American industries. President Obama not only chooses not to know this, but selects union leaders as his companions, including the leader of the United Automobile Workers Union. (The Times article from which I quoted him is accompanied by a photograph that shows him, in what appears to be a round of golf, with Ron Gettelfinger, who is the president of the U.A.W., James Hoffa, who is the president of the Teamsters, and John Sweeney, who is the president of the A.F.L.-C.I.O. The article notes that “Mr. Sweeney has visited the White House at least once a week since Inauguration Day.”)

The reader should keep in mind the coercive nature of collective bargaining. Then he should consider Mr. Obama’s observation that “If you’ve got workers who have decent pay and benefits [as the alleged result of collective bargaining], they’re also customers for business.”

Moreover, the workers who are unemployed by collective bargaining are not customers of business, or not very good customers (they can’t afford to be). And the products offered by business to its customers are poorer and more expensive because of collective bargaining. This is something, it must be stressed, that reduces the buying power of the wages of workers throughout the economic system, i.e., reduces what economists call their “real wages.” Mr. Obama needs to forget the nonsense he believes about collective bargaining and paying extortionate wages somehow benefiting business and learn to understand how it harms wage earners, how it harms every wage earner who must pay more and get less as the result of legally enforced collective bargaining. He must learn to understand how it also harms every worker who must earn less as the result of being displaced by collective bargaining from the better paying jobs he could have had if wage rates in those lines had not been driven artificially still higher by collective bargaining and thus reduced the number of workers who could be employed in them and thereby forced those workers into lower paying jobs.

Unfortunately, it does not seem very likely that Mr. Obama will ever learn any of this. He appears to be so charmed by the use of compulsion and coercion that he and his supporters in Congress are ready to unleash a reign of outright mass intimidation against American workers.

In a bow to Orwell’s 1984 and its world filled with such slogans as “war is peace,” “freedom is slavery,” and “love is hate,” Obama and his henchmen are readying “the Employee Free Choice Act.” This is an act designed precisely to end employee free choice, by depriving workers of the benefit of a secret ballot in deciding whether or not they want to join a union. In the words of The Times article, this is “a bill that unions hope will add millions of new members by giving workers the right to union recognition as soon as a majority of employees at a workplace sign pro-union cards. The bill would take away management’s ability to insist on a secret ballot election.”

Here we have it. Obama is against the secret ballot. No, he’s not yet announced any opposition to the secret ballot in elections for public office. But there’s absolutely no difference in principle between being against the secret ballot in elections concerning whether or not to unionize and being against it in elections for public office. In both cases, it is a matter of subjecting people to intimidation if they express a choice that is opposed to the one that an organized, powerful group wants them to make. In this case, that group would be the union goons who would distribute the “pro-union cards” that workers would be asked to sign or refuse to sign in their presence. Are Obama and his followers really so naive as not to know that any worker who would reject joining a union in these circumstances would, at a minimum, be exposing himself to ostracism and the chance of substantial personal economic loss in the event the union gained recognition and he is on record as having opposed it?

Be assured, they are not so naive. They look forward to the intimidation. They look forward to it in the recognition that that is what is required to swell the ranks of the unions once again.

The wider principle here is the readiness of Obama and his associates to resort to intimidation to further their goals. It is the method of street thugs and of dictators. That is what is present in their attempt to deprive workers of the secret ballot in deciding whether or not to unionize.

The last occupant of the White House often gave the impression of having an inadequate command of the English language and of experiencing great difficulty in speaking in grammatical sentences and using words in accordance with their proper meaning. The present occupant of the White House speaks impeccable English, with crisp, clear pronunciation. Nevertheless, his actual knowledge—of economics, of the meaning of individual rights, and of the nature of government—appears to lag far behind that of his bumbling predecessor.

Furthermore, while Bush may be accused of disregarding the rights of foreign terrorists at war with the United States, Obama is out to disregard the rights of peaceful, productive American citizens. This is apparent not only in his readiness to deprive American workers of the secret ballot in union organizing elections, but also in his efforts to dramatically raise the taxes of everyone earning more than $250,000 per year, in an attempt to achieve a substantial redistribution of income. It is also evident in his policies on energy and healthcare as well.

In sum, the “change” that Obama promised his mesmerized supporters in the election campaign, and is now in process of actually delivering, is nothing more than change from dumb to dumber and from bad to worse.

Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen. The book provides further, in-depth treatment of the substantive material discussed in this article and of practically all related aspects of economics.


 

ECONOMIC RECOVERY REQUIRES CAPITAL ACCUMULATION NOT GOVERNMENT “STIMULUS PACKAGES”

February 22nd, 2009

Part II: Stimulus Packages

 

Previously: Part I: Capital, Saving, and Our Economic Crisis

 

The Nature of Stimulus Packages

 

As was shown in Part I of this article, economic recovery requires greater saving and the accumulation of fresh capital, to make up for the losses caused by credit expansion and the malinvestment and overconsumption that follow from it. Yet the imposition of “stimulus packages” results in the further loss of capital. The Keynesians not only do not know this, but would not care even if they did know it.

 

Because of their ignorance of the role of capital in the economic system and resulting inability to see even the clearest evidence that suggests it, the Keynesians can conceive of no cause of a recession or depression but an insufficiency of consumption and no remedy but an increase in consumption. This is the basis of their calls for “stimulus packages” of one kind or another.

 

They assume that the economic system always has enough capital, indeed, that it is in danger of having too much capital, and that the problem is simply to get it to use the capital that it has. The way that this is done, they believe, is to get people to consume. Additional  consumption will be the “stimulus” to new and additional production. When people consume, the products of past production are taken off the shelves and disappear from the stores. These products, the Keynesians believe, now require replacement. Hence, the shops will order replacement supplies and the manufacturers will turn to producing them, and thus the economic system will be operating again and recovery will be achieved, provided the “stimulus” is large enough.

 

The essential meaning of a “stimulus package” is the government’s financing of consumption, indeed, practically any consumption, by anyone, for almost any purpose, in the conviction that this will cause an increase in employment and production as the means of replacing what is consumed. Despite talk of avoiding wasteful spending and being “careful with the taxpayers’ money,” the truth is that from the point of view of the advocates of economic stimulus, the bigger and more wasteful the project, the better.

 

This was made brilliantly clear many years ago by Henry Hazlitt, who chose the example of government spending for a bridge. It is one thing, Hazlitt showed, if the government builds a bridge because its construction is necessary to facilitate the flow of traffic. It is a very different matter, he pointed out, if the government builds the bridge for the purpose of promoting employment. In the first case, the government wants the best bridge for the lowest possible cost, which implies the employment of as few workers as possible, both in the construction of the bridge and in the production of any of the materials that go into it.

 

In the second case, that of stimulating employment, the government wants a bridge that requires as many workers as possible, for their employment is its actual purpose. The greater the number of workers employed, of course, the greater must be the cost of the bridge.

 

Indeed, no one could be more clear or explicit concerning the nature of government “fiscal policy” and its “stimuli” than Keynes himself, who declared (on p. 129 of his General Theory) that “Pyramid building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.”

 

Acts of sheer destruction, such as wars and natural disasters, appear as beneficial to Keynes and his followers for the same reason that the “stimulus” of government-financed consumption appears beneficial. This is because they too create a need for replacement and thus allegedly result in an increase in employment and production. So widespread is this view that one can very often hear people openly express favorable opinions about the alleged economic benefits of such things as earthquakes, hurricanes, and even wars.

 

Stimulus Packages Mean More Loss of Capital

 

Despite the fact that what the economic system needs for recovery is saving and the accumulation of new capital, to replace as far as possible the capital that has been lost, the effect of stimulus packages is further to reduce the supply of capital, and thus to worsen the recession or depression.

 

The reason that stimulus packages cause a further loss of capital is that their starting point is the consumption of previously produced wealth. That wealth is part of the capital of the business firms that own it. The stimulus programs offer money in exchange for this wealth and capital. But the money they offer does not come from the production of any comparable wealth by the government or those to whom it gives money—wealth which has had to be produced and sold and thus put into the economic system prior to the withdrawal that now takes place. The starting point for the government and its dependents is an act of consumption, which means a using up, a loss of previously existing wealth in the form of capital.

 

The supporters of stimulus packages look to the fresh production that is required to replace the wealth that has been consumed. It will require the performance of additional labor. They are delighted to the extent that this fresh production and additional employment materialize. They believe that at that point their mission has been accomplished. They have succeeded in generating new and additional economic activity, new and additional employment. The only shortcoming of such a policy, they believe, is that it may not be applied on a sufficiently large scale.

 

Unfortunately, there is  something they have overlooked. And that is the fact that any fresh production and employment that results is incapable by itself of replacing the capital that was consumed in starting the process. The reason for this is that all production, including any new and additional production called into being by stimulus packages, itself entails consumption. And this consumption tends at the very least to approximate the fresh production and, indeed, is capable of equaling or even exceeding it.

 

Thus, for example, we start with the purchase and consumption of a new television set by someone who has not previously produced and sold anything of equivalent monetary value that provided the funds for his now buying the television set. He has simply received the money from the government. In this case, what we have is one television set withdrawn from the capital of the economic system and placed in the hands of a non-producing consumer.

 

We can assume, for the sake of argument, that the retailer of the television set will order a replacement set from the wholesaler, and that the wholesaler in turn will order a replacement set from the manufacturer. We can assume further that the manufacturer will now produce a new television set to replace the one that he sells to the wholesaler from his inventory.

 

The production of the replacement television set entails a using up of materials and components and part of the useful life of the plant and equipment required. Aspects of such using up of capital goods also take place on the part of the retailer and wholesaler and in the transportation of the television set.

 

Very importantly, any new and additional workers who may be employed—precisely the goal of the whole operation—in producing a new television set or in moving a television set through the channels of distribution must be paid wages, which they in turn will consume. The goods these workers receive when they spend their wages represents a further depletion of inventories, on the part of all the retailers with whom they deal. In addition, the various business firms involved have additional profits, or at least diminished losses, as the result of the various additional purchases. This enables their owners to consume more and probably results in the payment of additional taxes, which the government consumes.

 

Even whatever depreciation allowances are earned along the way in the various stages of replacing the television set are likely to be consumed. This is because in the context of a recession or depression investors are afraid of losses if they invest in private businesses and thus prefer to invest in short-term treasury securities, such as treasury bills, which they consider to be far safer. But when depreciation allowances are used to purchase treasury securities, they end up financing consumption rather than capital replacement. This is because the Treasury uses the proceeds from the sale of its securities to finance nothing but consumption, either that of the government itself or that of the private individuals to whom the government gives money.

 

The point here is that any replacement of a good consumed by a non-producer itself entails very substantial additional consumption of inventories and the useful life of plant and equipment of business firms. The same is obviously true of the replacement of goods that have simply been destroyed, whether by war or by an act of nature.

 

No matter how long the process of spending and respending of the funds introduced into the economic system by a stimulus package might continue—no matter how many instances of replacement production there might be following the purchase and consumption of our hypothetical television set or of any other such good—the initial loss of capital need never be made up.

 

This is because each act of replacement production is accompanied by corresponding additional consumption. Thus the initial act of consumption—or destruction—of wealth and capital may be followed by 10 or 100 acts of subsequent production, each carried on in order to replace the goods used up before it. But if each of these subsequent acts of production is accompanied by fresh consumption that is equivalent to it, the net effect is still one act of consumption. As a result, the supply of capital is reduced. For what is always present is X instances of production respectively following X+1 instances of consumption.

 

Now countries have suffered enormous losses of capital and yet still managed to recover and go on to new heights of wealth and prosperity. Germany and Japan in the decades following  World War II are perhaps the most outstanding examples of this.

 

What enabled them to recover was not further acts of consumption, not “stimulus packages” of any kind, but increases in production in excess—substantially in excess—of increases in consumption. That is to say, it was a process of saving and capital accumulation that made their recovery possible. On average, people in those countries, in those years, saved and reinvested a major portion of their income, often in excess of 25 percent.

 

It is possible, but highly unlikely, that the replacement production induced by an initial consumption/destruction of wealth might itself entail some such new saving. If round after round of replacement production were in fact accompanied by some such saving, then, eventually, the original loss of capital would be made good. But that would be the case only if such saving was not offset by fresh acts of “stimulus” or other policies that waste or destroy capital.

 

However, as I say, such an outcome is highly unlikely. If for no other reason, this is because, as I have already pointed out, the stimulus packages take place in an environment in which investors fear to invest in private firms. As a result, they use not only whatever new and additional savings they might make, for the purpose of buying “safe” treasury securities but also even funds they earn that are required for the replacement of capital goods. In this way, savings are diverted into consumption rather than capital accumulation.

 

(It is ironic that while, if it did manage to occur and was not diverted into consumption, such saving might mitigate the effects of a stimulus package, it is attacked as undermining the process of recovery. Thus, for example, Paul Krugman, the 2008 Nobel Prize winner in economics, writes: “Meanwhile, it’s clear that when it comes to economic stimulus, public spending provides much more bang for the buck than tax cuts…because a large fraction of any tax cut will simply be saved.” New York Times, January 26, 2009, p. A23.)

 

In addition to the diversion into consumption of such new savings as might occur subsequent to a “stimulus,” there is the fact that the source of any such saving, namely, the net product produced, is likely to be greatly diminished. The net product is the excess of the product produced over the capital goods used up in order to produce it. It is what is available for consumption or saving out of current wage,  profit, and interest income.

 

The net product is diminished to the extent that production is made to take place in accordance with methods requiring the employment of unnecessary capital goods per unit of output. Environmental and consumer product safety legislation provide numerous instances of this kind.

 

For example, requiring gas stations, dry-cleaning establishments, and many other types of businesses to substantially increase their capital investments merely in order to placate the largely groundless fears of the environmental movement. Similarly, requiring safety features in automobiles, dishwashers, display cases, ice machines, stepladders, and countless other goods—features that the market does not judge to be worth their cost—adds to the cost of the materials and components that enter into the production of products without increasing the perceived value of the products. In both instances, the result is a larger consumption of capital goods but no increase  in production, and thus a reduction in the size of the net product produced and thus in the ability to engage in saving out of current income.

 

As indicated in Part I of this article, the effect of capital decumulation, whether caused by stimulus packages or anything else, is  a reduction in the ability of the economic system to produce, to employ labor, and to provide credit, for each of these things depends on capital. The reduced ability to produce and employ labor may not be apparent in the midst of mass unemployment. But it will become apparent if and when economic recovery begins. At that point, the economic system will be less capable than it otherwise would have been, because of the reduction in its supply of capital. Real wages and the general standard of living will be lower than they otherwise would have been. And all along, the ability to grant credit will be less than it otherwise would have been.

 

Stimulus Packages Are a Drain on the Rest of the Economic System

 

Even though stimulus packages may be able to generate additional economic activity, they cannot achieve any kind of meaningful economic recovery. Their actual effect is the creation of a system of public welfare in the guise of work. That is in the nature of employing people not for the sake of the products they produce but having them produce products for the sake of being able to employ them.

 

But stimulus packages are much more costly than simple welfare. On top of the welfare dole that allows unemployed workers to live, stimulus packages add the cost of the materials and equipment that the workers use in producing their pretended products.

 

The work created by stimulus packages is a make-believe work that is carried on at the expense of the rest of the economic system. It draws products and services produced in the rest of the economic system and returns to the rest of the economic system little or nothing in the way of goods or services that would constitute value for value or payment of any kind. In other words, stimulus packages and the needless work they create cause the great majority of other people to be poorer. I’ve already shown how they cause them to have less capital. Shortly, I will show how they also cause them to consume less. (For elaboration on this point, please see the forthcoming republication of my article “Who Pays for `Full Employment’?”)

 

Rising Prices in the Midst of Mass Unemployment

 

If economic recovery is to be achieved, the first thing that must be done is to stop “stimulus packages” and undo as far as possible any that are already in progress. This is because their effect is to worsen the problem of loss of capital that is the underlying cause of the economic crisis in the first place.

 

Unfortunately, they are not likely to be stopped. If they are implemented, especially on the scale already approved by Congress, the effect will be a decumulation of capital up to the point where scarcities of capital goods, including inventories of consumers’ goods in the possession of business firms, start to drive up prices.

 

Higher prices of consumers’ goods will result not only from scarcities of consumers’ goods (which, of course, are capital goods so long as they are in the hands of business firms), but also from scarcities of capital goods further back in the process of production. Thus a scarcity of steel sheet will not only raise the price of steel sheet, but will carry forward to the price of automobiles via the higher cost of producing automobiles that results from a rise in the price of steel sheet. Likewise, a scarcity of iron ore will carry forward to the price of steel sheet, which, again, will carry forward to the price of automobiles. And, of course, the pattern will be the same throughout the economic system, in such further cases as oil and oil products, cotton and cotton products, wheat and wheat products, and so on.

 

A rise in the prices of consumers’ goods is capable of stopping further capital decumulation stemming from the stimulus packages. When the point is reached that additional funds spent on consumers’ goods serve merely to raise their prices, then no additional quantities of them are sold. The same quantities are sold at higher prices. This ends the decumulation of inventories. From this point on, the buyers who obtain their funds from the government consume at the expense of people who have earned their incomes but now get less for them.

 

Once inventories become scarce in relation to the spending for goods, all of the funds that the government has been pouring into the economic system become capable of launching a major increase in prices. This rise in prices can take place even in the midst of mass unemployment. This is because the abundance of unemployed workers does nothing to mitigate the scarcity of capital goods that has occurred as the result of the attempts to stimulate employment.

 

Even though rising prices can deprive stimulus packages of the ability to cause further capital decumulation, the inflation of the money supply by the government results in continuing capital decumulation. In large part, this occurs as the result of the fact that the additional spending resulting from a larger money supply raises business sales revenues immediately while it raises business costs only with a time lag. So long as this goes on, profits are artificially increased.

 

Despite the fact that most or all of the additional profits may be required simply in order to replace assets at higher prices, the additional profits are taxed as though they were genuine gains. This impairs the ability of firms to replace their assets. The destructive consequences of this phenomenon can be seen in the transformation of what was once America’s industrial heartland into the “rustbelt.”

 

At the same time, throughout the economic system, starting long before today’s stimulus packages and continuing on alongside them, regular, almost year-in, year-out government budget deficits do their work of destruction. They cause a continuing diversion into consumption not only of a considerable part of whatever savings might be made out of income but also of the replacement allowances for the using up of plant and equipment and all other fixed assets. Generations of government budget deficits have sucked up trillions of dollars of what would have been capital funds and have gone a long way toward turning America into an industrial wasteland.

 

The blind rush into massive “stimulus packages” is the culmination of generations of economic ignorance transmitted from professor to student in the guise of advanced, revolutionary thinking—the “Keynesian revolution.” The accelerating destruction of our economic system that we are now experiencing is the product of a prior destruction of economic thought. Our entire intellectual establishment has been the victim—the willing victim—of a massive intellectual con job that goes under the name “Keynesianism.” And we are  now paying the price.

 

I say, willing victims of an intellectual con job. What other description can there be of those who were ready to hail as a genius the man who wrote, “Pyramid building, earthquakes, even wars may serve to increase wealth….”

 

Only a brave few—most notably Ludwig von Mises and Henry Hazlitt—  stood apart from this madness, and for doing so, they were made intellectual pariahs. But the time is coming when it will be clear to all who think that it is they who have had the last word.

 

 

*Copyright © 2009, by George Reisman. George Reisman, Ph.D.  is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.

 

ECONOMIC RECOVERY REQUIRES CAPITAL ACCUMULATION NOT GOVERNMENT “STIMULUS PACKAGES”

February 21st, 2009

This two-part article is the second in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity. The first article in the series was “Falling Prices Are Not Deflation but the Antidote to Deflation.” 

Part I: Capital, Saving, and
Our Economic Crisis

                                        

I

magine an individual who is lethargic and lacks the energy to function at his normal level because of too little sleep. There are drugs that can make him feel fully refreshed, even after a night without any sleep whatever, and apparently capable of functioning the next day with full efficiency.

 

Nevertheless taking such drugs is definitely not a good idea. This is because the individual’s underlying problem of insufficient sleep is not only not addressed by his being stimulated but is actually worsened. For the stimulus further depletes his body’s already diminished energy reserves and takes him down the path of utter exhaustion.

 

This description applies to the current slowdown in our economic system and to the efforts to overcome it through the use of “fiscal policy” and its “stimulus packages.” The meaning of these terms is more government spending and lower taxes specifically designed to promote consumption. This includes giving income-tax refunds to people who paid no income tax and who, because of their low incomes, can presumably be most counted on to rush out and consume more as soon as additional funds are put in their hands.

 

The main difference between such economic “stimulants” and pharmaceutical stimulants is that the economic stimulants will not succeed even in temporarily restoring the economic system to anything approaching its normal level of activity.

 

An economic system entering into a major recession or depression is in a situation very similar to that of our imaginary, sleep-deprived individual. All that one need do is substitute for the loss of the sleep required for the body’s proper functioning the loss of something required for the proper functioning of the economic system.

 

Capital

 

In the case of the economic system, that something is capital. The economic system is not functioning properly because it has lost capital. Capital is the accumulated wealth that is owned by business enterprises or individuals and that is used for the purpose of earning profit or interest.

 

Capital embraces all of the farms, factories, mines, machinery and all other equipment, means of transportation and communication, warehouses, shops, office buildings, rental housing, and inventories of materials, components, supplies, semi-manufactures, and finished goods that are owned by business firms.

 

Capital also embraces the money that is owned by business firms, though money is in a special category. In addition, it embraces funds that have been lent to consumers at interest, for the purpose of buying consumers’ goods such as houses, automobiles, appliances, and anything else that is too expensive to be paid for out of the income earned in one pay period and for which the purchaser himself does not have sufficient savings.

 

The amount of capital in an economic system determines its ability to produce goods and services and to employ labor, and also to purchase consumers’ goods on credit. The greater the capital, the greater the ability to do all of these things; the less the capital, the less the ability to do any of these things.

 

Saving

 

Capital is accumulated on a foundation of saving. Saving is the act of abstaining from consuming funds that have been earned in the sale of goods or services.

 

Saving does not mean not spending. It does not mean hoarding. It means not spending for purposes of consumption. Abstaining from spending for consumption makes possible equivalent spending for production. Whoever saves is in a position to that extent to buy capital goods and pay wages to workers, to lend funds for the purchase of expensive consumers’ goods, or to lend funds to others who will use them for any of these purposes.

 

It is necessary to stress these facts because of the prevailing state of utter ignorance on the subject. Such ignorance is typified by a casual statement made in a recent New York Times news article. The statement was offered in the conviction that its truth was so well established as to be non-controversial. It claimed that “A dollar saved does not circulate through the economy and higher savings rates translate into fewer sales and lower revenue for struggling businesses.” (Jack Healy, “Consumers Are Saving More and Spending Less,” February 3, 2009, p. B3.)

 

The writer of the article apparently believes that houses and other expensive consumers’ goods are purchased out of the earnings of a single week or month, which is the normal range of time between paychecks. If that were the case, no savings would be necessary in order to purchase them. In fact, of course, the purchase of a house typically requires a sum equal to the purchaser’s entire income of three years or more; that of an automobile, the income of several months; and that of countless other goods, too large a fraction of the income of just one pay period to be affordable out of such limited funds.

 

In all such cases, a process of saving is essential for the purchase of consumers’ goods. The savings accumulated may be those of the purchaser himself, or they may be borrowed, or be partly the purchaser’s own and partly borrowed. But, in every case, savings are essential for the purchase of expensive consumers’ goods.

 

The Times reporter, and all of his colleagues, and the professors who supposedly educated him and his colleagues, all of whom spout such nonsense about saving, also do not know other, even more important facts abut saving. They do not know that saving is the precondition of retailers being able to buy goods from wholesalers, of wholesalers being able to buy goods from manufacturers, of manufacturers, and all other producers, being able to buy goods from their suppliers, and so on and on. It is also the precondition of sellers at any and all stages being able to pay wages.

 

Such expenditures must generally be made and paid for prior to the purchaser’s receipt of money from the sale of his own goods that will ultimately result. For example, automobile and steel companies cannot pay their workers and suppliers out of the receipts from the sale of the automobiles that will eventually come in as the result of using the labor and capital goods purchased. And even in the cases in which the payments to suppliers are made out of receipts from the sale of the resulting goods, the seller must abstain from consuming those funds, i.e., he must save them and use them to pay for the capital goods and labor he previously purchased.

 

In contrast, the Keynesian reporters and professors believe that sellers do nothing but consume or hoard cash. They are too dull to realize that if that were really the case, there would be no demand for anything but consumers’ goods. This becomes clear simply by following the pattern of the Keynesian textbooks in allegedly describing the process of spending.

 

Thus a consumer buys, say, $100 dollars worth of shirts in a department store; the owner of the department store, following his Keynesian “marginal propensity to consume” of .75, then buys $75 worth of food in a restaurant, and allegedly hoards the other $25 of his income; the owner of the restaurant then buys $56.25 (.75 x $75) worth of books, while allegedly hoarding the remaining $18.75 of his income; and so on and on. Now, unknown to the Keynesians, if such a sequence of spending actually took place, all that would exist is a sum of consumption expenditures and nothing else.

 

The fact is that most spending in the economic system rests on a foundation of saving. The seller of the shirts will likely save and productively expend $95 or more in buying replacement shirts and in paying his employees and making other purchases necessary for the conduct of his business, and perhaps only $5 on consumption. And so it will be for those who sell to him, or to the suppliers of his suppliers, or to the suppliers of those suppliers, and so on.

 

Any business income statement can provide a simple confirmation of such facts. The ratio of costs to sales revenues that can be derived from it, is an indicator of the ratio of the use of savings to make expenditures for labor and capital goods relative to sales revenues. For the costs it shows are a reflection of expenditures for labor and capital goods made in the past. The saving and productive expenditure out of current sales revenues will show up as costs in the future. The higher is the ratio of costs to sales, the higher is the degree of saving and productive expenditure relative to sales revenues. A firm with costs of $95 and sales revenues of $100 is a firm that can be understood as saving and productively expending $95 out of its $100 of sales revenues. This relationship applies throughout the economic system.

 

 

Hoarding Versus Saving

 

To the extent that “hoarding” or, more accurately, an increase in the demand for money for cash holding takes place, it is not because people have decided to save. What is actually going on is that business firms and investors have decided that they need to change the composition of their already accumulated savings in favor of holding more cash and less of other assets.

 

For example, an individual may decide that instead of being 90 percent invested in stocks and other securities and having only 10 percent of his savings in cash in his checking account, he needs to increase his cash holding to 20 or 25 percent of his savings.

 

Similarly, a corporation may decide that it needs to increase its cash holding relative to its other assets in order to be better able to meet its bills coming due. Indeed, this is happening right now as more and more firms find that they can no longer count on being able to borrow money for such purposes.

 

Furthermore, the increases in cash holdings that take place in such circumstances are not only not an addition to savings but occur in the midst of a sharp decline in the overall amount of accumulated savings. For example, the increases in cash holdings that are taking place today are in response to a major plunge in the real estate and stock markets, of numerous and sizable corporate bankruptcies, and of huge losses on the part of banks and other financial institutions.

 

All of this represents a reduction in asset values, i.e., in the value of accumulated savings. People are turning to cash in order to avoid further such losses of their accumulated savings. Of course, widespread attempts to convert assets other than cash into cash, entail further declines in the value of accumulated savings, since the unloading of those assets reduces their value.

 

Accumulated savings in the economic system have fallen by several trillion dollars, and nothing could be more incredible than that, in the midst of this, many people, including the great majority of professional economists, fear saving and think that it is necessary to stimulate consumption at the expense of saving. Such is the complete and utter lack of economic understanding that prevails.

 

One might expect that a group of people such as most of today’s economists, who pride themselves on their empiricism, would once and a while look at the actual facts of the world in which they live, and, in the midst of the loss of trillions of dollars of accumulated savings, begin to suspect that there might actually be a need to replace savings that have been lost rather than do everything possible to prevent their replacement.

 

Depressions and Credit Expansion

 

The loss of accumulated savings is at the core of the problem of economic depressions. Recessions and depressions and the losses that accompany them are the result of the attempt to create capital on a foundation of credit expansion rather than saving. Credit expansion is the lending out of new and additional money that is created out of thin air by the banking system, which acts with the encouragement and support of the government. The money so created and lent has the appearance of being new and additional capital, but it is not.

 

The fact of its appearing to be new and additional capital creates an exaggerated, false understanding of the amount of capital that is available to support economic activity. Like an individual who believes he has grown rich in the course of a financial bubble, and who is led to adopt a level of living that is beyond his actual means, business firms are led to undertake ventures that are beyond their actual means.

 

For an individual consumer, the purchase of an expensive home or automobile in the delusion that he is rich later on turns out to be a major loss in the light of the fact that he cannot actually afford these things and would have been better off had he not bought them. In the same way, business construction projects, stepped up store openings, acquisitions of other firms, and the like, carried out in the delusion of a sudden abundance of available capital, turn out to be sources of major losses when the delusion of additional capital evaporates.

 

Credit expansion also fosters an artificial reduction in the demand for money for cash holding, which sets the stage for a later rise in the demand for money for cash holding, such as was described a few paragraphs ago. The reduction in the demand for money for cash holding occurs because so long as credit expansion continues, it is possible for business firms to borrow easily and profitably and thus to come to believe that they can substitute their ability to borrow for the holding of actual cash. The rising sales revenues created by the expenditure of the new and additional money that is lent out also encourages the  holding of additional inventories as a substitute for the holding of cash, in the conviction that the inventories can be liquidated easily and profitably.

 

Recessions and depressions are the result of the loss of capital in the malinvestments and overconsumption that credit expansion causes. The losses are then compounded by the rise in the demand for money for cash holding that subsequently follows.  They can be further compounded by reductions in the quantity of money as well, such as would occur if the losses suffered by banks resulted in losses to the banks’ checking depositors. (Checking deposits are part of the money supply, indeed, the far greater part. In such cases, they would lose the status of money and assume that of a security in default, which would render them useless for making purchases or paying bills.)

 

The Housing Bubble

 

Our housing bubble is an excellent illustration of the malinvestment and overconsumption caused by credit expansion. Perhaps as much as $2 trillion or more of capital has been lost in the construction and financing of houses for people who, it turned out, could not afford to pay for them. The housing bubble was financed by the creation of $1.5 trillion of new and additional money in the form of checking deposits created for the benefit of home buyers.

 

The creation of these deposits rested on the readiness of the Federal Reserve System to create whatever new and additional supporting funds were required in the form of bank reserves. In the three years 2001-2004, the Federal Reserve created enough such funds to drive the interest rate paid on them, i.e., the Federal Funds Rate, below 2 percent. And from July of 2003 to June of 2004, it created enough such funds to hold this rate down to just 1 percent. The end result was a substantial reduction in mortgage interest rates and thus in monthly mortgage payments, which served greatly to increase the demand for houses.

 

Government also greatly contributed specifically to loans being made to homebuyers who were not credit worthy. It did this through its various loan-guarantee programs, carried out by Fannie Mae, Freddie Mac, and the Department of Housing and Urban Development; and by means even of outright extortion, though the Community Reinvestment Act, which required banks to make sufficient such loans as would satisfy local “community groups.”

 

In physical terms, the result of credit expansion was the passage of literally millions of houses that represented capital to the firms that built them, and to the banks and others that financed them, into the hands of consumers who not only had not contributed anything remotely comparable to the wealth and capital of the economic system but also had no realistic prospect of ever being able to do so. The further result has been that many of the builders of these houses are now ruined as are many of the banks and other investors that financed the construction and sale of those houses. And because so many lenders have lost so much, the business firms that depend on them for loans can no longer obtain those loans, and so they must close their doors and fire their workers.

 

The growing problem of unemployment that we are experiencing and the accompanying reduction in consumer spending on the part both of the unemployed and of those who fear becoming unemployed is the result of this loss of capital, not of any sudden, capricious refusal of consumers to spend or of banks to lend. Indeed, the kind of consumer spending that so many people want to revive and encourage, by means of “stimulus packages,” played a major role in the loss of capital that has taken place and now results in unemployment and impoverishment.

 

During the housing boom, millions of owners of existing houses thought that they were growing rich as the result of the rise in the prices of their homes and that they could actually live to a substantial degree off the accompanying increase in the equity in their homes.  They borrowed against the increased equity and spent the proceeds. This consumption was at the expense of capital investment in the economic system, which was rendered correspondingly poorer by it. And when housing prices collapsed, and fell below the enlarged mortgage debts that had been taken on, the effect was to add to the losses suffered by lenders. This was the case to the extent such equity-consuming homeowners then walked away from their homes, leaving their creditors to lose by the decline in the price of their homes.

 

Keynesian Ignorance and Blindness

 

The immense majority of people, including, of course, most professional economists, are ignorant of the actual nature and cause of our financial crisis. This is because they are ignorant of the role of capital in the economic system. They are all Keynesians. (Even Milton Friedman, the alleged arch-defender of capitalism is reported to  have said, “We are all Keynesians now.”)

 

But as von Mises so aptly put it, “The essence of Keynesianism is its complete failure to conceive the role that saving and capital accumulation play in the improvement of economic conditions.” (Planning for Freedom, 4th ed., p. 207. Italics in original.) In the eyes of Keynes and his countless followers, economic activity begins and ends with consumption.

 

So deeply do people hold the view that consumption is everything, that it blinds them to obvious facts. Thus, the present crisis has been well underway at least since the late spring of 2007, when the sudden collapse of two large Bear Stearns hedge funds occurred. This was followed by a continuing string of bankruptcies between June of 2007 and August of 2008 of significant-sized and fairly well-known firms, such as Aloha Airlines, Levitz Furniture, Wickes Furniture, Mervyns Department Stores, Linens N’ Things, IndyMac Bank, and Bear Stearns itself. The list includes an actual run on a major bank—Northern Rock in Great Britain—in September of 2007, probably the first such run since the 1930s.

 

Financial failures reached a crisis point in September of 2008, with the collapse of such major firms as American International Group (AIG), Lehman Brothers, and the Halifax Bank of Scotland. These were followed by the bankruptcy of Fannie Mae and Freddie Mac, the two giant government-sponsored mortgage lenders that had led the way in guaranteeing sub-prime mortgages to borrowers who could not repay them.

 

Yet as late as September of 2008, the unemployment rate in the United States was no more than 6.2 percent and at mid-month the Dow Jones Industrial Average was still well above 11,000.

 

All this confirms that the crisis did not originate in any sudden refusal of consumers to consume or in any surge in unemployment. To the extent that unemployment is growing and consumption is declining, they are both the consequence of the economy’s loss of capital. The loss of capital is what precipitated a reduction in the availability of credit and a widening wave of bankruptcies, which in turn has resulted in growing unemployment and a decline in the ability and willingness of people to consume. The collapse in home prices and the more recent collapse in the stock market have also contributed to the decline in consumption, and probably to an even greater extent, at least up to now. Both of these events are also an aspect of the loss of capital and accumulated savings.

 

What Economic Recovery Requires

 

What all of the preceding discussion implies is that economic recovery requires that the economic system rebuild its stock of capital and that to be able to do so, it needs to engage in greater saving relative to consumption. This is what will help to restore the supply of credit and thus help put an end to financial failures based on a lack of credit.

 

Recovery also requires the freedom of wage rates and prices to fall, so that the presently reduced supply of capital and credit becomes capable of supporting a larger volume of employment and production, as I explained in “Falling Prices Are Not Deflation but the Antidote to Deflation,” which was my first article in this series. Recovery will be achieved by the combination of more saving, capital, and credit along with lower wage rates, costs, and prices.

 

In addition, recovery requires the rapid liquidation of unsound investments. If borrowers are unable to meet their contractual obligation to pay principal and interest, the assets involved need to be sold off and the proceeds turned over to the lenders as quickly as possible, in order to put an end to further losses and thus salvage as much capital from the debacle as possible.

 

In the present situation of widespread financial paralysis, firms and individuals can be driven into bankruptcy because they are unable to collect the sums due them from their debtors. Thus, for example, the failure of mortgage lenders would be alleviated, if not perhaps altogether avoided in some cases, if the mortgage borrowers who were in default on their properties lost their houses quickly, with the proceeds quickly being turned over to the lenders.

 

In that way, the lenders would at least have those funds available to meet their obligations and thus might avoid their own default; in either event, their creditors would be better off. In helping to restore the capital of lenders, or what will become the capital of the creditors of the lenders, quick foreclosures would serve to restore the ability to originate new loans.                

 

Recovery requires the end of financial pretense. There are banks that do not want to see the liquidation of various types of assets that they own, notably, “collateralized debt obligations” (CDOs). These are securities issued against collections of other securities, which in turn were issued against collections of mortgages, an undetermined number of which are in default or likely to go into default. The presumably low prices that such securities would bring in the market would likely serve to reveal the presence of so little capital on the part of many banks that they would be plunged into immediate bankruptcy.  To avoid that, the banks want to prevent the discovery of the actual value of those securities. At the same time, they want creditors to trust them. Yet before trust can be established, the actual, market value of the banks’ assets must be established, even if it serves to bankrupt many of them. The safety of their deposits can be secured without the banks’ present owners continuing in that role.

 

When these various requirements have been met and the process of financial contraction comes to an end, the profitability of business investment will be restored and recovery will be at hand.

 

Next: Part II: Stimulus Packages

 

 

*Copyright © 2009, by George Reisman. George Reisman, Ph.D.  is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.