Chapter 11—Money and Its Purchasing Power
(continued)
Previous
Section * Next
Section
Table
of Contents
Chapter
11—Money and Its Purchasing Power
(continued)
F.
Hoarding and the Keynesian System
(1)
Social Income, Expenditures, and Unemployment
To the great bulk of writers
“hoarding”—an increase in the demand for
money—has appeared an unmitigated catastrophe. The very word
“hoarding” is a most inappropriate one to use in
economics, since it is laden with connotations of vicious
antisocial action. But there is nothing at all antisocial
about either “hoarding” or
“dishoarding.” “Hoarding” is
simply an increase in the demand for money, and the result of this
change in valuations is that people get what they desire,
i.e., an increase in the real value of their cash balances and of the
monetary unit.
Conversely, if the people
desire a lowering of their real cash
balances or in the value of the monetary unit, they may
accomplish this through “dishoarding.” No other
significant economic relation—real income, capital
structure, etc.—need be changed at all. The process of
hoarding and dishoarding, then, simply means that people want
something, either an increase or a decrease in their real cash balances
or in the real value of the monetary unit, and that they are able to
obtain this result. What is wrong with that? We see here simply another
manifestation of consumers’ or individuals’
“sovereignty” on the free market.
Furthermore, there is no theoretical way of defining
“hoarding” beyond a simple addition to
one’s cash balance in a certain period of time. Yet most
writers use the term in a normative fashion, implying that there is
some vague standard below which a cash balance is legitimate and above
which it is antisocial and vicious. But any quantitative limit set on
the demand-for-money schedule would be completely arbitrary and
unwarranted.
One of the two major pillars of the Keynesian system (now happily
beginning to wane after sweeping the economic world in the
1930’s and 1940’s) is the proclamation that savings
become equal to investment only through the terrible route of a decline
in social income. The (implicit) foundation of Keynesianism is the
assertion that at a certain level of total social income, total social
expenditures out of this income will be lower than income, the
remainder going into hoards. This will lower total social income in the
next period of time, since, as we have seen, total income in one
“day” equals, and is determined by, total
expenditures in the previous “day.”
The Keynesian “consumption function” plays its part
in establishing an alleged law that there exists a certain
level of total income, say A, above which
expenditures will be less than income (net hoarding), and below
which expenditures will be greater than income (net
dishoarding). But the basic Keynesian worry is hoarding, when
total income must decline. This situation may be diagramed as
in Figure 78.
In this graph, money income is plotted on both the horizontal and the
vertical axes. Hence, a 45-degree straight line between the axes is
equal to social income.To illustrate: A social income of
100 on the horizontal axis will correspond to, and equal, a social
income of 100 on the vertical axis. The co-ordinates of these
figures will meet at a point equidistant between the two axes. The
Keynesian law asserts social expenditures to be lower than
social income above point A, and higher
than social income below point A, so that A
will be the equilibrium point for social income to equal expenditure.
For if social income is higher than A, social
expenditures will be lower than income, and income will
therefore tend to decline from one day to the next until the
equilibrium point A is reached. If social
income is lower than A, dishoarding will occur,
expenditures will be higher than income, until finally A
is reached again.
Below, we shall investigate the validity of this alleged law and the
“consumption function” on which it rests. But
suppose that we now grant the validity of such a law; the only comment
can be an impertinent: So what? What if there is a fall in the
national income? Since the fall need only be in money
terms, and real income, real capital, etc., may remain the same, why
any alarm? The only change is that the hoarders have accomplished their
objective of increasing their real cash balances and
increasing the real value of the monetary unit. It is true
that the picture is rather more complex for the transition
process until equilibrium is reached, and this will be treated
further below (although our final conclusion will be the
same). But the Keynesian system attempts to establish the
perniciousness of the equilibrium position, and this it cannot do.
Therefore, the elaborate attempts of the Keynesians to
demonstrate that free-market expenditures will be
limited—that consumption is limited by the
“function,” and investment by stagnation
of opportunities and “liquidity
preference”—are futile. For even if they were
correct (which they are not), the result would be pointless. There is
nothing wrong with hoarding or dishoarding, or with
“low” or “high” levels
(whatever that may mean) of social money income.
The Keynesian attempt to salvage meaning for their doctrine rests on
one point and one point alone—the second major pillar of
their system. This is the thesis that money social income and
level of employment are correlated, and that the
latter is a function of the former. This assumes
that a certain “full employment” level of social
income exists below which there is correspondingly greater
unemployment. This can be diagramed as in Figure 79.
On the previous diagram is superimposed a vertical FF
line, which represents the point of alleged
“full-employment” social income. If the
intersection A is below (to the left of) the FF
line, then there is permanent unemployment corresponding to the
distance by which A falls short of that
line.
Keynesians have also attempted, with little success, to give meaning to
an equilibrium position where A falls to the right
of the FF line, identifying this with inflation.
Inflation, as we shall see below, is a dynamic process, the essence of
which is change. The Keynesian system centers around the equilibrium
position and therefore is hardly well equipped to analyze an
inflationary situation.
The nub of the Keynesian critique of the free market economy,
then, rests on the involuntary unemployment allegedly caused by too low
a level of social expenditures and income. But how can this be, since
we have previously explained that there can be no involuntary
unemployment in a free market? The answer has become evident (and is
admitted in the most intelligent of the Keynesian writings): The
Keynesian “underemployment equilibrium”
occurs only if money wage rates are rigid downward,
i.e., if the supply curve of labor below “full
employment” is infinitely elastic.
Thus, suppose there is a
“hoarding” (an increased demand for money), and
social income falls. The result is a fall in the monetary demand curves
for labor factors, as well as in all other monetary demand
curves. We would expect the general supply curve of labor factors to be
vertical. Since only money wage rates are
being changed while real wage rates (in terms of
purchasing power) remain the same, there will be no shift in
labor/leisure preferences, and the total stock of labor offered on the
market will remain constant. At any rate, certainly no involuntary
unemployment will arise.
How then can the Keynesian case arise? How can the supply of labor
remain horizontal at the old money wage rate? In only two ways: (1) if
people voluntarily agree with the unions, which insist that no one be
employed at lower than the old money wage rate. Since selling prices
are falling, maintaining the old money wage rate is equivalent to
demanding a higher real wage rate. We have seen above that the
unions’ raising of real wage rates causes unemployment. But
this unemployment is voluntary, since the workers
acquiesce in the imposition of a higher minimum real wage rate, below
which they will not undercut the union and accept employment. Or (2)
unions or government coercively impose the minimum wage rate. But this
is an example of a hampered market, not the free
market to which we are confining our analysis here.
Situation (1) or (2) may be diagramed as in Figure 80.
The original demand curve for labor is DD (for
simplicity of exposition we assume as meaningful the concept of
“demand for labor” in general). Total stock of
labor in the society is 0F, or at least that is the
stock put forward upon the market. Now an increase in the demand for
money shifts all demand curves downward as all money prices
fall. If wage rates are free to fall, the intersection point will move
from H to C and nominal wage
rates reduced accordingly, from FH to FC.
There is still “full employment” at level 0F.
Now suppose however, that a union sets a minimum money wage rate of 0B
(or FH). Then the supply-of-labor curve
becomes BHG; horizontal up to FG
and vertical from there on. The new demand curve D'D'
will now intersect the supply of labor at point E
instead of point C. Total amount of labor now
employed is reduced to BE, and EH
are now unemployed as a result of the union action.
Keynes’ own exposition tended to run in terms of real rather
than money magnitudes—real social income, real expenditures,
etc.
Such an analysis obscures
dynamic considerations, since transactions take place at least
superficially in monetary terms on the market. However, the essential
conclusion of our analysis remains unchanged if we pursue it directly
in real terms. Instead of falling, demand curves in real
terms will now remain the same. This is true for the labor market as
well. Instead of being depicted on a diagram as a horizontal line at
existing wage rates, the effect of union action would have to be shown
as a horizontally imposed increase in real wage
rates (the result of keeping money wage rates constant while selling
prices fall). The relevant diagram is shown in Figure 81. The facts
depicted in this diagram are the same as in the previous diagram:
unions causing unemployment (EH) by
insisting on an excessively high money (and therefore real) wage (0B).
The sum and substance of the “Keynesian Revolution”
was the thesis that there can be an unemployment
equilibrium on the free market. As we have seen, the only sense in
which this is true was known years before Keynes: that widespread union
maintenance of excessively high wage rates will cause
unemployment.
Keynes believed that while other elements of the economic system,
including prices, were set basically in real terms, workers bargained
even ultimately only in terms of money
wages—that unions insisted on minimum money wage rates
downward, but would passively accept falling real wages in the form of
rising prices, money wage rates remaining the same. The Keynesian
prescription for eliminating unemployment therefore rests
specifically on the “money
illusion”—that unions will impose minimum money
wage rates, but are too stupid to impose minimum real wage rates per
se. Unions, however, have learned about
purchasing-power problems and the distinction between money
and real rates; indeed, it hardly requires much reasoning ability to
grasp this distinction.
Ironically,
Keynes’ advocacy of inflation based on the “money
illusion” rested on the historical experience (which
we shall treat more fully below) that, during an inflation,
selling prices rise faster than wage rates. Yet an economy in which
unions impose minimum wage rates is precisely an economy in
which unions will be alive to any losses in their real, as well as
their money, wages. Inflation, therefore, cannot be used as a means of
duping unions into relieving unemployment.Keynesianism has been
touted as at least a “practical” system.
Whatever its theoretical defects, it is alleged to be fit for
the modern world of unionism. Yet it is precisely in the modern world
that Keynes’ doctrine is least appropriate or practical.
The Keynesians object that to allow rigid money wage rates to become
flexible downward would further lower monetary demand for
goods, and therefore monetary income. But this completely
confuses wage rates with aggregate payroll,
or total income going to wages.
That the former falls does
not mean that the latter falls. On the contrary, total income is, as we
have seen, determined by total expenditures in the previous period of
time. Lower wage rates will cause the hiring of those made unemployed
by the old excessively high wage rates. The fact that labor is now
cheaper relatively to land factors will cause investors to expend a
greater proportion on labor vis-à-vis land than before. And
the employment of unemployed labor increases production and
therefore aggregate real income. Furthermore, even if payrolls
also decline, prices and wage rates can adjust—but
this will be taken up in the next section on liquidity preference.
(2)
“Liquidity Preference”
Those Keynesians who recognize the grave difficulties of their system
fall back on one last string in their
bow—“liquidity preference.”
Intelligent Keynesians will concede that involuntary
unemployment is a “special” or rare case,
and Lindahl goes even further to say that it could be only a short-run
and not a long-run equilibrium phenomenon.
Neither Modigliani nor
Lindahl, however, is thoroughgoing enough in his critique of
the Keynesian system, particularly of the “liquidity
preference” doctrine.
The Keynesian system, as is quite clear from the mathematical
portrayals of it given by its followers, suffers grievously from the
mathematical-economic sin of “mutual
determination.” The use of mathematical functions, which are
reversible at will, is appropriate in physics, where we do not know the
causes of the observed movements. Since we do not know the causes, any
mathematical law explaining or describing movements will be
reversible, and, as far as we are concerned, any of the
variables in the function is just as much “cause”
as another. In praxeology, the science of human action, however, we know
the original cause—motivated action by individuals. This
knowledge provides us with true axioms. From these axioms, true laws
are deduced. They are deduced step by step in a logical,
cause-and-effect relationship. Since first causes are known, their
consequent effects are also known. Economics therefore traces unilinear
cause-and-effect relations, not vague “mutually
determining” relations.
This methodological reminder is singularly applicable to the Keynesian
theory of interest. For the Keynesians consider the rate of interest (a)
as determining investment and (b)
as being determined by the demand for money to hold “for
speculative purposes” (liquidity preference). In practice,
however, they treat the latter not as determining
the rate of interest, but as being determined by
it. The methodology of “mutual determination” has
completely obscured this sleight of hand. Keynesians might object that
all demand and supply curves are “mutually
determining” in their relation to price. But this
facile assertion is not correct. Demand curves are determined by
utility scales, and supply curves by speculation and the stock produced
by given labor and land factors, which is ultimately governed by time
preferences.
The Keynesians therefore treat the rate of interest, not
as they believe they do—as determined by liquidity
preference—but rather as some sort of mysterious and
unexplained force imposing itself on the other elements of the economic
system. Thus, Keynesian discussion of liquidity preference centers
around “inducement to hold cash” as the rate of
interest rises or falls. According to the theory of liquidity
preference, a fall in the rate of interest increases the
quantity of cash demanded for “speculative
purposes” (liquidity preferences), and a rise in the rate of
interest lowers liquidity preference.
The first error in this concept is the arbitrary separation of the
demand for money into two separate parts: a “transactions
demand,” supposedly determined by the size of social income,
and a “speculative demand,” determined by the rate
of interest. We have seen that all sorts of influences impinge
themselves on the demand for money. But they are only influences
working through the value scales of individuals.
And there is only one final demand for
money, because each individual has only one value scale. There is no
way by which we can split the demand up into two parts and speak of
them as independent entities. Furthermore, there are far more
than two influences on demand. In the final analysis, the demand for
money, like all utilities, cannot be reduced to simple determinants; it
is the outcome of free, independent decisions on individual
value scales. There is, therefore, no “transaction
demand” uniquely determined by the size of income.
The “speculative demand” is mysterious indeed.
Modigliani explains this “liquidity preference” as
follows:
we
should expect that any fall in the rate of interest . . . would induce
a growing number of potential investors to keep their assets in the
form of money, rather than securities; that is to say, we should expect
a fall in the rate of interest to increase the demand for money as an
asset.
This
is subject to the criticism, as we have seen, that the rate of interest
is here determining, and is not itself
explained by any cause. Furthermore, what does this statement
mean? A fall in the rate of interest, according to the
Keynesians, means that less interest is being earned from
bonds, and therefore there is a greater inducement to hold cash. This
is correct (as long as we allow ourselves to think in terms of
the interest rate as determining instead
of being determined), but highly inadequate. For if
a lower interest rate “induces” greater cash
holdings, it also induces greater consumption,
since consumption also becomes more attractive. In fact, one of the
grave defects of the liquidity-preference approach is that the
Keynesians never think in terms of three
“margins” being decided at once. They think only in
terms of two at a time. Hence, Modigliani: “Having
made his consumption-saving plan, the individual has to make decisions
concerning the assets he owns”; i.e., he then allocates them
between money and securities.
In other words, people
first decide between consumption and saving (in the sense of not
consuming); and then they decide between
investing and hoarding these savings. But this is an absurdly
artificial construction. People decide on all three of their
alternatives, weighing one against each of the others. To say that
people first decide between consuming and not consuming and then
choose between hoarding and investing is just as misleading as to say
that people first choose how much to hoard and then decide between
consumption and investment.
People, therefore, allocate their money among consumption, investment,
and hoarding. The proportion between consumption and
investment reflects individual time preferences. Consumption
reflects desires for present goods, and investment reflects desires for
future goods. An increase in the demand-for-money schedule does not
affect the rate of interest if the proportion between consumption and
investment (i.e., time preference) remains the same.
The rate of interest, we must reiterate, is determined
by time preferences, which also determine the proportions of
consumption and investment. To think of the rate of interest as
“inducing” more or less saving or hoarding is to
misunderstand the problem completely.
Admitting, then, that time preference determines the proportions of
consumption and investment and that the demand for money determines the
proportion of income hoarded, does the demand for money play a role in
determining the interest rate? The Keynesians assert that there is a
relation between the rate of interest and a
“speculative” demand for cash. Should the schedule
of the latter rise, the former rises also. But this is not necessarily
true. A greater proportion of funds hoarded can be drawn from three
alternative sources: (a) from funds that formerly
went into consumption, (b) from funds that went into
investment, and (c) from a mixture of both that
leaves the old consumption-investment proportion unchanged. Condition (a)
will bring about a fall in the rate of interest;
condition (b) a rise in the rate
of interest, and condition (c) will leave the rate
of interest unchanged. Thus hoarding may reflect either a rise, a fall,
or no change in the rate of interest, depending on whether time
preferences have concomitantly risen, fallen, or remained the
same.
The Keynesians contend that the speculative demand for cash depends
upon and determines the rate of interest in this way: if people expect
that the rate of interest will rise in the near future, then their
liquidity preference increases to await this rise. This, however, can
hardly be a part of a long-run equilibrium theory,
such as Keynes is trying to establish. Speculation, by its very nature,
disappears in the ERE, and hence no fundamental causal theory can be
based upon it. Furthermore, what is an
interest rate? One grave and fundamental Keynesian error is to
persist in regarding the interest rate as a contract rate on loans,
instead of the price spreads between stages of production. The former,
as we have seen, is only the reflection of the latter. A strong
expectation of a rapid rise in interest rate means a strong expectation
of an increase in the price spreads, or rate of net return. A fall in
prices means that entrepreneurs generally expect that factor
prices will fall further in the near future than
their selling prices. But it requires no Keynesian labyrinth to explain
this phenomenon; all we are confronted with is a situation in
which entrepreneurs, expecting that factor prices will soon fall, cease
investing and wait for this happy event so that their return will be
greater. This is not “liquidity
preference,” but speculation on price changes.
It involves a modification of our previous discussion of the relation
between prices and the demand for money, caused by a fact that
we shall explore soon in detail, namely, that prices do not change
equally and proportionately.
The expectation of falling factor prices speeds up the
movement toward equilibrium and hence toward the pure interest
relation as determined by time preference.
If, for example, unions keep wage rates artificially high,
“hoarding” will increase as unions keep
wage rates ever higher than the equilibrium rate at which
“full employment” can be maintained. This induced
hoarding lowers the money demand for factors and increases unemployment
still further, but only because of wage-rate rigidity.
The final Keynesian bogey is that people may acquire an
unlimited demand for money, so that hoards will indefinitely
increase. This is termed an “infinite”
liquidity preference. And this is the only case in which neo-Keynesians
such as Modigliani believe that involuntary unemployment can
be compatible with price and wage freedom. The Keynesian worry is that
people will hoard instead of buying bonds for fear of a fall in the
price of securities. Translating this into more important
“natural” terms, this would mean, as we have
stated, not investing because of expectation of imminent increases in
the natural interest rate. Rather than act as a blockade, however, this
expectation speeds the ensuing adjustment.
Furthermore, the demand for money could not be infinite since people
must always continue consuming, whatever their expectations.
Of necessity, therefore, the demand for money could never be
infinite. The existing level of consumption, in turn, will require a
certain level of investment. As long as productive activities are
continuing, there is no need or possibility of lasting unemployment,
regardless of the degree of hoarding.
A demand for money to hold stems from the general uncertainty
of the market. Keynesians, however, attribute liquidity preference, not
to general uncertainty, but to the specific
uncertainty of future bond prices. Surely this is a highly
superficial and limiting view.
In the first place, this cause of liquidity preference could
occur only on a highly imperfect securities market. As
Lachmann pointed out years ago in a neglected article,
Keynes’ causal
pattern—“bearishness” causing
“liquidity preference” (demand for cash) and high
interest rates—could take place only in the absence
of an organized forward or futures market for
securities. If such a market existed, both bears and bulls on the bond
market
could
express their expectations by forward transactions which do not require
any cash. Where the market for securities is fully organized over time,
the owner of 4% bonds who fears a rise in the rate of interest has no
incentive to exchange them for cash, for he can always
“hedge” by selling them forward.
Bearishness
would cause a fall in forward bond prices, followed immediately by a
fall in spot prices. Thus, speculative bearishness would, of
course, cause at least a temporary rise in the rate of interest, but
accompanied by no increase in the demand for cash.
Hence, any attempted connection between liquidity preference,
or demand for cash, and the rate of interest, falls to the ground.
The fact that such a securities market has not been organized indicates
that traders are not nearly as worried about rising interest
rates as Keynes believes. If they were and this fear loomed as an
important phenomenon, then surely a futures market would have developed
in securities.
Furthermore, as we have seen, interest rates on loans are merely a
reflection of price spreads, so that a prediction of higher
interest rates really means the expectation of lower prices
and, especially, lower costs, resulting in a greater demand
for money. And all speculation, on the free market, is self-correcting
and speeds adjustment, rather than a cause of economic trouble.
G.
The Purchasing-Power and Terms-of-Trade Components in the Rate
of Interest
Many economists, beginning with Irving Fisher, have asserted that the
market rate of interest, in addition to containing specific
entrepreneurial components superimposed on the pure rate of interest,
also contains a “price” or a
“purchasing-power component.” When the
purchasing power of money is generally expected to rise, the
theory asserts that the market rate of interest falls correspondingly;
when the PPM is expected to fall, the theory declares that the
market rate of interest rises correspondingly.
These economists erred by concentrating on the loan rate
rather than on the natural rate (the rate of return). The reasoning
behind this theory was as follows: If the purchasing power of
money is expected to change, then the pure rate of interest (determined
by time preference) will no longer be the same in “real
terms.” Suppose that 100 gold ounces exchange for 105 gold
ounces a year from now—i.e., that the rate of interest is 5
percent. Now, suddenly, let there be a general expectation that the
purchasing power of money will increase. In that case, a lower
amount to be returned, say 102 ounces, may yield 5 percent real
interest in terms of purchasing power. A general expectation of a rise
in purchasing power, therefore, will lower the market rate of
interest at present, while a general expectation of a fall in
purchasing power will raise the rate.
There is a fatal defect in this generally accepted line of
reasoning. Suppose, for example, that prices are generally
expected to fall by 50 percent in the next year. Would someone lend 100
gold ounces to exchange for 53 ounces one year from now? Why not? This
would certainly preserve the real interest rate at 5 percent. But then
why should the would-be lenders not simply hold on to their money and double
their real assets as a result of the price fall? And that is precisely
what they would do; they certainly would not give money away, even
though their real assets would be greater than before. Fisher simply
shrugged off this point by saying that the purchasing-power premium
could never make the interest rate negative. But this flaw vitiates the
entire theory.
The root of the difficulty consists in ignoring the natural rate of
interest. Let us consider the interest rate in those terms. Then,
suppose 100 ounces are paid for factors that will be transformed in one
year into a product that sells for 105 gold ounces, for an interest
gain of five and an interest return of 5 percent. Now a general
expectation arises of a general halving of prices
one year from now. The selling price of the product will be 53 ounces
in a year’s time. What happens now? Will entrepreneurs buy
factors for 100 and sell at 53 merely because their real interest rate
is preserved? Certainly not. They will do so only if they do not at all
anticipate the change in purchasing power. But to the extent that it is
anticipated, they will hold money rather than buy factors.
This will immediately lower factor prices to their
expected future levels, say from 100 to 50.
What happens to the loan rate is analytically quite
trivial. It is simply a reflection of the natural rate and depends on
how the expectations and judgment of the people on the loan market
compare with those on the stock and other markets. For the free
economy, there is no point in separately analyzing the loan
market. Analysis of the Fisher problem—the relation
of the interest rate to price changes—should concentrate on
the natural rate of interest. Discussion of the
relation between price movements and the (natural) rate of interest
should be divided into two parts: first, assuming “neutral
money”—that all prices change equally and at the
same time—and second, analyzing conditions where factor and
product change at different rates. And these changes should first be
analyzed without considering that they had been anticipated
by people on the market.
Suppose, first, that all prices change equally and at the same time.
Instead of thinking in terms of 100 ounces borrowed on the loan market,
let us consider the natural rate. An investor buys factors in period 1
and then sells the product, say in period 3. Time, as we have
seen, is the essence of the production structure. All the processes
take time, and capitalists pay money to owners of factors in advance of
production and sale. Since factors are bought before products
are sold, what is the effect of a period of rising general prices
(i.e., falling PPM)? The result is that the entrepreneur reaps an
apparent extra profit. Suppose that he normally purchases original
factors for 100 and then sells the product for 120 ounces two years
later, for an interest return of 10 percent per annum. Now suppose that
a decrease in the demand for money or an increase of money stock
propels a general upward movement in prices and that all
prices double in two years’ time. Then, just because of the
passage of time, an entrepreneur who purchases factors for 100 now will
sell for 240 ounces in two years’ time. Instead of a net
return of 20 ounces, or 10 percent per annum, he reaps 140 ounces, or
70 percent per annum.
It would seem that a rise in prices creates an inherent
tendency for large-scale profits that are not simply
individual rewards for more accurate forecasting. However, more careful
analysis reveals that this is not an extra profit at all. For
the 240 ounces two years from now is roughly equivalent, in terms of
purchasing power, to 120 ounces now. The real
rate of net return, based on money’s services, is the same 10
percent as it has always been. It is clear that any lower net return
would amount to a decline in real return. A return of a mere 120
ounces, for example, would amount to a drastic negative real return,
for 100 ounces would then be invested for the equivalent gross return
of only 60 ounces. It has often been shown that a period of rising
prices misleads businessmen into thinking that their increased money
profits are also real gains, whereas they only maintain real rates of
return. Consider, for example, “replacement
costs”—the prices which the businessmen will now
have to pay for factors. The capitalist who earns 240 ounces on a
100-ounce investment neglects to his sorrow the fact that his
factor bundle now costs 200 ounces instead of 100. Businessmen who
under such circumstances treat their monetary profits as real profits
and consume them soon find that they are really consuming their capital.
The converse occurs in the case of falling prices. The
capitalist buys factors in period 1 and sells the product in
period 3, when all-around prices are lower. If prices are to fall by a
half in two years, an investment of 100, followed by a sale at 60, does
not really involve the terrific loss that it appears to be. For the 60
return is equivalent in real terms, both in generalized
purchasing power and in replacement of factors, to 120
previous ounces. His real rate of return remains the same. The
consequence is that businessmen will be likely to overstate
their losses in a period of price contraction. Perhaps this
is one of the major reasons for the deep-seated belief of most
businessmen that they always gain during a general price expansion and
lose during a period of general contraction. This belief is
purely illusory.
In these examples, the natural interest rate on the market has
contained a purchasing-power component, which
corrects for real rates, positively in money terms during a general
expansion, and negatively during a general contraction. The loan rate
will be simply a reflection of what has been happening in the natural
rate. So far, the discussion is similar to Fisher’s, except
that these are the effects of actual, not
anticipated, changes and the Fisher thesis cannot take account of the
negative interest rate case. We have seen that rather than take a
monetary loss, even though their real return will be the same,
entrepreneurs will hold back their purchases of factors until factor
prices fall immediately to their future low level. But this process of
anticipatory price movement does not occur only in the extreme case of
a prospective “negative” return. It
happens whenever a price change is anticipated. Thus, suppose
all entrepreneurs generally anticipate that prices will double in two
years. The fact of an anticipated rise will lead to an increase in the
price level now and an approach
immediately toward a doubled price level. An anticipated fall
will lead to an immediate fall in factor prices. If all changes were
anticipated by everyone, there would be no room for a
purchasing-power component to develop. Prices would simply fall
immediately to their future level.
The purchasing-power component, then, is not the
reflection, as has been thought, of expectations of
changes in purchasing power. It is the reflection of the change itself;
indeed, if the change were completely anticipated, the
purchasing power would change immediately, and there would be no room
for a purchasing-power component in the rate of interest.
As it is, partial anticipations speed up the adjustment of the
PPM to the changed conditions.
So far we have distinguished three components of the natural rate of
interest (all reflected in the loan rate of interest). One is the pure
rate of interest—the result of individual time
preferences, tending to be uniform throughout the economy.
Second are the specific entrepreneurial rates of interest. These differ
from firm to firm and so are not uniform. They are anticipated in
advance, and they are the rates that an investor will have to
anticipate receiving before he enters the field. A
particularly “risky” venture, if successful at all,
will therefore tend to earn more in net return than what is generally
anticipated to be a “safe” venture. The
third component of the natural rate of interest is the purchasing-power
component, correcting for general PPM changes because of the inevitable
time lags in production. This will be positive in an expansion and
negative in a contraction, but will be ephemeral. The more that changes
in the PPM are anticipated, the less important will
be the purchasing-power component and the more rapid will be the
adjustment in the PPM itself.
There is still a fourth component in the natural rate of
interest. This exists to the extent that money changes are not
neutral (and they never are). Sometimes product prices rise
and fall faster than factor prices, sometimes they rise and fall more
slowly, and sometimes their behavior is mixed, with some factor prices
and some product prices rising more rapidly. Whenever there is
a general divergence in rates of movement between the prices of the
product and of original factors, a terms-of-trade
component emerges in the natural rate of interest.
Historically, it has often been the case that product prices rise more
rapidly and fall more rapidly than the prices of original factors. In
the former case, there is, during the period of transition, a
favorable change in the terms of trade to the general run of
capitalists. For selling prices are increasing faster
than the buying prices of original factors. This will increase
the general rate of return and constitute a general positive
terms-of-trade component in the natural rate of interest.
This, of course, will also tend to be reflected in the loan rate of
interest. In the case of a contraction, a more sluggish fall in the
prices of factors creates a general negative terms-of-trade component
in the interest rate. The components are precisely the reverse whenever
factor prices change more rapidly than product prices. Whenever there
is no general change in the “terms of trade” to
capitalist-entrepreneurs, no terms-of-trade component will appear in
the interest rate.
Changes in terms of trade discussed here are only those
resulting purely from differences in the speed of reaction to
changing conditions. They do not include basic
changes in the terms of trade resulting from changes in time
preferences, such as we have discussed above.
It is clear that all the interest-rate components aside from the pure
rate—entrepreneurial, purchasing power, and terms of
trade—are “dynamic” and the result of
uncertainty. None of these components would exist in the ERE,
and therefore the market interest rate in the ERE would equal
the pure rate determined by time preferences alone. In the ERE the only
net incomes would be a uniform pure interest return and wages to labor
(ground land rents being capitalized into an interest return).
See the
excellent article by W.H. Hutt, “The Significance of Price
Flexibility” in Hazlitt, Critics of
Keynseian Economics, pp. 383–406.
The term generally
used is “national” income. However, in a
free-market economy the nation will no more be an important economic
boundary than the village or region. It is more convenient, then, to
set aside regional problems for other analysis and to
concentrate on aggregate social income; this is especially true since
regions do not present a problem to economic theory until their
governments begin intervening in the free market.
Thus, see the
revealing article by Franco Modigliani, “Liquidity
Preference and the Theory of Interest and Money” in
Hazlitt, Critics of Keynesian Economics, pp.
156–69. Also see the articles by Erik Lindahl, “On
Keynes’ Economic System—Part I,” The
Economic Record, May, 1954, pp. 19–32; November,
1954, pp. 159–71; and Wassily W. Leontief,
“Postulates: Keynes’ General Theory
and the Classicists” in S. Harris, ed., The New
Economics (New York: Knopf, 1952), pp. 232–42. For
an empirical critique of the assumed Keynesian correspondence between
aggregate output and employment, see George W.
Wilson, “The Relationship between Output and
Employment,” Review of Economics and Statistics,
February, 1960, pp. 37–43.
This is what
Keynes’ discussion of “wage units”
amounted to. Cf. Lindahl, “On Keynes’ Economic
System—Part I,” p. 20.
Cf. Lindahl,
“On Keynes’ Economic System—Part
I,” pp. 25, 159ff. Lindahl’s articles provide a
good summary as well as a critique of the Keynesian system.
Furthermore,
inflation is, at best, an inefficient and distortive substitute for
flexible wage rates. For inflation affects the entire economy and its
prices, while particular wage rates will fall only to the extent
necessary to “clear” the market for the particular
labor factor. Thus, freely flexible wage rates will fall only in those
fields necessary to eliminate unemployment in those particular areas.
Cf. Henry Hazlitt, The Failure of the “New
Economics” (Princeton, N.J.: D. Van Nostrand,
1959), pp. 278ff.
Cf. L. Albert
Hahn, The Economics of Illusion (New York: Squier
Publishing Co., 1949), pp. 50ff., 166ff., and passim.
Cf. Hutt,
“Significance of Price Flexibility.”
Cf.
Lindahl’s critique of Lawrence Klein’s The
Keynesian Revolution in “On Keynes’
Economic System—Part I,” p. 162. Also see
Leontief, “Postulates: Keynes’ General
Theory and the Classicists.”
Modigliani,
“Liquidity Preference and the Theory of Interest and
Money,” pp. 139–40.
Ibid.,
p. 137.
See
the critique of the Keynesian doctrine by Tjardus Greidanus, The
Value of Money (2nd ed.; London: Staples Press, 1950), pp.
194–215, and of the liquidity-preference theory by D.H.
Robertson, “Mr. Keynes and the Rate of Interest” in
Readings in the Theory of Income Distribution, pp.
439–41. In contrast to Keynes’ famous phrase that
the rate of interest is “the reward for parting with
liquidity,” Greidanus points out that buying
consumers’ goods (or even producers’ goods in
Keynes’ sense of “interest”) sacrifices
liquidity and yet earns no interest “reward.”
Greidanus, Value of Money, p. 211. Also
see Hazlitt, Failure of the “New
Economics,” pp. 186ff.
Mises, Human
Action, pp. 529–30.
Hutt concludes
that equilibrium
is secured when
all services and products
are so priced that they are (i) brought within the reach of
people’s pockets (i.e., so that they are purchasable by
existing money incomes) or (ii) brought into such a relation to
predicted prices that no postponement of expenditure on them
is induced. For instance, the products and services used in the
manufacture of investment goods must be so priced that anticipated
future money incomes will be able to buy the services and depreciation
of new equipment or replacement. (Hutt, “Significance of
Price Flexibility,” p. 394)
“Postponements
(in purchases) arise because it is judged that a cut in costs (or other
prices) is less than will eventually have to take place, or because the
rate of fall of costs is insufficiently rapid.” Ibid.,
p. 395.
As Hutt points
out, if we can conceive of a situation of infinitely elastic liquidity
preference (and no such situation has ever existed), then “we
can conceive of prices falling rapidly, keeping pace with expectations
of price changes, but never reaching zero, with full utilization of
resources persisting all the way.” Ibid.,
p. 398.
L.M. Lachmann,
“Uncertainty and Liquidity Preference,” Economica,
August, 1937, p. 301.
Irving Fisher, The
Rate of Interest (New York, 1907), chap. v, xiv; idem,
Purchasing Power of Money, pp. 56–59.
Previous
Section * Next
Section
Table of
Contents