Chapter 11—Money and Its Purchasing Power (continued)
15. Business Fluctuations
In the real world, there will be continual changes in the pattern of economic activity, changes resulting from shifts in the tastes and demands of consumers, in resources available, technological knowledge, etc. That prices and outputs fluctuate, therefore, is to be expected, and absence of fluctuation would be unusual. Particular prices and outputs will change under the impact of shifts in demand and production conditions; the general level of production will change according to individual time preferences. Prices will all tend to move in the same direction, instead of shifting in different directions for different goods, whenever there is a change in the money relation. Only a change in the supply of or demand for money will transmit its impulses throughout the entire monetary economy and impel prices in a similar direction, albeit at varying rates of speed. General price fluctuations can be understood only by analyzing the money relation.
Yet simple fluctuations and changes do not suffice to explain that terrible phenomenon so marked in the last century and a half—the “business cycle.” The business cycle has had certain definite features which reveal themselves time and again. First, there is a boom period, when prices and productive activity expand. There is a greater boom in the heavy capital-goods and higher-order industries—such as industrial raw materials, machine goods, and construction, and in the markets for titles to these goods, such as the stock market and real estate. Then, suddenly, without warning, there is a “crash.” A financial panic with runs on banks ensues, prices fall very sharply, and there is a sudden piling up of unsold inventory, and particularly a revelation of great excess capacity in the higher-order capital-goods industries. A painful period of liquidation and bankruptcy follows, accompanied by heavy unemployment, until recovery to normal conditions gradually takes place.
This is the empirical pattern of the modern business cycle. Historical events can be explained by laws of praxeology, which isolate causal connections. Some of these events can be explained by laws that we have learned: a general price rise could result from an increase in the supply of money or from a fall in demand, unemployment from insistence on maintaining wage rates that have suddenly increased in real value, a reduction in unemployment from a fall in real wage rates, etc. But one thing cannot be explained by any economics of the free market. And this is the crucial phenomenon of the crisis: Why is there a sudden revelation of business error? Suddenly, all or nearly all businessmen find that their investments and estimates have been in error, that they cannot sell their products for the prices which they had anticipated. This is the central problem of the business cycle, and this is the problem which any adequate theory of the cycle must explain.
No businessman in the real world is equipped with perfect foresight; all make errors. But the free-market process precisely rewards those businessmen who are equipped to make a minimum number of errors. Why should there suddenly be a cluster of errors? Furthermore, why should these errors particularly pervade the capital-goods industries?
Sometimes sharp changes, such as a sudden burst of hoarding or a sudden raising of time preferences and hence a decrease in saving, may arrive unanticipated, with a resulting crisis of error. But since the eighteenth century there has been an almost regular pattern of consistent clusters of error which always follow a boom and expansion of money and prices. In the Middle Ages and down to the seventeenth and eighteenth centuries, business crises rarely followed upon booms in this manner. They took place suddenly, in the midst of normal activity, and as the result of some obvious and identifiable external event. Thus, Scott lists crises in sixteenth- and early seventeenth-century England as irregular and caused by some obvious event: famine, plague, seizures of goods in war, bad harvest, crises in the cloth trade as a result of royal manipulations, seizure of bullion by the King, etc.But in the late seventeenth, eighteenth and nineteenth centuries, there developed the aforementioned pattern of the business cycle, and it became obvious that the crisis and ensuing depression could no longer be attributed to some single external event or single act of government.
Since no one event could account for the crisis and depression, observers began to theorize that there must be some deep-seated defect within the free-market economy that causes these crises and cycles. The blame must rest with the “capitalist system” itself. Many ingenious theories have been put forward to explain the business cycle as an outgrowth of the free-market economy, but none of them has been able to explain the crucial point: the cluster of errors after a boom. In fact, such an explanation can never be found, since no such cluster could appear on the free market.
The nearest attempt at an explanation stressed general swings of “overoptimism” and “overpessimism” in the business community. But put in such fashion, the theory looks very much like a deus ex machina. Why should hardheaded businessmen, schooled in trying to maximize their profits, suddenly fall victim to such psychological swings? In fact, the crisis brings bankruptcies regardless of the emotional state of particular entrepreneurs. We shall see in chapter 12 that feelings of optimism do play a role, but they are induced by certain objective economic conditions. We must search for the objective reasons that cause businessmen to become “overoptimistic.” And they cannot be found on the free market. The positive explanation of the business cycle, therefore, will have to be postponed to the next chapter.
Joseph Schumpeter’s business cycle theory is one of the very few that attempts to integrate an explanation of the business cycle with an analysis of the entire economic system. The theory was presented in essence in his Theory of Economic Development, published in 1912. This analysis formed the basis for the “first approximation” of his more elaborate doctrine, presented in the two-volume Business Cycles, published in 1939. The latter volume, however, was a distinct retrogression from the former, for it attempted to explain the business cycle by postulating three superimposed cycles (each of which was explainable according to his “first approximation”). Each of these cycles is supposed to be roughly periodic in length. They are alleged by Schumpeter to be the three-year “Kitchin” cycle; the nine-year “Juglar”; and the very long (50-year) “Kondratieff.” These cycles are conceived as independent entities, combining in various ways to yield the aggregate cyclical pattern. Any such “multicyclic” approach must be set down as a mystical adoption of the fallacy of conceptual realism. There is no reality or meaning to the allegedly independent sets of “cycles.” The market is one interdependent unit, and the more developed it is, the greater the interrelations among market elements. It is therefore impossible for several or numerous independent cycles to coexist as self-contained units. It is precisely the characteristic of a business cycle that it permeates all market activities.
Many theorists have assumed the existence of periodic cycles, where the length of each successive cycle is uniform, even down to the precise number of months. The quest for periodicity is a chimerical hankering after the laws of physics; in human action there are no quantitative constants. Praxeological laws can be only qualitative in nature. Therefore, there will be no periodicity in the length of business cycles.
It is best, then, to discard Schumpeter’s multicyclical schema entirely and to consider his more interesting one-cycle “approximation” (as presented in his earlier book), which he attempts to derive from his general economic analysis. Schumpeter begins his study with the economy in a state of “circular flow” equilibrium, i.e., what amounts to a picture of an evenly rotating economy. This is proper, since it is only by hypothetically investigating the disturbances of an imaginary state of equilibrium that we can mentally isolate the causal factors of the business cycle. First, Schumpeter describes the ERE, where all anticipations are fulfilled, every individual and economic element is in equilibrium, profits and losses are zero—all based on given values and resources. Then, asks Schumpeter, what can impel changes in this setup? First, there are possible changes in consumer tastes and demands. This is cavalierly dismissed by Schumpeter as unimportant.There are possible changes in population and therefore in the labor supply; but these are gradual, and entrepreneurs can readily adapt to them. Third, there can be new saving and investment. Wisely, Schumpeter sees that changes in saving-investment rates imply no business cycle; new saving will cause continuous growth. Sudden changes in the rate of saving, when unanticipated by the market, can cause dislocations, of course, as may any sudden, unanticipated change. But there is nothing cyclic or mysterious about these effects. Instead of concluding from this survey, as he should have done, that there can be no business cycle on the free market, Schumpeter turned to a fourth element, which for him was the generator of all growth as well as of business cycles—innovation in productive techniques.
We have seen above that innovations cannot be considered the prime mover of the economy, since innovations can work their effects only through saving and investment and since there are always a great many investments that could improve techniques within the corpus of existing knowledge, but which are not made for lack of adequate savings. This consideration alone is enough to invalidate Schumpeter’s business-cycle theory.
A further consideration is that Schumpeter’s own theory relies specifically for the financing of innovations on newly expanded bank credit, on new money issued by the banks. Without delving into Schumpeter’s theory of bank credit and its consequences, it is clear that Schumpeter assumes a hampered market, for we have seen that there could not be any monetary credit expansion on a free market. Schumpeter therefore cannot establish a business-cycle theory for a purely unhampered market.
Finally, Schumpeter’s explanation of innovations as the trigger for the business cycle necessarily assumes that there is a recurrent cluster of innovations that takes place in each boom period. Why should there be such a cluster of innovations? Why are innovations not more or less continuous, as we would expect? Schumpeter cannot answer this question satisfactorily. The fact that a bold few begin innovating and that they are followed by imitators does not yield a cluster, for this process could be continuous, with new innovators arriving on the scene. Schumpeter offers two explanations for the slackening of innovatory activity toward the end of the boom (a slackening essential to his theory). On the one hand, the release of new products yielded by the new investments creates difficulties for old producers and leads to a period of uncertainty and need for “rest.” In contrast, in equilibrium periods, the risk of failure and uncertainty is less than in other periods. But here Schumpeter mistakes the auxiliary construction of the ERE for the real world. There is never in existence any actual period of certainty; all periods are uncertain, and there is no reason why increased production should cause more uncertainty to develop or any vague needs for rest. Entrepreneurs are always seeking profit-making opportunities, and there is no reason for any periods of “waiting” or of “gathering the harvest” to develop suddenly in the economic system.
Schumpeter’s second explanation is that innovations cluster in only one or a few industries and that these innovation opportunities are therefore limited. After a while they become exhausted, and the cluster of innovations ceases. This is obviously related to the Hansen stagnation thesis, in the sense that there are alleged to be a certain limited number of “investment opportunities”—here innovation opportunities—at any time, and that once these are exhausted there is temporarily no further room for investments or innovations. The whole concept of “opportunity” in this connection, however, is meaningless. There is no limit on “opportunity” as long as wants remain unfulfilled. The only other limit on investment or innovation is saved capital available to embark on the projects. But this has nothing to do with vaguely available opportunities which become “exhausted”; the existence of saved capital is a continuing factor. As for innovations, there is no reason why innovations cannot be continuous or take place in many industries, or why the innovatory pace has to slacken.
As Kuznets has shown, a cluster of innovation must assume a cluster of entrepreneurial ability as well, and this is clearly unwarranted. Clemence and Doody, Schumpeterian disciples, countered that entrepreneurial ability is exhausted in the act of founding a new firm. But to view entrepreneurship as simply the founding of new firms is completely invalid. Entrepreneurship is not just the founding of new firms, it is not merely innovation; it is adjustment: adjustment to the uncertain, changing conditions of the future. This adjustment takes place, perforce, all the time and is not exhausted in any single act of investment.
We must conclude that Schumpeter’s praiseworthy attempt to derive a business cycle theory from general economic analysis is a failure. Schumpeter almost hit on the right explanation when he stated that the only other explanation that could be found for the business cycle would be a cluster of errors by entrepreneurs, and he saw no reason, no objective cause, why there should be such a cluster of errors. That is perfectly true—for the free, unhampered market!
In the text above, we saw that even if the Keynesian functions were correct and social expenditures fell below income above a certain point and vice versa, this would have no unfortunate consequences for the economy. The level of national money income, and consequently of hoarding, is an imaginary bogey. In this section, we shall pursue our analysis of the Keynesian system and demonstrate further grave fallacies within the system itself. In other words, we shall see that the consumption function and investment are not ultimate determinants of social income (whereas above we demonstrated that it makes no particular difference if they are or not).
Investment, though the dynamic and volatile factor in the Keynesian system, is also the Keynesian stepchild. Keynesians have differed on the causal determinants of investment. Originally, Keynes determined it by the interest rate as compared with the marginal efficiency of capital, or prospect for net return. The interest rate is supposed to be determined by the money relation; we have seen that this idea is fallacious. Actually, the equilibrium net rate of return is the interest rate, the natural rate to which the bond rate conforms. Rather than changes in the interest rate causing changes in investment, as we have seen before, changes in time preference are reflected in changes in consumption-investment decisions. Changes in the interest rate and in investment are two sides of a coin, both determined by individual valuations and time preferences.
The error of calling the interest rate the cause of investment changes, and itself determined by the money relation, is also adopted by such “critics” of the Keynesian system as Pigou, who asserts that falling prices will release enough cash to lower the interest rate, stimulate investment, and thus finally restore full employment.
Modern Keynesians have tended to abandon the intricacies of the relation between interest and investment and simply declare themselves agnostic on the factors determining investment. They rest their case on an alleged determination of consumption.
If Keynesians are unsure about investment, they have, until very recently, been very emphatic about consumption. Investment is a volatile, uncertain expenditure. Aggregate consumption, on the other hand, is a passive, stable “function” of immediately previous social income. Total net expenditures determining and equaling total net income in a period (gross expenditures between stages of production are unfortunately removed from discussion) consist of investment and consumption. Furthermore, consumption always behaves so that below a certain income level consumption will be higher than income, and above that level consumption will be lower. Figure 82 depicts the relations among consumption, investment, expenditure, and social income.
The relation between income and expenditure is the same as shown in Figure 78. Now we see why the Keynesians assume the expenditure curve to have a smaller slope than income. Consumption is supposed to have the identical slope as expenditures; for investment is unrelated to income, as the determinants are unknown. Hence, investment is depicted as having no functional relation to income and is represented as a constant gap between the expenditure and consumption lines.
The stability of the passive consumption function, as contrasted with the volatility of active investment, is a keystone of the Keynesian system. This assumption is replete with so many grave errors that it is necessary to take them up one at a time.
(a) How do the Keynesians justify the assumption of a stable consumption function with the shape as shown above? One route was through “budget studies”—cross-sectional studies of the relation between family income and expenditure by income groups in a given year. Budget studies such as that of the National Resources Committee in the mid-1930’s yielded similar “consumption functions” with dishoardings increasing below a certain point, and hoardings above it (i.e., income below expenditures below a certain point, and expenditures below income above it).
This is supposed to intimate that those doing the “dissaving,” i.e., the dishoarding, are poor people below the subsistence level who incur deficits by borrowing. But how long is this supposed to go on? How can there be a continuous deficit? Who would continue to lend these people the money? It is more reasonable to suppose that the dishoarders are decumulating their previously accumulated capital, i.e., that they are wealthy people whose businesses suffered losses during that year.
(b) Aside from the fact that budget studies are misinterpreted, there are graver fallacies involved. For the curve given by the budget study has no relation whatever to the Keynesian consumption function! The former, at best, gives a cross section of the relation between classes of family expenditure and income for one year; the Keynesian consumption function attempts to establish a relation between total social income and total social consumption for any given year, holding true over a hypothetical range of social incomes. At best, one entire budget curve can be summed up to yield only one point on the Keynesian consumption function. Budget studies, therefore, can in no way confirm the Keynesian assumptions.
(c) Another very popular device to confirm the consumption function reached the peak of its popularity during World War II. This was historical-statistical correlation of national income and consumption for a definite period of time, usually the 1930’s. This correlation equation was then assumed to be the “stable” consumption function. Errors in this procedure were numerous. In the first place, even assuming such a stable relation, it would only be an historical conclusion, not a theoretical law. In physics, an experimentally determined law may be assumed to be constant for other identical situations; in human action, historical situations are never the same, and therefore there are no quantitative constants! Conditions and valuations could change at any time, and the “stable” relationship altered. There is here no proof of a stable consumption function. The dismal record of forecasts (such as those of postwar unemployment) made on this assumption should not have been surprising.
Moreover, a stable relation was not even established. Income was correlated with consumption and with investment. Since consumption is a much larger magnitude than (net) investment, no wonder that its percentage deviations around the regression equation were smaller! Furthermore, income is here being correlated with 80–90 percent of itself; naturally, the “stability” is tremendous. If income were correlated with saving, of similar magnitude as investment, there would be no greater stability in the income-saving function than in the “income-investment function.”
Thirdly, the consumption function is necessarily an ex ante relation; it is supposed to tell how much consumers will decide to spend given a certain total income. Historical statistics, on the other hand, record only ex post data, which give a completely different story. For any given period of time, for example, hoarding and dishoarding cannot be recorded ex post. In fact, ex post, on double-entry accounting records, total social income is always equal to total social expenditures. Yet, in the dynamic, ex ante, sense, it is precisely the divergence between total social income and total social expenditures (hoarding or dishoarding) that plays the crucial role in the Keynesian theory. But these divergences can never be revealed, as Keynesians believe, by study of ex post data. Ex post, in fact, saving always equals investment, and social expenditure always equals social income, so that the ex post expenditure line coincides with the income line.
(d) Actually, the whole idea of stable consumption functions has now been discredited, although many Keynesians do not fully realize this fact. In fact, Keynesians themselves have admitted that, in the long run, the consumption function is not stable, since total consumption rises as income rises; and that in the short run it is not stable, since it is affected by all sorts of changing factors. But if it is not stable in the short run and not stable in the long run, what kind of stability does it have? Of what use is it? We have seen that the only really important runs are the immediate and the long-run, which shows the direction in which the immediate is tending. There is no use for some sort of separate “intermediate” situation.
(e) it is instructive to turn now to the reasons that Keynes himself, in contrast to his followers, gave for assuming his stable consumption function. It is a confused exposition indeed.The “propensity to consume” out of given income, according to Keynes, is determined by two sets of factors, “objective” and “subjective.” It seems clear, however, that these are purely subjective decisions, so that there can be no separate objective determinants. In classifying subjective factors, Keynes makes the mistake of subsuming hoarding and investing motivations under categories of separate “causes”: precaution, foresight, improvement, etc. Actually, as we have seen, the demand for money is ultimately determined by each individual for all sorts of reasons, but all tied up with uncertainty; motives for investment are to maintain and increase future standards of living. By a sleight of hand completely unsupported by facts or argument Keynes simply assumes all these subjective factors to be given in the short run, although he admits that they will change in the long run. (If they change in the long run, how can his system yield an equilibrium position?) He simply reduces the subjective motives to current economic organization, customs, standards of living, etc., and assumes them to be given. The “objective factors” (which in reality are subjective, such as time-preference changes, expectations, etc.) can admittedly cause short-run changes in the consumption function (such as windfall changes in capital values). Expectations of future changes in income can affect an individual’s consumption, but Keynes simply asserts without discussion that this factor “is likely to average out for the community as a whole.” Time preferences are discussed in a very confused way, with interest rate and time preference assumed to be apart from and influencing the propensity to consume. Here again, short-run fluctuations are assumed to have little effect, and Keynes simply leaps to the conclusion that the propensity to consume is, in the short run, a “fairly” stable function.
(f) The failure of the consumption-function theory is not only the failure of a specific theory. It is a profound epistemological failure as well. For the concept of a consumption function has no place in economics at all. Economics is praxeological, i.e., its propositions are absolutely true given the existence of the axioms—the basic axiom being the existence of human action itself. Economics, therefore, is not and cannot be “empirical” in the positivist sense, i.e., it cannot establish some sort of empirical hypothesis which could or could not be true, and at best is only true approximately. Quantitative, empirico-historical “laws” are worthless in economics, since they may only be coincidences of complex facts, and not isolable, repeatable laws which will hold true in the future. The idea of the consumption function is not only wrong on many counts; it is irrelevant to economics.
Furthermore, the very term “function” is inappropriate in a study of human action. Function implies a quantitative, determined relationship, whereas no such quantitative determinism exists. People act and can change their actions at any time; no causal, constant, external determinants of action can exist. The term “function” is appropriate only to the unmotivated, repeatable motion of inorganic matter.
In conclusion, there is no reason whatever to assume that at some point, expenditures will be below income, while at lower points it will be above income. Economics does not and cannot know what ex ante expenditure will ever be in relation to income; at any point, it could be equal, or there could be net hoarding or dishoarding. The ultimate decisions are made by the individuals and are not determinable by science. There is, therefore, no stable expenditure function whatever.
The once highly esteemed “multiplier” has now happily faded in popularity, as economists have begun to realize that it is simply the obverse of the stable consumption function. However, the complete absurdity of the multiplier has not yet been fully appreciated. The theory of the “investment multiplier” runs somewhat as follows:
Social Income = Consumption + Investment
Consumption is a stable function of income, as revealed by statistical correlation, etc. Let us say, for the sake of simplicity, that Consumption will always be .80 (Income). In that case,
Income = .80 (Income) + Investment.
.20 (Income) = Investment; or
Income = 5 (Investment).
The “5” is the “investment multiplier.” It is then obvious that all we need to increase social money income by a desired amount is to increase investment by 1/5 of that amount; and the multiplier magic will do the rest. The early “pump primers” believed in approaching this goal through stimulating private investment; later Keynesians realized that if investment is an “active” volatile factor, government spending is no less active and more certain, so that government spending must be relied upon to provide the needed multiplier effect. Creating new money would be most effective, since the government would then be sure not to reduce private funds. Hence the basis for calling all government spending “investment”: it is “investment” because it is not tied passively to income.
The following is offered as a far more potent “multiplier,” on Keynesian grounds even more potent and effective than the investment multiplier, and on Keynesian grounds there can be no objection to it. It is a reductio ad absurdum, but it is not simply a parody, for it is in keeping with the Keynesian method.
Social Income = Income of (insert name of any person, say the reader) + Income of everyone else.
Let us use symbols:
Social income = Y
Income of the Reader = R
Income of everyone else = V
We find that V is a completely stable function of Y. Plot the two on coordinates, and we find historical one-to-one correspondence between them. It is a tremendously stable function, far more stable than the “consumption function.” On the other hand, plot R against Y. Here we find, instead of perfect correlation, only the remotest of connections between the fluctuating income of the reader of these lines and the social income. Therefore, this reader’s income is the active, volatile, uncertain element in the social income, while everyone else’s income is passive, stable, determined by the social income.
Let us say the equation arrived at is:
V = .99999 Y
Then, Y = .99999 Y + R
.00001 Y = R
Y = 100,000 R
This is the reader’s own personal multiplier, a far more powerful one than the investment multiplier. To increase social income and thereby cure depression and unemployment, it is only necessary for the government to print a certain number of dollars and give them to the reader of these lines. The reader’s spending will prime the pump of a 100,000-fold increase in the national income.
The “acceleration principle” has been adopted by some Keynesians as their explanation of investment, then to be combined with the “multiplier” to yield various mathematical “models” of the business cycle. The acceleration principle antedates Keynesianism, however, and may be considered on its own merits. It is almost always used to explain the behavior of investment in the business cycle.
The essence of the acceleration principle may be summed up in the following illustration:
Let us take a certain firm or industry, preferably a first-rank producer of consumers’ goods. Assume that the firm is producing an output of 100 units of a good during a certain period of time and that 10 machines of a certain type are needed in this production. If the period is a year, consumers demand and purchase 100 units of output per year. The firm has a stock of 10 machines. Suppose that the average life of a machine is 10 years. In equilibrium, the firm buys one machine as replacement every year (assuming it had bought a new machine every year to build up to 10). Now suppose that there is a 20-percent increase in the consumer demand for the firm’s output. Consumers now wish to purchase 120 units of output. Assuming a fixed ratio of capital investment to output, it is now necessary for the firm to have 12 machines (maintaining the ratio of one machine: 10 units of annual output). In order to have the 12 machines, it must buy two additional machines this year. Add this demand to its usual demand of one machine, and we see that there has been a 200-percent increase in demand for the machine. A 20-percent increase in demand for the product has caused a 200-percent increase in demand for the capital good. Hence, say the proponents of the acceleration principle, an increase in consumption demand in general causes an enormously magnified increase in demand for capital goods. Or rather, it causes a magnified increase in demand for “fixed” capital goods, of high durability. Obviously, capital goods lasting only one year would receive no magnification effect. The essence of the acceleration principle is the relationship between the increased demand and the low level of replacement demand for a durable good. The more durable the good, the greater the magnification and the greater, therefore, the acceleration effect.
Now suppose that, in the next year, consumer demand for output remains at 120 units. There has been no change in consumer demand from the second year (when it changed from 100 to 120) to the third year. And yet, the accelerationists point out, dire things are happening in the demand for fixed capital. For now there is no longer any need for firms to purchase any new machines beyond what is necessary for replacement. Needed for replacement is still only one machine per year. As a result, while there is zero change in demand for consumers’ goods, there is a 200-percent decline in demand for fixed capital. And the former is the cause of the latter. In the long run, of course, the situation stabilizes into an equilibrium with 120 units of output and one unit of replacement. But in the short run there has been consequent upon a simple increase of 20 percent in consumer demand, first a 200-percent increase in the demand for fixed capital, and next a 200-percent decrease.
To the upholders of the acceleration principle, this illustration provides the key to some of the main features of the business cycle: the greater fluctuations of fixed capital-goods industries as compared with consumers’ goods, and the mass of errors revealed by the crisis in the investment goods industries. The acceleration principle leaps boldly from the example of a single firm to a discussion of aggregate consumption and aggregate investment. Everyone knows, the advocates say, that consumption increases in a boom. This increase in consumption accelerates and magnifies increases in investment. Then, the rate of increase of consumption slows down, and a decline is brought about in investment in fixed capital. Furthermore, if consumption demand declines, then there is “excess capacity” in fixed capital—another feature of the depression.
The acceleration principle is rife with error. An important fallacy at the heart of the principle has been uncovered by Professor Hutt. We have seen that consumer demand increases by 20 percent; but why must two extra machines be purchased in a year? What does the year have to do with it? If we analyze the matter closely, we find that the year is a purely arbitrary and irrelevant unit even within the terms of the example itself. We might just as readily take a week as the period of time. Then we would have to say that consumer demand (which, after all, goes on continuously) increases 20 percent over the first week, thereby necessitating a 200-percent increase in demand for machines in the first week (or even an infinite increase if the replacement does not precisely occur in the first week), followed by a 200-percent (or infinite) decline in the next week, and stability thereafter. A week is never used by the accelerationists because the example would then be glaringly inapplicable to real life, which does not see such enormous fluctuations in the course of a couple of weeks. But a week is no more arbitrary than a year. In fact, the only nonarbitrary period to choose would be the life of the machine (e.g., 10 years). Over a ten-year period, demand for machines had previously been ten (in the previous decade), and in the current and succeeding decades it will be 10 plus the extra two, i.e., 12. In short, over the 10-year period the demand for machines will increase precisely in the same proportion as the demand for consumers’ goods—and there is no magnification effect whatever.
Since businesses buy and produce over planned periods covering the life of their equipment, there is no reason to assume that the market will not plan production suitably and smoothly, without the erratic fluctuations manufactured by the model of the acceleration principle. There is, in fact, no validity in saying that increased consumption requires increased production of machines immediately; on the contrary, it is only increased saving and investment in machines, at points of time chosen by entrepreneurs strictly on the basis of expected profit, that permits increased production of consumers’ goods in the future.
Secondly, the acceleration principle makes a completely unjustified leap from the single firm or industry to the whole economy. A 20-percent increase in consumption demand at one point must signify a 20-percent drop in consumption somewhere else. For how can consumption demand in general increase? Consumption demand in general can increase only through a shift from saving. But if saving decreases, then there are less funds available for investment. If there are less funds available for investment, how can investment increase even more than consumption? In fact, there are less funds available for investment when consumption increases. Consumption and investment compete for the use of funds.
Another important consideration is that the proof of the acceleration principle is couched in physical rather than monetary terms. Actually, consumption demand, particularly aggregate consumption demand, as well as demand for capital goods, cannot be expressed in physical terms; it must be expressed in monetary terms, since the demand for goods is the reverse of the supply of money on the market for exchange. If consumer demand increases either for one good or for all, it increases in monetary terms, thereby raising prices of consumers’ goods. Yet we notice that there has been no discussion whatever of prices or price relationships in the acceleration principle. This neglect of price relationships is sufficient by itself to invalidate the entire principle. The acceleration principle simply glides from a demonstration in physical terms to a conclusion in monetary terms.
Furthermore, the acceleration principle assumes a constant relationship between “fixed” capital and output, ignoring substitutability, the possibility of a range of output, the more or less intensive working of factors. It also assumes that the new machines are produced practically instantaneously, thus ignoring the requisite period of production.
In fact, the entire acceleration principle is a fallaciously mechanistic one, assuming automatic reactions by entrepreneurs to present data, thereby ignoring the most important fact about entrepreneurship: that it is speculative, that its essence is estimating the data of the uncertain future. It therefore involves judgment of future conditions by businessmen, and not simply blind reactions to past data. Successful entrepreneurs are those who best forecast the future. Why can’t the entrepreneurs foresee the supposed slackening of demand and arrange their investments accordingly? In fact, that is what they will do. If the economist, armed with knowledge of the acceleration principle, thinks that he will be able to operate more profitably than the generally successful entrepreneur, why does he not become an entrepreneur and reap the rewards of success himself? All theories of the business cycle attempting to demonstrate general entrepreneurial error on the free market founder on this problem. They do not answer the crucial question: Why does a whole set of men most able in judging the future suddenly lapse into forecasting error?
A clue to the correct business cycle theory is contained in the fact that buried somewhere in a footnote or minor clause of all business cycle theories is the assumption that the money supply expands during the boom, in particular through credit expansion by the banks. The fact that this is a necessary condition in all the theories should lead us to explore this factor further: perhaps it is a sufficient condition as well. But, as we have seen above, there can be no bank credit expansion on the free market, since this is equivalent to the issue of fraudulent warehouse receipts. The positive discussion of business cycle theory will have to be postponed to the next chapter, since there can be no business cycle in the purely free market.
Business-cycle theorists have always claimed to be more “realistic” than general economic theorists. With the exceptions of Mises and Hayek (correctly) and Schumpeter (fallaciously), none has tried to deduce his business cycle theory from general economic analysis. It should be clear that this is required for a satisfactory explanation of the business cycle. Some, in fact, have explicitly discarded economic analysis altogether in their study of business cycles, while most writers use aggregative “models” with no relation to a general economic analysis of individual action. All of these commit the fallacy of “conceptual realism”—i.e., of using aggregative concepts and shuffling them at will, without relating them to actual individual action, while believing that something is being said about the real world. The business-cycle theorist pores over sine curves, mathematical models, and curves of all types; he shuffles equations and interactions and thinks that he is saying something about the economic system or about human action. In fact, he is not. The overwhelming bulk of current business cycle theory is not economics at all, but meaningless manipulation of mathematical equations and geometric diagrams.
 Cited in Wesley C. Mitchell, Business Cycles, the Problem and Its Setting (New York: National Bureau of Economic Research, 1927), pp. 76–77.
See V. Lewis Bassie:
The whole psychological theory of the business cycle appears to be hardly more than an inversion of the real causal sequence. Expectations more nearly derive from objective conditions than produce them. . . . It is not the wave of optimism that makes times good. Good times are almost bound to bring a wave of optimism with them. On the other hand, when the decline comes, it comes not because anyone loses confidence, but because the basic economic forces are changing. (V. Lewis Bassie, “Recent Development in Short-Term Forecasting,” Studies in Income and Wealth, XVII [Princeton, N.J.: National Bureau of Economic Research, 1955], 10–12)
Joseph A. Schumpeter, The Theory of Economic Development (Cambridge: Harvard University Press, 1936), and idem, Business Cycles (New York: McGraw-Hill, 1939).
Warren and Pearson, as well as Dewey and Dakin, conceive of the business cycle as made up of superimposed, independent, periodic cycles from each field of production activity. See George F. Warren and Frank A. Pearson, Prices (New York: John Wiley and Sons, 1933); E.R. Dewey and E.F. Dakin, Cycles: The Science of Prediction (New York: Holt, 1949).
On the tendency to neglect the consumer’s role in innovation, cf. Ernst W. Swanson, “The Economic Stagnation Thesis, Once More,” The Southern Economic Journal, January, 1956, pp. 287–304.
S.S. Kuznets, “Schumpeter’s Business Cycles,” American Economic Review, June, 1940, pp. 262–63; and Richard V. Clemence and Francis S. Doody, The Schumpeterian System (Cambridge: Addison-Wesley Press, 1950), pp. 52ff.
In so far as innovation is a regularized business procedure of research and development, rents from innovations will accrue to the research and development workers in firms, rather than to entrepreneurial profits. Cf. Carolyn Shaw Solo, “Innovation in the Capitalist Process: A Critique of the Schumpeterian Theory,” Quarterly Journal of Economics, August, 1951, pp. 417–28.
Some Keynesians account for investment by the “acceleration principle” (see below). The Hansen “stagnation” thesis—that investment is determined by population growth, the rate of technological improvement, etc.—seems happily to be a thing of the past.
See Lindahl, “On Keynes’ Economic System—Part I,” p. 169n. Lindahl shows the difficulties of mixing an ex post income line with ex ante consumption and spending, as the Keynesians do. Lindahl also shows that the expenditure and income lines coincide if the divergence between expected and realized income affects income and not stocks. Yet it cannot affect stocks, for, contrary to Keynesian assertion, there is no such thing as hoarding or any other unexpected event leading to “unintended increase in inventories.” An increase in inventories is never unintended, since the seller has the alternative of selling the good at the market price. The fact that his inventory increases means that he has voluntarily invested in larger inventory, hoping for a future price rise.
Summing up disillusionment with the consumption function are two significant articles: Murray E. Polakoff, “Some Critical Observations on the Major Keynesian Building Blocks,” Southern Economic Journal, October, 1954, pp. 141–51; and Leo Fishman, “Consumer Expectations and the Consumption Function,” ibid., January, 1954, pp. 243–51.
Keynes, General Theory, pp. 89–112.
Ibid., pp. 109–10.
What is “fairly” supposed to mean? How can a theoretical law be based on “fair” stability? More stable than other functions? What are the grounds for this assumption, particularly as a law of human action? Ibid., pp. 89–96.
Actually, the form of the Keynesian function is generally “linear,” e.g., Consumption = .80 (Income) + 20. The form given in the text simplifies the exposition without, however, changing its essence.
Also see Hazlitt, Failure of the “New Economics,” pp. 135–55.
It is usually overlooked that this replacement pattern, necessary to the acceleration principle, could apply only to those firms or industries that had been growing in size rapidly and continuously.
See his brilliant critique of the acceleration principle in W.H. Hutt, Co-ordination and the Price System (unpublished, but available from the Foundation for Economic Education, Irvington-on-Hudson, N.Y., 1955), pp. 73–117.
Neglect of prices and price relations is at the core of a great many economic fallacies.
See Mises, Human Action, pp. 581f.; S.S. Kuznets, “Relations between Capital Goods and Finished Products in the Business Cycle” in Economic Essays in Honor of Wesley Clair Mitchell (New York: Columbia University Press, 1935), p. 228; and Hahn, Commonsense Economics, pp. 139–43.
See the excellent critique by Leland B. Yeager of the neostagnationist Keynesian versions of “growth economics” of Harrod and Domar, which make use of the acceleration principle. Yeager, “Some Questions on Growth Economics,” pp. 53–63.