America's Great Depression (12 page)

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America’s Great Depression

of spending. The task of government in a depression, according to the Keynesians, is accordingly to stimulate investments and discourage savings, so that total spendings increase.

Savings and investment are indissolubly linked. It is impossible to encourage one and discourage the other. Aside from bank credit, investments can come from no other source than savings (and we have seen what happens when investments are financed by bank credit). Not only consumers save directly, but also consumers in their capacity as independent businessmen or as owners of corporations. But can’t savings be “hoarded”? This, however, is an artificial and misleading way of putting the matter. Consider a man’s possible allocation of his monetary assets: He can (1) spend money on consumption; (2) spend on investment; (3) add to cash balance or subtract from previous cash balance. This is the sum of his alternatives. The Keynesians assume, most contrivedly, that he
first
decides how much to consume or not, calling this “not-consumption”
saving
, and
then
decides how much to invest and how much to “leak” into hoards. (This, of course, is neo-Keynesianism rather than pure Keynesian ortho-doxy, which banishes hoarding from the living room, while read-mitting it by the back door.) This is a highly artificial approach and confirms Sir Dennis Robertson’s charge that the Keynesians are incapable of “visualizing more than two margins at once.”2 Clearly, our individual decides at one and the same stroke about allocating his income in the three different channels. Furthermore, he allocates between the various categories on the basis of two embracing utilities:
his time preferences
decide his allocation between consumption and investment (between spending on present vs. future consumption);
his utility of money
decides how much he will keep in his cash balance. In order to
invest
resources in the future, he must restrict his consumption and
save
funds. This restricting is 2Dennis H. Robertson, “Mr. Keynes and the Rate of Interest,” in
Readings in
the Theory of Income Distribution
(Philadelphia: Blakiston, 1946), p. 440. Also see the article by Carl Landauer, “A Break in Keynes’s Theory of Interest,”
American
Economic Review
(June, 1937): 260–66.

Keynesian Criticisms of the Theory

39

his savings, and so saving and investment are always equivalent.

The two terms may be used almost interchangeably.

These various individual valuations sum up to social time-preference ratios and social demand for money. If people’s demand for cash balances increases, we do not call this “savings leaking into hoards”; we simply say that demand for money has increased. In the aggregate, total cash balances can only rise to the extent that the total supply of money rises, since the two are identical. But
real
cash balances can increase through a rise in the value of the dollar.

If the value of the dollar is permitted to rise (prices are permitted to fall) without hindrance, no dislocations will be caused by this increased demand, and depressions will not be aggravated. The Keynesian doctrine artificially assumes that any increase (or decrease) in hoards will be matched by a corresponding fall (or rise) in invested funds. But this is not correct. The demand for money is completely unrelated to the time-preference proportions people might adopt; increased hoarding, therefore, could just as easily come out of reduced consumption as out of reduced investment. In short, the savings-investment–consumption proportions are determined by time preferences of individuals; the spending-cash balance proportion is determined by their demands for money.

THE LIQUIDITY “TRAP”

The ultimate weapon in the Keynesian arsenal of explanations of depressions is the “liquidity trap.” This is not precisely a critique of the Mises theory, but it is the last line of Keynesian defense of their own inflationary “cures” for depression. Keynesians claim that “liquidity preference” (demand for money) may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression. This statement assumes that the rate of interest is determined by “liquidity preference” instead of by time preference; and it also assumes again that the link between savings and investment is very tenuous indeed, only tentatively exerting itself
through
the rate of interest. But, on the contrary, it is not a question of saving and investment each being acted upon by the
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America’s Great Depression

rate of interest; in fact, saving, investment, and the rate of interest are each and all
simultaneously
determined by individual time preferences on the market. Liquidity preference has nothing to do with this matter. Keynesians maintain that if the “speculative” demand for cash rises in a depression, this will raise the rate of interest. But this is not at all necessary. Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption–investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on “liquidity preference.” In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to
fall
—because time preferences have fallen.

In their stress on the liquidity trap as a potent factor in aggravating depression and perpetuating unemployment, the Keynesians make much fuss over the alleged fact that people, in a financial crisis,
expect
a rise in the rate of interest, and will therefore hoard money instead of purchasing bonds and contributing toward lower rates. It is this “speculative hoard” that constitutes the “liquidity trap,” and is supposed to indicate the relation between liquidity preference and the interest rate. But the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the
natural rate
—the “profit spread” on the market.

Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate. What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers’ goods prices falling
faster than
do consumer goods’ prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned “classical” speculation on price changes. This expectation, far from being an
upsetting
element, actually
speeds up
the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal
Keynesian Criticisms of the Theory

41

prosperity to return that much faster. Far from “speculative” hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.3

Such intelligent neo-Keynesians as Modigliani concede that only an “infinite” liquidity preference (an unlimited demand for money) will block return to full-employment equilibrium in a free market.4 But, as we have seen, heavy speculative demand for money speeds the adjustment process. Moreover, the demand for money could never be
infinite
because people must always continue consuming, on
some
level, regardless of their expectations. Since people must continue consuming, they must also continue producing, so that there can be adjustment and full employment regardless of the degree of hoarding. The failure to juxtapose hoarding and
consuming
again stems from the Keynesian neglect of more than two margins at once and their erroneous belief that hoarding only reduces investment, not consumption.

In a brilliant article on Keynesianism and price-wage flexibility, Professor Hutt points out that:

No condition which even distinctly resembles infinite elasticity of demand for money assets has even been recognized, I believe, because general expectations have always envisaged either (a) the attainment in the not too 3For more on the equilibrating effects of wage reductions in a depression see the following section.

4Some of the most damaging blows to the Keynesian system have come from friendly, but unsparing, neo-Keynesian sources; e.g., Franco Modigliani,

“Liquidity Preference and the Theory of Interest and Money,” in Henry Hazlitt, ed.,
The Critics of Keynesian Economics
(Princeton, N.J.: D. Van Nostrand, 1960), pp. 131–84; Erik Lindahl, “On Keynes’ Economic System,”
Economic Record
(May and November, 1954): 19–32, 159–71. As Hutt sums up:

[T]he apparent revolution wrought by Keynes after 1936 has been reversed by a bloodless counterrevolution conducted unwittingly by higher critics who tried very hard to be faithful. Whether some permanent benefit to our science will have made up for the destruction which the revolution left in its train, is a question which economic historians of the future will have to answer.

W.H. Hutt, “The Significance of Price Flexibility,” in Hazlitt,
The Critics of
Keynesian Economics.,
p. 402.

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America’s Great Depression

distant future of some definite scale of prices, or (b) so gradual a decline of prices that no cumulative postpone-ment of expenditure has seemed profitable.

But even if such an unlikely demand arose:

If one can seriously imagine [this situation] . . . with the aggregate real value of money assets being inflated, and prices being driven down catastrophically, then one may equally legitimately (and equally extravagantly) imagine continuous price coordination accompanying the emergence of such a position. We can conceive, that is, of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utiliza-tion of resources persisting all the way.5

WAGE RATES AND UNEMPLOYMENT

Sophisticated Keynesians now admit that the Keynesian theory of “underemployment equilibrium” does not really apply (as was first believed) to the free and unhampered market: that it assumes, in fact, that wage rates are
rigid downward.
“Classical” economists have always maintained that unemployment is caused precisely by wage rates not being allowed to fall freely; but in the Keynesian system this assumption has been buried in a mass of irrelevant equations. The assumption is there, nevertheless, and it is crucial.6

The Keynesian prescription for unemployment rests on the persistence of a “money illusion” among workers, i.e., on the belief that while, through unions and government, they will keep money wage rates from falling, they will also accept a fall in real wage rates via higher prices. Governmental inflation, then, is supposed to eliminate unemployment by bringing about such a fall in
real
wage rates. In these times of ardent concentration on the cost-of-living 5Hutt, “The Significance of Price Flexibility,” pp. 397n. and 398.

6See Modigliani, “Liquidity Preference and the Theory of Interest and Money,” and Lindahl, “On Keynes’ Economic System,” ibid.

Keynesian Criticisms of the Theory

43

index, such duplicity is impossible and we need not repeat here the various undesirable consequences of inflation.7

It is curious that even economists who subscribe to a general theory of prices balk whenever the theory is logically applied to wages, the prices of labor services. Marginal productivity theory, for example, may be applied strictly to other factors; but, when wages are discussed, we suddenly read about “zones of indeterminacy” and “bargaining.”8 Similarly, most economists would readily admit that keeping the price of any good above the amount that would clear the market will cause unsold surpluses to pile up. Yet, they are reluctant to admit this in the case of labor. If they claim that “labor” is a general good, and therefore that wage cuts will injure general purchasing power, it must first be replied that “general labor” is not sold on the market; that it is certain specific labor that is usually kept artificially high and that this labor will be unemployed. It is true, however, that the wider the extent of the artificially high wage rates, the more likely will mass unemployment be. If, for example, only a few crafts manage, by union or government coercion to boost the wage rate in their fields above the free-market rate, displaced workers will move into a poorer line of work, and find employment there. In that case, the remaining union workers have gained their wage increase at the expense of lower wage rates elsewhere and of a general misallocation of productive factors. The wider the extent of the rigid wages, however, the less opportunity there will be to move and the greater will be the extent and duration of the unemployment.

In a free market, wage rates will tend to adjust themselves so that there is no involuntary unemployment, i.e., so that all those desiring to work can find jobs. Generally, wage rates can only be kept above full-employment rates through coercion by government, 7See L. Albert Hahn,
The Economics of Illusion
(New York: Squier, 1949), pp. 50ff., 166ff.

8Actually, zones of indeterminacy are apt to be wide where only two or three people live on a desert island and narrow progressively the greater the population and the more advanced the economic system. No special zone adheres to the labor contract.

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America’s Great Depression

unions, or both. Occasionally, however, the high wage rates are maintained by voluntary choice (although the choice is usually ignorant of the consequences) or by coercion supplemented by voluntary choice. It may happen, for example, that either business firms or the workers themselves may become persuaded that maintaining wage rates artificially high is their bounden duty. Such persuasion has actually been at the root of much of the unemployment of our time, and this was particularly true in the 1929 depression.