With his usual astuteness, Mises observed that it is common for one and the same doctrine to circulate in more than one version, typically, in its original, scholarly version and then also in a greatly simplified version designed for popular consumption. He illustrated how this applied to doctrines as diverse as Catholicism, Darwinism, and Freudianism. (Money, Method, and the Market Process, pp. 301f.)
Not surprisingly, his observation also applies to Keynesianism and its claim that a free economy is incapable of eliminating unemployment, because its method of doing so, namely, a fall in wage rates, is allegedly unable to increase the quantity of labor demanded.
The popular version of the Keynesian doctrine, which is championed above all by the labor unions, is simply that a fall in wage rates, in reducing the incomes of wage earners, causes a fall in consumer spending, which allegedly serves to worsen the problem of unemployment. This doctrine can be disposed of fairly simply, before proceeding to the scholarly version of Keynesianism, which is known as the IS-LM doctrine.
First of all, it overlooks the fact that at lower wage rates more workers will be employed. The effect of this is to enable total wage payments and consumer spending in the economic system to remain the same or even increase while the wages of the individual worker decline. For example, 10 workers each employed at 90 percent of the wages earn the same total wages and can spend just as much in buying consumers’ goods as could 9 workers each earning the original wage. (It’s as simple as the fact that 10 times .9 equals 9 times 1.) And, of course, more than 10 workers employed at 90 percent of the wage per worker would earn more collectively and spend more for consumers’ goods collectively than was possible before.
The popular version of the Keynesian doctrine also overlooks the fact that even if total wage payments and consumer spending did decline, business sales revenues would not decline insofar as reduced wage payments made possible increased expenditures for capital goods. Indeed, to the extent that additional spending for capital goods took the place of wage payments and the consumer spending supported by wage payments, not only would sales revenues in the economic system remain the same, but, what is particularly important for the process of economic recovery, the amount of profit earned on those same total sales revenues would actually increase.
This result follows because wage payments as a rule show up fairly quickly—usually within a matter of weeks or months—as equivalent costs that must be deducted from sales revenues in calculating profits. In contrast, expenditures for machinery will not show up as equivalent costs deducted from sales revenues for several years or more, in accordance with the depreciable life of the machines. And expenditures for construction materials and the services of construction equipment will not show up as equivalent costs deducted from sales revenues for several decades, in accordance with the still longer depreciable lives of buildings and other highly durable assets.
Spending for Capital Goods Can Rise at the Same Time that Spending for Consumers’ Goods Falls
Some readers may wonder how it is possible for more to be spent for capital goods at the same time that less is spent for consumers’ goods. Less spending for consumers’ goods, it would seem, should imply less spending for the capital goods required to produce the consumers’ goods. The answer lies in the fact that while this may well be true, the spending for capital goods to produce consumers’ goods declines in a lesser degree than does the spending to buy consumers’ goods. This means that it now stands in a higher proportion to the spending for consumers’ goods. In turn, the spending to buy the capital goods to produce those capital goods comes to stand in a compounded higher proportion to the spending for consumers’ goods, and so on, with the spending for capital goods further compounded at every succeeding stage of production.
The following series of numbers will help to illustrate what is involved. Thus imagine that initially spending for consumers’ goods in the economic system was 500 units of money, the spending for the capital goods to produce those consumers’ goods was 250 units of money, the spending for the capital goods to produce those capital goods, 125 units of money, and so on, with each succeeding amount of spending for capital goods being half of the spending for the capital goods it helps to produce.
Hoarding and the Rate of Profit
Finally, it should also be realized that the effect even of a decline in total wage payments that was not accompanied by any increase in spending for capital goods, would soon be very positive for profits. It would not increase profits in absolute amount, but it would increase them as a percentage of sales revenues and costs.
Here it must be kept in mind that wage payments are not only a source of funds for wage earners to spend in buying consumers goods, but they also show up equivalently as business costs, which must be deducted from sales revenues in computing profits, and do so fairly soon. Thus a decline in wage payments would quickly result in equal reductions in sales revenues and costs. To whatever extent sales revenues were greater than costs to begin with, the amount of that excess would remain unchanged, because equals subtracted from unequals do not affect the amount of the inequality. However, the same amount of inequality, i.e., of profit, would now represent a larger percentage of the reduced sales revenues and costs.
The same amount of profit in the economic system would also represent a rise in the rate of return on capital invested in the economic system. This would be the result not only of the monetary value of the capital invested shrinking in consequence of reduced spending for labor (and capital goods), but also, and far more immediately, of the write-down of the value of existing capital assets to correspond with their lower level of replacement costs made possible by widespread declines in wage rates and prices. In addition, purchases of assets at fire-sale prices following bankruptcies contribute to the same result.
What this implies is that to the extent that savings in the economic system might be unduly held in the form of cash, i.e., “hoarded,” the effect is to raise the rate of return on capital invested and thus to provide a greater incentive for savings being invested rather than being hoarded. In other words, “hoarding” is always a self-limiting phenomenon.
It follows that even if a decline in wage rates was initially accompanied not only by a fall in total wage payments but also by a fall in total business spending for labor and capital goods combined, the subsequent rise in the rate of return on capital would operate to restore total wage payments and the spending for capital goods. Consequently, once the underlying aspects of a process of financial contraction have come to an end, a fall in wage rates operates at least fairly soon to increase the quantity of labor demanded.
100 Percent Hoarding and an Infinite Rate of Profit
An implication of this discussion that may appear startling to many readers is that if it were ever the case that people kept all of their savings in the form of cash holdings and spent absolutely nothing for labor or capital goods, the rate of profit and interest in the economic system would become infinitely high. This is because while there would still be some amount of sales revenues in the economic system, resulting from consumption expenditures by those who possessed money, there would be no money costs of production to deduct from those sales revenues, since no expenditures giving rise to money costs would have been made. Thus the amount of profit in the economic system would equal 100 percent of the sales revenues generated by whatever consumer spending existed. At the same time it would equal an infinite percentage of the zero money costs of production and an infinite percentage of the zero money value of capital invested.
These conclusions are confirmed by the fact that the rate of profit and interest is far higher in countries that lack the security of property and developed financial markets and institutions and where, as a result, a far larger portion of savings takes the form of precious metals and gems rather than investments in business.
More on Hoarding and the Rate of Profit
“Hoarding,” or more precisely an increase in the demand for money for cash holding, has two effects on the rate of profit. One is its longer-run effect, which can take place within a period as short as a few months, and which is to raise the rate of profit, as I have just shown.
Its other, more immediate effect, however, is to reduce the rate of profit, even to the point of wiping it out entirely and replacing profits with losses throughout the economic system. This is the effect with which everyone is familiar and in the name of which they desire to do everything possible to avoid reductions in spending of any kind.
The reason that hoarding first reduces profits is merely the fact that reductions in spending for labor and capital goods exert their effect on business sales revenues to a more or less substantial extent before they exert their effect on the business costs deducted from sales revenues in arriving at profits. Business sales revenues decline immediately when spending for capital goods declines: for example, less spending for steel sheet by an automobile company is less sales revenues for steel companies at the very same moment. Sales revenues decline almost immediately when spending to employ labor declines, i.e., as soon as reduced wage payments show up in reduced consumer spending.
Now some costs deducted from sales revenues also decline immediately in response to reduced business spending, notably, such costs as typically come under the heading of selling, general, or administrative expenses. But other costs, namely, those which come under the headings of “cost of goods sold” and “depreciation cost” are not immediately affected by declines in current business spending. They are determined historically, that is, by business spending for inventories and plant and equipment that has taken place in the past, and which cannot retroactively be reduced.
Current spending on account of inventories and plant and equipment shows up as costs to be deducted from sales revenues only in the future, a future that ranges from days to decades. Of course, in a major recession or depression, long-term investment spending falls to a far greater extent than spending required to carry on current operations, and as a result, further declines in business spending, notably for labor and materials, almost all show up fairly quickly as declines in costs deducted from sales revenues.
Long-term investment spending falls disproportionately in large part because the wage rates of construction workers and of workers producing construction materials and the various kinds of machinery have not fallen or have not fallen to the point to which it is believed they will fall. In that case, it pays to postpone such investments and hold cash instead, because they would be at a major disadvantage in competition with investments made in the future. And when these wage rates and prices do finally fall, permitting current long-term investment to be worthwhile once again, the monetary value of existing plant and equipment can be written down commensurately, as previously indicated. The effect of the write-downs is to reduce depreciation cost on existing plant and equipment. (For example, the annual depreciation charge on plant with an asset value of $1 billion and a remaining depreciable life of 20 years is $50 million. But if the value of that plant and equipment were written down to $500 million, the annual depreciation charge incurred would also fall by half, to $25 million.)
Along with a fall in wage rates and prices, an essential condition of economic recovery from a major recession or depression is simply the end of further financial contraction, i.e., further economy-wide declines in spending. Further financial contraction stops when bank failures and their accompanying declines in the quantity of money stop (or, better still, do not start in the first place) and when the demand for money for cash holding has risen sufficiently to satisfy the need to operate without access to loans created on a foundation of credit expansion.
The additional demand for money for cash holding also includes whatever temporary further component may be necessary to allow for a failure of wage rates and prices to fall and the consequent postponement of long-term investments. At this point, the short-run negative effect of less spending on the amount and rate of profit begins to come to an end. Its final end is greatly accelerated by the write-downs of assets that accompany reductions in wage rates and prices and hence in the replacement cost of existing business assets. (As indicated, purchases of assets at fire-sale prices following bankruptcies contribute to the same result.)
These write-downs not only serve to reduce costs deducted from sales revenues earned with existing assets, thereby increasing current profits, but also serve to reduce the money value of the capital invested, thereby further increasing the rate of profit on existing assets in the economic system. In effect, they serve to increase the size of the profit numerator while reducing the size of the capital-invested denominator. More profit earned on less capital is a two-sided increase in the rate of return on capital.
In this environment, reductions in wage rates not yet accompanied by the employment of more workers or by the purchase of more capital goods quickly result in improvement in the rate of profit. They do so not only by reducing costs as much as sales revenues, but by reducing them by more than sales revenues when the effect of write-downs is taken into account. The write downs, as just shown, also raise the rate of profit by reducing the money value of the capital invested in the economic system.
This rise in the rate of profit, and consequently also in the rate of interest, operates to reduce the demand for money for cash holding, by virtue of making the investment of money relatively more attractive in comparison with the holding of money. The reduction in the demand for money for cash holding is greatly furthered by the restoration of the profitability of long-term investment that accompanies the necessary fall in wage rates and prices and also by the rise in the rate of profit that takes place pursuant to the putting of funds into longer-term investments.
The net upshot is that the necessary fall in wage rates and prices serves to increase the quantity of labor demanded disproportionately, by virtue of calling back into the market funds that had been withheld in anticipation of the fall in wage rates and prices. At the same time, the increase in the quantity of labor demanded and the corresponding movement of the economic system toward “full employment” is accompanied by a rise in the rate of profit in the economic system.
The Keynesian IS-LM Doctrine
The doctrine of Keynes himself is far more complex than the popular variant. It is so complex that it calls to mind a popular song from years ago called “Collarbone” that described the connection of one bone to another, from toe to head. The song went, “Toe bone connected to the ankle bone, ankle bone connected to the shin bone, shin bone connected to the knee bone…neck bone connected to the head bone.”
My reason for associating Keynesian economics with this song is that just as one bone is connected to another in the song, so in textbooks expounding the Keynesian system, each separate but connected piece of the anatomy of that system—a bone, if you will—is presented in a series of successively connected diagrams totaling as many as eleven in all. Each one of the diagrams repeats an axis of the one before it. Thus, in the Keynesian system, the “production function” is connected to the “IS curve”; the “IS curve” is connected to the “saving function”; the “saving function” is connected to the “saving-equals-investment line”; the “saving-equals-investment line” is connected to the “marginal efficiency of capital schedule”; the “marginal efficiency of capital schedule" is connected back to the “IS curve”; the “IS curve” is connected to the “aggregate demand curve.…” The diagram below, which is from the first edition of Joseph P. McKenna's Aggregate Economic Analysis, depicts all the various relationships involved.
Anatomy of the Keynesian System
Just as in the case of the highly simplified labor-union version, the ultimate conclusion drawn from this extensive series of connections is that full employment cannot be achieved in a free market, because, once again, a fall in wage rates allegedly turns out to be incapable of increasing the quantity of labor demanded.
Even though the two versions of Keynesianism reach the same conclusion, they differ profoundly in the complexity of their explanations. And as a result, they require separate critiques.
In the textbook version, the reason that a fall in wage rates allegedly cannot reduce unemployment is not that it automatically reduces spending in the economic system. Keynes is willing to concede that initially spending might remain the same or even increase and that at the lower wage rates it would in fact employ additional workers. He writes:
Perhaps it will help to rebut the crude conclusion that a reduction in money-wages will increase employment “because it reduces the cost of production”, if we follow up the course of events on the hypothesis most favourable to this view, namely that at he outset entrepreneurs expect the reduction in money-wages to have this effect. It is indeed not unlikely that the individual entrepreneur, seeing his own costs reduced, will overlook at the outset the repercussions on the demand for his product and will act on the assumption that he will be able to sell at a profit a larger output than before. (General Theory, p. 261.)
The basic problem, Keynes contends, lies in what would happen next, if the fall in wage rates did in fact manage to increase the volume of employment. Continuing in the very same paragraph, he argues that the effect of the greater employment would be a fall in the rate of profit (which he usually calls “the marginal efficiency of capital”) below the lowest rate that is sufficient to induce investment. This would serve to make the employment of additional workers no longer worthwhile and result in employment being pushed back to its previous figure. In his words (to which I’ve taken the liberty of adding explanatory comments, which appear in brackets):
If, then, entrepreneurs generally act on this expectation, will they in fact succeed in increasing their profits? Only if the community’s marginal propensity to consume is equal to unity, so that there is no gap between the increment of income and the increment of consumption [i.e., there is no additional saving]; or if there is an increase in investment, corresponding to the gap between the increment of income and the increment of consumption, which will only occur if the schedule of marginal efficiencies of capital has increased relatively to the rate of interest [i.e., either the mec schedule must somehow move to the right, which there is allegedly no reason for its doing, or the rate of interest must fall, which it can’t do, because it is allegedly already at its lowest acceptable rate, which is usually assumed to be 2 percent]. Thus the proceeds realised from the increased output will disappoint the entrepreneurs and employment will fall back again to its previous figure, unless the marginal propensity to consume is equal to unity [i.e., there is no additional saving] or the reduction in money-wages has had the effect of increasing the schedule of marginal efficiencies of capital relatively to the rate of interest and hence the amount of investment [Keynes means, of course, increase the amount of investment that is worthwhile—i.e., yields 2 percent or more]. For if entrepreneurs offer employment on a scale which, if they could sell their output at the expected price, would provide the public with incomes out of which they would save more than the amount of current investment, entrepreneurs are bound to make a loss equal to the difference; and this will be the case absolutely irrespective of the level of money wages.
I have italicized the last sentence because if any single sentence of Keynes can express the theoretical substance of his doctrine, that is the one.
Here is the line of argument Keynes is presenting in the passage above and which is depicted in the graphical analysis. The employment of more workers results in more production, which at the same time means more real income. By a process of equivocation, which I note here, but will not make a major issue of, real income suddenly becomes interchangeable with money income, out of which saving and cash hoarding can potentially take place.
Saving, according to Keynes and his followers, is a mathematical function of income, such that more income results in more saving, e.g., 20 percent of each additional dollar of income is saved, while 80 percent of each additional dollar of income is consumed. The extra saving relative to extra income is called “the marginal propensity to save,” while the extra consumption relative to extra income is called “the marginal propensity to consume.” The names of the full mathematical functions are “the saving function” and “the consumption function.”
As the quotation indicates, the existence of saving allegedly creates a problem. If there were no additional saving as employment and income increased, there would be nothing to stop the additional employment achieved as the result of a fall in wage rates from being maintained. But saving creates the potential for cash hoarding.
Cash hoarding, in the Keynesian system need not automatically and necessarily occur every time there is saving. Potentially, additional saving might be offset by equivalent additional investment. If it were, that would put the money saved back into the spending stream. In this case too, the additional employment achieved as the result of a fall in wage rates could be maintained.
The problem that arises, according to Keynes and his followers, is that the additional investment required is the cause of a fall in the “marginal efficiency of capital,” i.e., the rate of profit or rate of return on capital. The effect of achieving full employment, believe the Keynesians, would be an increase in the volume of saving to such an extent that it would require an offsetting increase in the volume of investment of such a magnitude that the rate of return on capital would allegedly be driven to an unacceptably low level. (Below 2 percent is the figure usually assumed.)
In response to a rate of return less than the minimum acceptable rate, funds would be withdrawn from investment and hoarded. This would reduce spending throughout the economic system and cause the return of unemployment.
The fundamental problem, say the Keynesians, is that the existence of full employment would impose an unacceptably low rate of return on capital and therefore could not be maintained if it were achieved. The return of unemployment would be necessary because by reducing output/income, it would reduce the volume of saving, since less income results in less saving. With saving reduced, less investment is required to offset it in order to prevent hoarding. And with less investment, the rate of return on capital will be higher.
Keynes’s whole argument depends on the rate of profit falling as the end result of the increase in employment and output. If the rate of profit did not fall, if it stayed the same or rose as employment and output increased on the foundation of a fall in wage rates and prices, there would be absolutely nothing standing in the way of the achievement of full employment by means of a fall in wages and prices.
Clearly, it is essential to examine Keynes’s argument that the rate of profit (mec) declines as investment increases. For his whole analysis depends on it. In explaining it, he writes:
If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased, partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase.… Thus for each type of capital we can build up a schedule, showing by how much investment in it will have to increase within the period, in order that its marginal efficiency should fall to any given figure. We can then aggregate these schedules for all the different types of capital, so as to provide a schedule relating the rate of aggregate investment to the corresponding marginal efficiency of capital in general which that rate of investment will establish. We shall call this the investment demand-schedule; or, alternatively, the schedule of the marginal efficiency of capital. (General Theory, p. 136.)
Keynes’s reference to the prospective yield on capital falling is usually divided into two related aspects: a decline in the prospective selling prices of products as stepped up investment increases their supply, and also a decline in the physical amount of additional product produced per successive equal increment of additional investment. Thus, for example, each additional $10 billion of investment in the economic system might be imagined to result in increments of product that would sell for less and less because of increases in the supply of products and that would also bring in less and less because the physical size of the increases was smaller and smaller. Thus the first $10 billion of additional investment might be imagined to result in 1 million units of additional product that would sell at a price of $100 each. The second $10 billion, however, would supposedly result only in an additional 900 thousand units of product, which would sell at a price of, say, $95 each. By the same token, the third $10 billion of additional investment might result in only 800 thousand units of additional product that would sell for $90 per unit, and so on. Clearly, the extra revenue accompanying equal extra increments of investment would fall under these conditions. And since that extra revenue is the source of the profit on the investment, it seems to follow that the rate of profit would decline as investment increased.
In addition, of course, Keynes refers to a rising “supply price” for the various types of capital goods as their production expands in response to the additional demand constituted by additional investment. Thus, in his view, the rate of profit declines as investment increases because more investment both raises the prices of capital goods and at the same time operates to reduce their yields in terms of revenue.
Keynes’s Bait and Switch
When Keynes’s explanation of the falling “marginal efficiency of capital,” just quoted, is taken in conjunction with his previously quoted explanation of why a fall in wage rates allegedly cannot succeed in overcoming unemployment, it turns out that what is present is something similar to the technique of a dishonest salesmen who begins by appearing to offer something that is very different from what he actually ends up offering, i.e., the technique known as “bait and switch.”
When Keynes tries to explain the alleged impossibility of full employment being achieved by virtue of a fall in wage rates, he is clearly talking about the alleged impossibility of a fall in wage rates achieving full employment. But when all is said and done, what this alleged impossibility turns out to rest upon is not at all consistent with a fall in wage rates. To the contrary, in the last analysis Keynes’s argument against the ability of a fall in wage rates to achieve full employment depends on the absence of a fall in wage rates, indeed, on their rise.
The fall in the “marginal efficiency of capital”/rate of profit that supposedly results from investment having to be pushed beyond its worthwhile limit in order to offset all of the saving taking place out of the level of income resulting from full employment, and which allegedly prevents full employment from being achieved more than very temporarily—that fall turns out to depend on wage rates not falling, indeed, rising.
Consider. Why should a fall in the selling prices of products serve to reduce profitability if that fall has been preceded by a fall in wage rates and in the prices of existing capital goods, i.e., in the costs of production, which is the situation under discussion? It would be reasonable to argue that a fall in selling prices serves to reduce profits if it were not preceded by a fall in wage rates and the prices of existing capital goods, but not when it is so preceded. What Keynes has done here is to substitute the effects of a fall in selling prices on the rate of profit in the absence of a preceding fall in wage rates and the prices of existing capital goods for its alleged effect in the presence of such a preceding fall.
The same point applies even more strongly to the alleged decline in yields based on declines in physical increments of product accompanying additional increments of investment. Here Keynes and his followers take for granted the supply of labor and consider the effects on output merely of successive equal increments of investment. But this too is a total contradiction of the situation under discussion.
That situation, recall, is whether or not the re-employment of masses of previously unemployed workers can be maintained following a fall in wage rates and the prices of existing capital goods. Keynes and his followers say no, in part because of alleged diminishing physical returns to additional increments of capital investment. Here they ignore the fact that the situation under discussion implies an increase in the supply of labor employed far in excess of any secondary, derivative increase in the supply of capital goods that might come about as the result of additional saving taking place as the by-product of full employment.
Going from a state of mass unemployment to full employment implies a correspondingly large reduction in the ratio of accumulated capital to labor. The supply of existing capital goods is what it is. But going from, say, an unemployment rate of 25 percent, such as existed in the depths of the Great Depression of the 1930s, to full employment, implies in increase in the supply of labor employed in the ratio of 4:3. This, in turn, implies a fall in the ratio of capital to labor to ¾ of its previous level. Thus, if in the state of mass unemployment there were 12 units of capital in existence for every 3 workers employed, giving a ratio of capital to labor of 4:1, now, with the employment of 4 workers for every 3 previously employed, the ratio of capital to labor falls to 3:1. With capital now less abundant relative to labor, i.e., scarcer relative to labor, successive equal increments of investment should have substantially higher physical yields than they did in the state of mass unemployment. Thus, if it were the case that physical increments of output accompanying increments of investment had a connection with the rate of profit, the rate of profit would have to be expected to rise as the accompaniment of the economic system going from a state of mass unemployment to full employment.
Even if at some point, after many years of full employment and accompanying additional saving, the ratio of capital to labor ultimately came to surpass what it had been in the period of mass unemployment, it would still be far less than it would be in the face of fresh mass unemployment. Always, the employment of more labor serves to reduce the ratio of capital to labor and to have a correspondingly positive effect on physical yields to capital, all other things being equal.
The third alleged reason for the rate of profit falling as employment increases turns out to be no less bizarre and contradictory. This is Keynes’s claim that pressure on the facilities for producing capital “will cause its supply price to increase.” Since when do the prices of capital goods rise on a foundation of falling wage rates and costs of production? They would rise in a situation of rising wage rates and costs of production, but not falling wage rates and costs of production. This is just another aspect of the switch Keynes has pulled off.
Further Problems with Keynesianism
The Keynesian argument is actually absurd on its face. If one looks at its so-called IS curve, one sees a relationship purporting to show that as output and, implicitly, employment increase along the horizontal axis, the “marginal efficiency of capital”/rate of profit falls on the vertical axis. The economic system is allegedly locked into a state of permanent mass unemployment because the rate of return is already as low as it is possible for it to go consistent with investment being worthwhile, while full employment would result in an even lower rate of return. What this means is that the economic system cannot achieve full employment and recovery, because if it did, the rate of profit would be lower in the recovery than it is in the depths of the depression.
There is another problem. A leading doctrine of the Keynesians is the “investment multiplier.” According to this doctrine, every additional dollar of investment results in an induced rise in consumption spending and thus in substantially more than a dollar of additional spending overall, perhaps $2 or $3. This additional spending is held to be synonymous with additional national income. While national income is composed essentially of profits and wages, the Keynesians seem to overlook the fact that additional national income implies additional profits. If profits were just 10 percent of national income, and the multiplier were just 2, every additional dollar of investment would imply 20 cents of additional profits in the economic system. What this in turn implies is that the rate of profit in the economic system must be rising in the direction of 20 percent, i.e., that more investment has a powerful positive effect on the rate of profit.
In a Recovery, Investment and Profits Move Together
The Keynesian claim is that the additional investment that accompanies additional employment reduces the rate of profit. The strongest argument against this claim is the fact that in the context of a business cycle, investment and profits move together, virtually dollar for dollar. Profit in the economic system is the totality of business sales revenues minus the totality of the costs deducted from those sales revenues. Net investment is the totality of business productive expenditure, i.e., wage payments plus purchases of newly produced capital goods, minus the very same costs that are deducted from sales revenues in arriving at profits. Since productive expenditure is the source of the great bulk of the sales revenues of the economic system, the only difference between net investment and profits in the economic system is the extent to which sales revenues exceed productive expenditure.
The reason that net investment equals productive expenditure minus costs is that productive expenditure represents additions to the value of accumulated assets, while costs represent subtractions from the value of accumulated assets. For example, productive expenditures on account of inventory are added to the value of inventory accounts on the balance sheets of the firms making the expenditures. Productive expenditures on account of plant and equipment are added to the gross plant accounts on the balance sheets of the firms making the expenditures. In these ways, productive expenditures increase the value of accumulated assets on the books of business firms.
By the same token, when firms make sales out of inventory, the value of inventory accounts is reduced by the cost value of the goods sold, which cost value enters into the income statements of firms, under the heading “cost of goods sold.” Similarly, as time passes, plant and equipment undergo depreciation. Depreciation allowances are accumulated in depreciation reserves, which are subtracted from the gross plant accounts, leaving net plant accounts. The same amount of depreciation that is deducted from gross plant and thereby reduces net plant, enters into the income statements of firms as depreciation cost.
If “cost of goods sold,” is subtracted from productive expenditure for inventory, the difference is the net change, i.e., the net investment, in inventory. If depreciation cost is subtracted from productive expenditure on account of plant and equipment, the difference is the net change, i.e., the net investment, in net plant and equipment.
There is a third major component of productive expenditure and costs, namely, productive expenditures that are not additions to any asset account and which are thus costs deducted from sales revenues in the very instant in which they are made; selling, general, and administrative expenses are can be taken as examples. When productive expenditures that constitute selling, general, or administrative expenses are added to the productive expenditures on account of inventory and plant, the result is total productive expenditure. When these productive expenditures are added as costs to cost of goods sold and depreciation cost, the result is the total costs deducted from sales revenues in calculating profits. Since this is a matter of equals being added to unequals, the amount of net investment equals the totality of productive expenditure minus the totality of business costs.
In the context of recovery from a depression, a rise in productive expenditure should be expected to constitute a virtually equivalent rise in business sales revenues. If costs in the economic system remained the same, profits and net investment would obviously rise to exactly the same extent. The additional productive expenditure in its capacity as the source of additional sales revenues would raise profits equivalently. In its capacity simply as additional productive expenditure, it would raise net investment equivalently. Thus the rise in profits and the rise in net investment would be equal.
Insofar as total business costs might increase at the same time that productive expenditure and sales revenue rose, the rise both in net investment and profits would be equivalently diminished. In any event profits and net investment would increase together, dollar for dollar. The implication of this is that the economy-wide average rate of profit rises in the direction of 100 percent. This is the ratio found by dividing equal additions to profits and to capital invested. Capital invested rises to the exact same extent as net investment and additional net investment.
In the same way, as was shown very early in this article, if costs in the economic system could be made to fall, say, by virtue of productive expenditure being shifted from wage payments to purchases of durable capital goods, profits and net investment would both rise equally.
The upshot is that to the extent that additional net investment accompanies the additional employment made possible by a fall in wage rates, the rate of profit increases, and increases the more, the greater is the increase in net investment. Keynes and his followers simply could not be more wrong about this subject.
In a Depression, Saving and Net Investment Are Negative
Closely related to the above, is another major error. This is the belief of Keynes and his followers that in the depths of depression and its accompanying mass unemployment, saving and investment are at their maximum tolerable limits. Allegedly, they are already as great as it is possible for them to be consistent with the rate of return on capital still being high enough to make investment worthwhile. The problem, say the Keynesians, is that full employment would result in still more saving, which would require still more investment to offset it, and which in turn would drive the already barely acceptable rate of return still lower, below the minimum acceptable rate.
Contrary to Keynes and his followers, the truth is that so far removed are saving and investment from being at their maximum tolerable limits in the conditions of depression and mass unemployment, that in reality they are both negative. For example, in the Great Depression of the 1930s, corporate saving (undistributed corporate profits) was negative in every year from 1930 to 1936 and again in 1938; personal saving was negative in 1932 and 1933 and barely more than zero in 1934; net investment was negative in the years 1931 to 1935 and again in 1938.
There should be nothing surprising in this. In a depression, business firms suffer widespread losses. What they are losing is a portion of their accumulated savings. Even many firms that manage to earn profits consume accumulated savings in a depression. This is the case to the extent that their profits are insufficient to cover the dividends they pay. Similarly, unemployed wage earners deplete their previously accumulated savings in consuming without the benefit of wages to provide the necessary funds.
Net investment becomes negative as the result of the exact same process that wipes out profits, namely, a sharp decline in productive expenditure, which results from the need to rebuild cash holdings in the aftermath of the end of the credit expansion of the preceding boom. The decline in productive expenditure wipes out profits insofar as it serves to reduce business sales revenues in the face of depreciation costs and costs of goods sold that reflect the higher levels of productive expenditure of the past. The decline in productive expenditure in the face of those same depreciation costs and costs of goods sold equivalently reduces net investment.
As explained previously, the demand for money for cash holding is also increased by a failure of wage rates to fall. And the decline in productive expenditure becomes greater still insofar as banks fail and the quantity of money is reduced. The effect is to further reduce productive expenditure, sales revenues, profits, and net investment.
In the light of such knowledge, it is difficult to imagine a theory that is more at odds with economic principles and obvious facts of reality than Keynesianism.
The essential conclusions to be drawn from this lengthy analysis is that once the process of financial contraction in a depression comes to an end, and existing business assets have been re-priced to reflect the deflationary aftermath of credit expansion—once this has occurred, a fall in wage rates will in fact serve to achieve the reemployment of the unemployed. Moreover, it will do so in a such way that the increase in employment is more than proportionate to the fall in wage rates. At the same time, as part of the same process, the decrease in the demand for money for cash holding that occurs in response to the necessary fall in wage rates, manifests itself in a rise in productive expenditure not only for labor but also for capital goods. As the result of the rise in productive expenditure, sales revenues, profits, and net investment in the economic system all rise together.
The fall in wage rates thus serves as an essential component of a full and complete economic recovery, one that entails full employment and the achievement of a substantially increased rate of profit that will be more than sufficient to make investment worthwhile.
The economic policy that is implied by these findings of economic theory is one of a fully free labor market. That is, a labor market free of coercive labor-union interference, free of minimum-wage laws, and free of all other laws that mandate expenditures by employers on behalf of the workers they employ. All legal obstacles in the way of wage rates falling, counting as part of wages the cost of so-called fringe benefits, must be swept aside. This is the policy that will allow the cost of employing labor to fall and thus the quantity of labor demanded to increase, and will thereby achieve the employment of everyone able and willing to work, i.e., full employment.
Beyond Keynesianism: Marxism
While essential, the overthrow of Keynesianism is insufficient for being able to implement the policy of a free labor market. It is insufficient because Keynesianism constitutes merely the outer ring of the defenses of the policy of government interference in the labor market. The inner ring, which Keynesianism has served to protect up to now, is the errors and contradictions of Marxism.
Marxism holds that a free market in labor is a vehicle for the exploitation of labor. It claims that in the absence of government intervention in the form of pro-union and minimum-wage and maximum-hours legislation, employers would be free to drive wage rates to or even below the level of minimum subsistence, while lengthening the hours of work beyond the limits of human endurance, and imposing conditions of work that are nightmarish.
Because of Keynesianism, the immense majority of economists have been able to avoid having to confront Marxism. They have been able to hide behind the Keynesian doctrine that even if a free market in labor existed, it would not be able to eliminate mass unemployment. And thus they have been able to believe that there is simply no point in fighting for a free market in labor.
Being able to believe this, I’m convinced, has been a source of great comfort and relief for most economists and thus a major source of their readiness to accept Keynesianism despite the obviously absurd nature of some of its claims, such as that “Pyramid-building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.” (General Theory, p. 129.) Keynesianism has spared them from having to do battle with practically the entire rest of the intellectual world, which has accepted Marxism as constituting a full and accurate description of what happens under laissez-faire capitalism.
In the absence of Keynesianism, economists who understood such elementary propositions as that quantity demanded rises as price falls would be obliged to argue for the repeal of pro-union and minimum-wage legislation. They would perceive such interferences as causing and perpetuating mass unemployment. But to do this, they themselves would have to understand why laissez-faire capitalism does not in fact result in any exploitation of labor and how, indeed, it is the foundation of progressively rising real wages, shortening of hours, and improvement in working conditions.
The immense majority of today’s economists, and those of the past several generations, have lacked both this essential knowledge and any will, or even mere willingness, to acquire it. They lack the will because they have no philosophical commitment to the value of individual rights and individual freedom and thus no basis for being prepared to challenge claims that these must be sacrificed for the sake of avoiding poverty. They are light years from understanding that it is precisely respect for individual rights and individual freedom that is the essential foundation of prosperity, including, as leading examples, full employment and high and progressively rising real wages.
Keynesianism has been a refuge for masses of economists badly deficient in understanding of economics and equally lacking in essential aspects of moral character, namely, lacking in abhorrence of the use of physical force for any purpose but that of self-defense, and lacking in an equal abhorrence of blatant irrationalism, such as manifested in Keynes’s claims about the economic value of wars and earthquakes. Content with the unchecked growing use of physical force by government in all aspect of the life of the individual, and often taking delight in the ability to confuse the minds of students by convincing them that the absurd is true, they are completely at home in Keynesianism.
Hopefully, the overthrow of Keynesianism will set the stage for the appearance of a body of intellectuals with a far better understanding of economics than that of today’s economists, an understanding which they will join to a philosophical commitment to the values of Freedom and Reason. Thus armed, there will be a group of intellectuals able to take on the rest of the intellectual world and start to overcome the ideas that have made today’s colleges and universities more into centers of civilization-destroying intellectual disease than centers of knowledge and education.
 In this article “profit” is to be understood as inclusive of any interest paid on borrowed capital, and the rate of profit as reflecting the division of the sum of profits plus interest by the totality of the capital invested, i.e., as the rate of return on capital.
Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen. The book provides a deeper and more comprehensive treatment of all aspects of the material discussed in this article. See in particular Chapters 13, 15, and 18.