George Reisman's Blog on Economics, Politics, Society, and Culture

New York Times Runs Pro-Capitalist Article

2011-12-23T21:06:00.000-08:00

I never thought I would live to see it, but The New York Times has run an article that puts capitalism in an extremely favorable light. The article is titled "Scaling Caste Walls With Capitalism's Ladders."It appeared on the front page of this last Thursday's (December 22, 2011) National Edition. It was written by Lydia Polgreen. (The Times' has retitled the article on the internet. There, when one does a search under the author's name, it appears as "India's Boom Creates Openings for Untouchables." A tribute to capitalism was evidently news that at least some at the Times thought simply didn't comply with its slogan "All the news that's fit to print," and so they tried to bury it.)

In any case, the article features the story of a now very wealthy and highly productive Indian businessman who was born in extreme poverty, as a member of the caste of the "Untouchables." It stresses the role of capitalism in making possible his success.

I can only hope that the author will be able to keep her job after this article.

A Romanian Translation

Mr. Alexander Orsov has translated the home page of http://www.capitalism.net/ into the Romanian language. Thank you, Mr. Orsov.

Free Speech and Occupy Wall Street

2011-12-15T20:01:00.000-08:00

The Occupy Wall Street protesters were allowed to remain in New York’s Zucotti Park for two months, against the will of its private owners. They were clearly trespassers, indeed, much worse than garden variety trespassers, who almost always quickly leave. They were there prepared to stay indefinitely. In effect, they were literally attempting to steal the park from its lawful owners.

Nevertheless, they were allowed to remain, in the belief that to eject them would somehow constitute a violation of their freedom of speech. They had seized the park in order to denounce capitalism. Ejecting them, would have ended their use of the park for that purpose and thus, according to virtually everyone with a public voice, from New York’s Mayor to the lowliest media reporter, would have violated their freedom of speech.

A major lesson to be learned from the occupation is that hardly anyone nowadays understands the meaning of freedom of speech. Contrary to the prevailing view, freedom of speech is not the ability to say anything, anywhere, at any time. Actual freedom of speech is consistent with respect for property rights. It presupposes that the speaker has the consent of the owners of any property he uses in speaking, such as the land, sound system, or lecture hall or radio or television studio that he uses.

Had the owners of Zucotti Park invited the protesters to camp on their land and propound their ideas, and then the police had ejected them, the protesters’ freedom of speech would in fact have been violated. But that was not the case. The only actual violation of freedom present was the protesters’ violation of the freedom of the owners of Zucotti park to use their property for their own purposes. The protesters did not violate specifically the freedom of speech of the owners, but they certainly did violate their freedom in general with respect to the use of Zucotti Park. Had the owners wanted to invite some other person or group for the purpose of speaking, then the protesters would have violated the freedom of speech specifically, by means of their presence and their activities.

Nevertheless, by the logic of the prevailing view of freedom of speech, protesters in the future will be able to storm into lecture halls and/or seize radio and television stations in order to deliver their message and then claim that their freedom of speech is violated when the police come to eject them, even though the police in such cases would in fact be acting precisely in order to uphold the freedom of speech. Indeed, since the days of the so-called Free Speech Movement at Berkeley, back in the 1960s, disruptions of speeches delivered by invited guests have occurred repeatedly on college campuses, in the name of the alleged freedom of speech of the disrupters. No attention has been paid to the actual violation of the freedom of speech of the invited speakers.

The prevailing view of freedom of speech is a major threat to freedom of speech. Not only does it provide justification for actual violations of freedom of speech of the kinds just mentioned, but it also makes freedom of speech appear to be a fundamental enemy of rational communication. Speakers cannot address audiences, professors cannot lecture to students if disrupters are permitted to drown them out and then hide behind the claim that they do so in the name of freedom of speech. If the prevailing view of freedom of speech were correct, the ability of speakers to speak and professors to lecture would require accepting the principle of the need to violate freedom of speech.

Of course, the prevailing view is totally incorrect. Actual freedom of speech, based on respect for property owners’ rights to use their own property as they see fit, is the guarantor of rational communication. If the property rights of the owners of parks, lecture halls, and radio and television stations are respected, the disrupters will be ejected and very soon will no longer even bother to appear. Rational communication will then proceed without incident.

Upholding freedom of speech and rational communication requires a policy of no tolerance for the occupation of property against the will of its owners. Any such occupation is in violation of the owners’ freedom, including their freedom of speech. Protester-occupiers are enemies of freedom, including, above all, freedom of speech.

Copyright © 2011 by George Reisman. George Reisman, Ph.D. is Pepperdine University Professor Emeritus of Economics, a Senior Fellow at the Goldwater Institute, and the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). His website is www.capitalism.net and his blog is georgereismansblog.blogspot.com.

How a Highly Productive and Provident One Percent Provides the Standard of Living of a Largely Ignorant and Ungrateful Ninety-Nine Percent

2011-10-19T17:21:00.000-07:00

The protesters in the Occupy Wall Street Movement and its numerous clones elsewhere in the country and around the world chant that one percent of the population owns all the wealth and lives at the expense of the remaining ninety-nine percent. The obvious solution that they imply is for the ninety-nine percent to seize the wealth of the one percent and use it for their benefit rather than allowing it to continue to be used for the benefit of the one percent, who are allegedly undeserving greedy capitalist exploiters. In other words, the implicit program of the protesters is that of socialism and the redistribution of wealth.

Putting aside the hyperbole in the movement’s claim, it is true that a relatively small minority of people does own the far greater part of the wealth of the country. The figures “one percent” and “ninety-nine” percent, however exaggerated, serve to place that fact in the strongest possible light.

What the protesters do not realize is that the wealth of the one percent provides the standard of living of the ninety-nine percent.

The protesters have no awareness of this, because they see the world through an intellectual lens that is inappropriate to life under capitalism and its market economy. They see a world, still present in some places, and present everywhere a few centuries ago, of self-sufficient farm families, each producing for its own consumption and having no essential connection to markets.

In such a world, if one sees a farmer’s field, or his barn, or plow, or draft animals, and asks who do these means of production serve, the answer is the farmer and his family, and no one else. In such a world, apart from the receipt of occasional charity from the owners, those who are not owners of means of production cannot benefit from means of production unless and until they themselves somehow become owners of means of production. They cannot benefit from other people’s means of production except by inheriting them or by seizing them.

In the world of the protesters, means of production have the same essential status as consumers’ goods, which as a rule are of benefit only to their owners. It is because of this that those who share the mentality of the protesters typically depict capitalists as fat men, whose plates are heaped high with food, while the masses of wage earners must live near starvation. According to this mentality, the redistribution of wealth is a matter merely of taking from the overflowing plates of the capitalists and giving to the starving workers.

Contrary to such beliefs, in the modern world in which we actually live, the wealth of the capitalists is simply not in the form of consumers’ goods to any great extent. Not only is it overwhelmingly in the form of means of production but those means of production are employed in the production of goods and services that are sold in the market. Totally unlike the conditions of self-sufficient farm families, the physical beneficiaries of the capitalists’ means of production are all the members of the general consuming public who buy the capitalists’ products.

For example, without owning so much as a single share of stock in General Motors or Exxon Mobil, everyone in a capitalist economy who buys the products of these firms benefits from their means of production: the buyer of a GM automobile benefits from the GM factory that produced that automobile; the buyer of Exxon’s gasoline benefits from its oil wells, pipelines, and tanker trucks. Furthermore, everyone benefits from their means of production who buys the products of the customers of GM or Exxon, insofar as their means of production indirectly contribute to the products of their customers. For example, the patrons of grocery stores whose goods are delivered in trucks made by GM or fueled by diesel oil produced in Exxon’s refineries are beneficiaries of the existence of GM’s truck factories and Exxon’s refineries. Even everyone who buys the products of the competitors of GM and Exxon, or of the customers of those competitors, benefits from the existence of GM’s and Exxon’s means of production. This is because GM’s and Exxon’s means of production result in a more abundant and thus lower-priced supply of the kind of goods the competitors sell.

In other words, all of us, one hundred percent of us, benefit from the wealth of the hated capitalists. We benefit without ourselves being capitalists, or being capitalists to any great extent. The protesters are literally kept alive on the foundation of the wealth of the capitalists they hate. As just indicated, the oil fields and pipelines of the hated Exxon corporation provide the fuel that powers the tractors and trucks that are essential to the production and delivery of the food the protesters eat. The protesters and all other haters of capitalists hate the foundations of their own existence.

The benefit of the capitalists’ means of production to non-owners of means of production extends not only to the buyers of the products of those means of production but also to the sellers of the labor that is employed to work with those means of production. The wealth of the capitalists, in other words, is the source both of the supply of products that non-owners of the means of production buy and of the demand for the labor that non-owners of the means of production sell. It follows that the larger the number and greater the wealth of the capitalists, the greater is both the supply of products and the demand for labor, and thus the lower are prices and the higher are wages, i.e., the higher is the standard of living of everyone. Nothing is more to the self-interest of the average person than to live in a society that is filled with multi-billionaire capitalists and their corporations, all busy using their vast wealth to produce the products he buys and to compete for the labor he sells.

Nevertheless, the world the protesters yearn for is a world from which the billionaire capitalists and their corporations have been banished, replaced by small, poor producers, who would not be significantly richer than they themselves are, which is to say, impoverished. They expect that in a world of such producers, producers who lack the capital required to produce very much of anything, let alone carry on the mass production of the technologically advanced products of modern capitalism, they will somehow be economically better off than they are now. Obviously, the protesters could not be more deluded.

In addition to not realizing that the wealth of the so-called one percent is the foundation of the standard of living of the so-called ninety-nine percent, what the protesters also do not realize is that the “greed” of those who seek to become part of the one percent, or to enlarge their position within it, is what serves progressively to improve the standard of living of the ninety-nine percent.

Of course, this does not apply to wealth which has been acquired by such means as obtaining government subsidies or preventing competition through protective tariffs and other forms of government intervention. These are methods which are made possible to the extent that the government is permitted to depart from a policy of strict laissez-faire and thereby arbitrarily reward or punish firms.

Apart from such aberrations, the way that business fortunes are accumulated is by means of the high profits generated by the introduction of new and improved products and more efficient, lower-cost methods of production, followed by the heavy saving and reinvestment of those high profits.

For example, the $6 billion fortune of the late Steve Jobs was built on a foundation of Mr. Jobs having made it possible for Apple Computer to introduce such new and improved products as the iPod, the iPhone, and the iPad, and then heavily saving and reinvesting the share of the profits that came to him.

Two closely related points need to be stressed. First, the fortunes that are accumulated in this way generally serve in the larger-scale production of the very sort of products that provided the profits out of which their accumulation took place. Thus, for example, Jobs’ billions serve largely in the production of Apple’s products. Similarly, old Henry Ford’s great personal fortune, earned on the foundation of introducing major improvements in the efficiency of automobile production, which brought down the price of a new automobile from about $10,000 at the beginning of the 20th Century to $300 in the mid 1920s, was used to make possible the production of millions of Ford automobiles.

Second, the high rates of profit earned on new and improved products and methods of production are temporary. As soon as the production of the new product or use of the new method of production becomes the norm in an industry, it no longer provides any exceptional profitability. Indeed, further improvements again and again render earlier improvements downright unprofitable. For example, the first generation of the iPhone, which was highly profitable just a few years ago, is or soon will be unprofitable, because further advances have rendered it obsolete.

As a result, the accumulation of great business fortunes generally requires the introduction of a series of improvements in products or methods of production. This is what is required to maintain a high rate of profit in the face of competition. For example, Intel’s ability to maintain its high rate of profit over the years has depended on its ability to introduce one substantial improvement in its computer chips after another. The net effect has been that computer users have gotten the benefit of improvement after improvement not only at no rise but a drastic decline in the prices of computer chips. Insofar as high profits rest on low costs of production, competition drives prices down to correspond to the lower level of costs, which necessitates the achievement of still further cost reductions to maintain high profits.

The same outcome, of course, applies not only to Intel and microprocessors but also to the rest of the computer industry, where gigabytes of memory and terabytes of hard drive data storage now sell at prices below the prices of megabytes of memory and hard drive data storage just a couple of decades ago. Indeed, if one knows how to look, the principle of ever more and better products for less and less applies throughout the economic system. It is present in the production of food, clothing, and shelter as well as in the high tech industries, and in virtually all industries in between.

It is present in these industries even though the government’s inflation of the money supply has caused the prices of their products to rise sharply over the years. Despite this, when calculated in terms of the amount of labor the average person must expend in order to earn the wages needed to enable him to buy these products, their prices have sharply fallen.

This can be seen in the fact that today, the average worker works 40 hours per week, while a worker of a century or so ago worked 60 hours a week. For the 40 hours he works, the average worker of today receives the goods and services comprising the average standard of living of 2011, which includes such things as an automobile, refrigerator, air conditioner, central heating, more and better living space, more and better food and clothing, modern medicine and dentistry, motion pictures, a computer, cell phone, television set, washer/dryer, microwave oven, and so on. The average worker of 1911 either did not have these things at all or had much less of them and of poorer quality.

If we describe the goods and services received by the average worker of today for his 40 hours of labor as being 10 times as great as those received by the average worker of 1911 for his 60 hours of labor, then it follows that expressed in terms of the amount of labor that needs to be performed today in order to be able to buy goods and services equivalent to the standard of living of 1911, prices have fallen to two-thirds of one-tenth of their level in 1911, i.e., to one-fifteenth of their level in 1911, which is to say, by 93 1/3 percent.

Capitalism—laissez-faire capitalism—is the ideal economic system. It is the embodiment of individual freedom and the pursuit of material self-interest. Its result is the progressive rise in the material well-being of all, manifested in lengthening life spans and ever improving standards of living.

The economic stagnation and decline, the problems of mass unemployment and growing poverty experienced in the United States in recent years, are the result of violations of individual freedom and the pursuit of material self-interest. The government has enmeshed the economic system in a growing web of paralyzing rules and regulations that prohibit the production of goods and services that people want, while compelling the production of goods and services they don’t want, and making the production of virtually everything more and more expensive than it needs to be. For example, prohibitions on the production of atomic power, oil, coal, and natural gas, make the cost of energy higher and in the face of less energy available for use in production, require the performance of more human labor to produce any given quantity of goods. This results in fewer goods being available to remunerate the performance of any given quantity of labor.

Uncontrolled government spending and its accompanying budget deficits and borrowing, along with the income, estate, and capital gains taxes, all levied on funds that otherwise would have been heavily saved and invested, drain capital from the economic system. They thus serve to prevent the increase in both the supply of goods and the demand for labor that more capital in the hands of business would have made possible. They have now gone far enough to have begun actually to reduce the supply of capital in the economic system in comparison with the past.

Capital accumulation is also impaired and can ultimately be turned into capital decumulation, through the effects of additional government regulation in raising the costs of production and thus reducing its efficiency. This applies to practically all of the regulations imposed by the Environmental Protection Agency, the Occupational Safety and Health Administration, the Consumer Product Safety Commission, the National Labor Relations Board, the Food and Drug Administration, and the various other government agencies. The effect of their regulations is that for any given amount of labor performed in the economic system, there is less product than would otherwise be produced.

Now anything that serves to reduce the ability to produce in general, serves also to reduce the ability to produce capital goods in particular. Because of such government interference, any given amount of labor and capital goods devoted to the production of capital goods results in a smaller output of capital goods, just as any given quantity of labor and capital goods devoted to the production of consumers’ goods results in a smaller output of consumers’ goods. At a minimum, the reduced supply of capital goods produced serves to reduce the rate of economic progress. A reduction in the supply of capital goods produced great enough to prevent the addition of any increment to the previously existing supply of capital goods, and thus to put an end to capital accumulation, brings economic progress to a complete halt. A still greater reduction, one that renders the supply of capital goods produced less than the supply being used up in production, constitutes capital decumulation and thus a decline in the economic system’s ability to produce. As indicated, the United States already appears to be at this point.

The problem of capital decumulation has been greatly compounded as the result of massive credit expansion induced by the Federal Reserve System and its policy of easy money and artificially low interest rates. This policy led first to a great stock market bubble and then a vast housing bubble, as large quantities of newly created money poured into the stock market and later the housing market. Between these two bubbles, trillions of dollars of capital were lost. In both instances, vast overconsumption occurred as people raced to buy such things as new automobiles, major appliances, vacations, and all kinds of luxury goods that they would not have believed they could afford in the absence of the effects of credit expansion, often incurring substantial debt in the process.

In the one case, it was the artificial rise in stock prices that misled people into believing that they could afford these things. In the other, it was the artificial rise in home prices that produced this result. The seeming wealth vanished with the fall in stock prices and then again, later, with the fall in housing prices. In the housing bubble, moreover, millions of homes were constructed for people who could not afford to pay for them. All of this represented a huge loss of capital and thus of the ability of business to produce and to employ labor. It is this loss of capital that is responsible for our present problem of mass unemployment.

Despite this loss of capital, unemployment could be eliminated. But given the loss of capital, what would be required to accomplish this is a fall in wage rates. This fall, however, is made virtually illegal as the result of the existence of minimum-wage laws and pro-union legislation. These laws prevent employers from offering the lower wage rates at which the unemployed would be reemployed.

Thus, however ironic it may be, it turns out that virtually all of the problems the Occupy Wall Street protesters complain about are the result of the enactment of policies that they support and in which they fervently believe. It is their mentality, the Marxism that permeates it, and the government policies that are the result, that are responsible for what they complain about. The protesters are, in effect, in the position of being unwitting flagellants. They are beating themselves left and right and as balm for their wounds they demand more whips and chains. They do not see this, because they have not learned to make the connection that in violating the freedom of businessmen and capitalists and seizing and consuming their wealth, i.e., using weapons of pain and suffering against this small hated group, they are destroying the basis of their own well being.

However much the protesters might deserve to suffer as the result of the injury caused by the enactment of their very own ideas, it would be far better, if they woke up to the modern world and came to understand the actual nature of capitalism, and then directed their ire at the targets that deserve it. In that case, they might make some real contribution to economic well being, including their own.

Copyright © 2011 by George Reisman. Permission is hereby given to reproduce this article via electronic transmission, including republication on other websites.
George Reisman, Ph.D. is Pepperdine University Professor Emeritus of Economics, a Senior Fellow at the Goldwater Institute, and the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). His website is http://www.capitalism.net/ and his blog is georgereismansblog.blogspot.com. Note: since its orginal publication on this blog, this article has also appeared under the title “In Praise of the Capitalist 1 Percent.”

Further Note: Please disregard all links to the web site "Fun With Gravity." They are unwelcome, but I am presently unable to get rid of them.

James Madison was Right About Property Rights—by Gen LaGreca & Marsha Enright

2011-09-22T11:59:00.000-07:00

Constitution Day on September 17 celebrates the 1787 signing of the document that established the United States of America. But like the victim of a terrible accident, the government that was formed that historic day in Philadelphia is hardly recognizable today, and the heart that propelled it—the principle of individual rights—is on life support.

Ironically, what started as a government of radically limited powers now mandates that the nation’s schools “hold an educational program on the United States Constitution” on the holiday of its signing.

In fact, the best “educational program” comes from James Madison, the man who scoured political thought and history to create the blueprint for our government, earning him the title Father of the Constitution. He has a crucial lesson for us on property rights.

To prepare for his lesson, let’s contrast today’s treatment of our First Amendment rights with that of property rights.

People would be shocked if the President of the United States said: “I do think at a certain point you’ve made enough speeches,” or “you’ve given enough sermons,” or “you’ve authored enough books.” Virtually all Americans would protest such remarks and boldly assert that it’s a free country, so they can say, preach, or write whatever they please.

Yet the president can get away with saying: “I do think at a certain point, you’ve made enough money.” And he can get away with seizing and redistributing our money in order to “spread the wealth around,” with only a minority shouting in disbelief at the outrage. These dissenting voices have been unable to stop a century-long growth of the welfare state.

Consider the onslaught against property in recent years: The city of New London, Connecticut can seize Susette Kelo’s house and land to sell to a shopping mall developer. Congress appropriates billions of our dollars and redistributes them to the companies of its choice, including failing banks, auto manufacturers, and solar panels producers. And businesspersons like Warren Buffet blithely suggest that the wealthy be taxed more.

Are these attacks on our possessions accepted because the right to property is a lesser right, one that isn’t unalienable like the others?

In his article Property, Madison emphatically says no. He explains that our right to property is as untouchable as our freedom of speech, press, religion, and conscience. In fact, he views the concept of property as fundamental, pertaining to much more than merely our material possessions.

In the narrow sense, Madison says, “a man’s land, or merchandize, or money is called his property.” But in a wider sense, “a man has a property in his opinions and the free communication of them . . . in his religious beliefs . . . in the safety and liberty of his person . . . in the free use of his faculties and free choice of the objects on which to employ them.”

He then concludes: “[A]s a man is said to have a right to his property, he may be equally said to have a property in his rights.”

This statement represents a profound expression of the individual’s sovereignty over his possessions of every kind: spiritual, intellectual, and material. According to Madison, a human being is master of his mind and body, his beliefs and possessions, his person and property. It is all the province of the individual to create and control.

Madison argues that there is no parceling of rights. Our rights to life, liberty, and property are indivisible. The reason for this was explained with unusual clarity by Ayn Rand two centuries later: “The right to life is the source of all rights—and the right to property is their only implementation. Without property rights, no other rights are possible. Since man has to sustain his life by his own effort, the man who has no right to the product of his effort has no means to sustain his life.”

Government, according to Madison, is “instituted to protect property of every sort,” and is judged solely by this yardstick: “If the United States mean to obtain or deserve the full praise due to wise and just governments, they will equally respect the rights of property, and the property in rights.”

But what does our current government do? Instead of respecting our material property at least as well as it does our other rights, its redistribution of wealth, strangling regulations on business, and deeply ingrained entitlement mentality are blatant assaults on our right to property. As Ronald Reagan famously remarked: “Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”

It’s as if Madison looked into the future as he observed: “When an excess of power prevails, property of no sort is duly respected.” That is precisely our current situation.

Today, the huge onslaught of regulations such as Dodd-Frank, Obamacare, and the EPA’s controls on energy production has brought us almost to the point of economic paralysis. Buying and selling homes, as well as autos, has all but halted. Companies are hoarding cash and not hiring as they fearfully watch the latest attempts by government to control them. The stock market is epileptic, with seizures up and down triggered by the latest political and economic news. With these curtailments on our right to acquire, use, and control our property in the economic realm, the very essence of our liberty—the right to free action—is lost.

And government’s violation of property rights isn’t limited to the economic realm. Because our rights are interconnected, it’s spreading to all aspects of life.

Consider the trial balloons we’ve already seen to limit free speech, such as the so-called “Fairness Doctrine” or “Net Neutrality.” Or consider the expanding government grip over deeply personal areas of our lives, such as regulations on what fats or sugars we eat, what physicians we see, what health insurance we buy, what treatments or drugs we’re allowed to have—and what our children may bring to school for lunch.

Because our rights can’t be divided, if we lose one, we could lose them all. That’s why we have to fight against government intrusion in the free market with the same moral certitude—and the same fire-in-the-belly—that we’d have if the government invaded our homes without a warrant, or forbade us to peacefully assemble. We have to treat the government’s encroachment on the economy as we would an encroachment on our opinions, beliefs, and conscience.

On Constitution Day, as well as on every other day, let’s remember Madison’s lesson on the full meaning of property—and fight for our right to property as if our life depended on it, because it does.

Gen LaGreca is author of Noble Vision, an award-winning novel about the struggle for liberty in healthcare today. Marsha Familaro Enright is president of the Reason, Individualism, Freedom Institute, the Foundation for the College of the United States.

All quotes from James Madison are taken from his essay Property, published March 29, 1792 in the National Gazette.

Copyright © 2011 by Gen LaGreca and Marsha Enright. Permission to reproduce is granted with copyright notice and author attribution.

Professor Brian Simpson of National University has asked me to make the following announcement:

2011-09-18T17:21:00.000-07:00

National University of La Jolla, CA has a limited number of scholarships available for three online courses that focus on free-market economics and the philosophical foundations of capitalism. These scholarships are being funded by a grant from the Charles G. Koch Charitable Foundation. The scholarships cover the full tuition for the courses plus the application fee to NU. Two courses (ECO 401 and 402, Market Process Economics I and II, respectively) use Capitalism: A Treatise on Economics by George Reisman as the required textbook. One course (ECO 430 - Economics and Philosophy) uses Ayn Rand’s The Virtue of Selfishness and Capitalism: The Unknown Ideal as the required textbooks. These courses can be taken from anywhere in the world, as long as one has access to the internet. The courses incorporate live chat sessions in which the professor and students interact in a virtual classroom, much as they would in a traditional classroom. The courses run for the next time in the summer and fall of 2012. More information about the courses on the web can be found here, simply by clicking on the names of the courses:

ECO 401 – Market Process Economics I

ECO 402 – Market Process Economics II

ECO 430 – Economics and Philosophy

To apply for one or more of these scholarships, send your name, transcript from your high school or university, and an essay of no more than 750 words discussing why you believe you deserve a scholarship and your future education and career plans to Dr. Brian P. Simpson. Send them to bsimpson@nu.edu or 11255 North Torrey Pines Rd.; La Jolla, CA 92037. Please indicate which course or courses for which you are applying for a scholarship. You can apply for one to three scholarships, depending on how many courses you are interested in taking. Note that to receive a scholarship you will have to apply to National University and enroll in the course(s). If you have questions, please contact Dr. Simpson at the email address above or 858-642-8431.

The New York Times Urges Government Aggression Against Producers and Consumers of Automobiles

2011-06-05T20:54:00.000-07:00

In its lead editorial, titled “Sticker Shock,” The New York Times of Sunday, June 5, 2011, has the audacity to declare that “…Detroit and other manufacturers make big changes only when regulators force them to.”

The Times apparently forgets that the big changes constituted first by the introduction of the automobile, way back in 1894, and then by the countless improvements in the automobile since that time, such as the self-starter, automatic transmission, power brakes, and power steering, were made by "Detroit" without the presence of government regulators, indeed, in large part precisely because of the absence of government regulators. And that the same point applies to virtually every other “big change,” in very line of business that has taken place since the beginning of the Industrial Revolution.

Clearly, the free market, the market insofar as it is free of government regulators, has made not merely big, but absolutely enormous changes, the enormous changes that constitute the economic progress of the last 260 years or more!

The “big changes” that the Times complains of not being made unless forced by regulators are changes that do not constitute economic progress but impoverishment. The specific change referred to in its editorial is compelling the automobile industry to produce cars so small and light that they will be able to achieve 62 miles per gallon. The obvious fact is that consumers do not want such pieces of junk and because they don’t, the automobile industry does not waste time trying to produce them. The only thing that can bring about such a “big change” is the government’s use of physical force in an act of naked aggression against the consuming public and the automobile producers who profit by serving the consumers.

Wages and the Irrelevance of Worker Need and Employer Greed

2011-04-12T17:07:00.001-07:00

The Marxian doctrine of the alleged arbitrary power of employers over wages appears plausible because there are two obvious facts that it relies on, facts which do not actually support it, but which appear to support it. These facts can be described as “worker need” and “employer greed.” The average worker must work in order to live, and he must find work fairly quickly, because his savings cannot sustain him for long. And if necessary—if he had no alternative—he would be willing to work for as little as minimum physical subsistence. At the same time, self-interest makes employers, like any other buyers, prefer to pay less rather than more—to pay lower wages rather than higher wages.

People put these two facts together and conclude that if employers were free, wages would be driven down by the force of the employers’ self-interest—as though by a giant plunger pushing down in an empty cylinder—and that no resistance to the fall in wages would be encountered until the point of minimum subsistence was reached. At that point, it is held, workers would refuse to work because starvation without the strain of labor would be preferable to starvation with the strain of labor.

What must be realized is that while it is true that workers would be willing to work for minimum subsistence if necessary, and that self-interest makes employers prefer to pay less rather than more, both of these facts are irrelevant to the wages the workers actually have to accept in the labor market.

Let us start with “worker need.” To understand why a worker’s willingness to work for subsistence if necessary is irrelevant to the wages he actually has to work for, consider the analogous case of the owner of a late-model car who decides to accept a job offer, and to live, in the heart of New York City. If this car owner cannot afford several hundred dollars a month to pay the cost of keeping his car in a garage, and if he cannot devote several prime working hours every week to driving around, hunting for places to park his car on the street, he will be willing, if he can find no better offer, to give his car away for free—indeed, to pay someone to come and take it off his hands. Yet the fact that he is willing to do this is absolutely irrelevant to the price he actually must accept for his car. That price is determined on the basis of the utility and scarcity of used cars—by the demand for and supply of such cars. Indeed, so long as the number of used cars offered for sale remained the same, and the demand for used cars remained the same, it would not matter even if every seller of such a car were willing to give his car away for free, or willing even to pay to have it taken off his hands. None of them would have to accept a zero or negative price or any price that is significantly different from the price he presently can receive.

This point is illustrated in terms of the simple supply and demand diagram presented in Figure 14–1. On the vertical axis, I depict the price of used cars, designated by P. On the horizontal axis, I depict the quantity of used cars, designated by Q, that sellers are prepared to sell and the buyers to buy at any given price. The willingness of sellers to sell some definite, given quantity of used cars at any price from zero on up (or, indeed, from less than zero by the cost of having the cars taken off their hands) is depicted by a vertical line drawn through that quantity. That vertical line, labeled SS, denotes the fact that sellers are willing to sell the specific quantity A of used cars at any price from something less than zero on up to as much as they can get for their cars. The fact that they are willing to sell for zero or a negative price has nothing whatever to do with the actual price they receive, which in this case is the very positive price P1. The actual price they receive in this case is determined by the limitation of the supply of used cars, together with the demand for used cars.

In Figure 14–1, it is determined at point E, which represents the intersection of the vertical supply line with the demand curve. The price that corresponds to that juncture of supply and demand is P1. The fact that the sellers are all willing if necessary to accept a price less than P1 is, as I say, simply irrelevant to the price they actually must accept. The price the sellers receive in a case of this kind is not determined by the terms on which they are willing to sell. Rather, it is determined by the competition of the buyers for the limited supply offered for sale. (This, of course, is the kind of case Böhm-Bawerk had in mind when he declared that “price is actually limited and determined by the valuations on the part of the buyers exclusively.”1)

Essentially the same diagram, Figure 14–2, depicts the case of labor. Instead of showing price on the vertical axis, I show wages, designated by W. Instead of the supply line being vertical to the point of the sellers being willing to pay to have their good taken off their hands, I assume that no supply whatever is offered below the point of “minimum subsistence,” M. This is depicted by a horizontal line drawn from M and parallel to the horizontal axis. Thus, the supply curve in this case has a horizontal portion at “minimum subsistence” before becoming vertical. These are the only differences between Figures 14–1 and 14–2.

Figure 14–2 makes clear that the fact that the workers are willing to work for as little as minimum subsistence is no more relevant to the wages they actually have to accept than was the fact in the previous example that the sellers of used cars were willing to give them away for free or pay to have them taken off their hands. For even though the workers are willing to work for as little as minimum subsistence, the wage they actually obtain in the conditions of the market is the incomparably higher wage W1, which is shown by the intersection—once again at point E—of the demand for labor with the limited supply of labor denoted by point A on the horizontal axis. Exactly like the value of used cars, or anything else that exists in a given, limited supply, the value of labor is determined on a foundation of its utility and scarcity, by demand and supply—more specifically, by the competition of buyers for the limited supply—not by any form of cost of production, least of all by any “cost of production of labor,” i.e., “minimum subsistence.”

It also quickly becomes clear that “employer greed” is fully as irrelevant to the determination of wage rates as “worker need.” This becomes apparent as soon as one thinks in terms of the conditions of an auction. The competition of two or more bidders at an auction brings out the essential nature of the market for labor and clearly demonstrates the actual nature of the self-interest of buyers. Thus, assume that there are two people at an art auction, both of whom want the same painting. One of these people, let us call him Mr. Smith, is willing and able to bid as high as $2,000 for the painting. The other, let us call him Mr. Jones, is willing and able to go no higher than $1,000.

Of course, Mr. Smith does not want to spend $2,000 for the painting. This figure is merely the limit of how high he will go if he has to. He would much prefer to obtain the painting for only $200, or better still, for only $20, or, best of all, for nothing at all. What we must understand here is precisely how low a bid Mr. Smith’s rational self-interest allows him to persist in. Would it, for example, actually be to Mr. Smith’s self-interest to persist in a bid of only $20, or $200?

It should be obvious that the answer to this question is decidedly no! This is because if Mr. Smith persists in such a low bid, the effect will be that he loses the painting to Mr. Jones, who is willing and able to bid more than $20 and more than $200. In fact, in the conditions of this case, Mr. Smith must lose the painting to the higher bidding of Mr. Jones, if he persists in bidding any sum under $1,000! If Mr. Smith is to obtain the painting, the conditions of the case require him to bid more than $1,000, because that is the sum required to exceed the maximum potential bid of Mr. Jones.

This case contains the fundamental principle that names the actual self-interest of buyers. That principle is that a buyer rationally desires to pay not the lowest price he can imagine or would like to pay, but the lowest price that is simultaneously too high for any other potential buyer of the good, who would otherwise obtain the good in his place.

This identical principle, of course, applies to the determination of wage rates.

The only difference between the labor market and the auction of a painting is the number of units involved. Instead of one painting with two potential buyers for it, there are many millions of workers who must sell their services, together with potential employers of all those workers and of untold millions more workers. This is because just as in the example of the art auction, the essential fact that is present in the labor market is that the potential quantity demanded exceeds the supply available. The potential quantity of labor demanded always far exceeds the quantity of labor that the workers are able, let alone willing, to perform.

For labor, it should be understood, is scarce. It is the most fundamentally useful and scarce thing in the economic system: virtually everything else that is useful is its product and is limited in supply only by virtue of our lack of ability or willingness to expend more labor to produce a larger quantity of it. (This, of course, includes raw materials, which can always be produced in larger quantity by devoting more labor to the more intensive exploitation of land and mineral deposits that are already used in production, or by devoting labor to the exploitation of land and mineral deposits not presently exploited.)

At the same time, for all practical purposes there is no limit to our need and desire for goods or, therefore, for the performance of the labor required to produce them. In having, for example, a need and desire to be able to spend incomes five or ten times the incomes we presently spend, we have an implicit need and desire for the performance of five or ten times the labor we presently perform, for that is what would be required in the present state of technology and the productivity of labor to supply us with such increases in the supply of goods. Moreover, almost all of us would welcome the full-time personal services of at least several other people. Thus, on both grounds labor is scarce.

For the maximum amount of labor available to satisfy the needs and desires of the average member of the economic system can never exceed the labor of just one person. One person is the number that always results when we divide one and the same number of people in their capacity as consumers by that number of people in their capacity as potential producers. Indeed, in actual practice, the amount of labor available per person falls far short of the labor of one person, because of the existence of large numbers of people, notably young children and the elderly, who are incapable of performing labor and must live as dependents on the labor of others.

The consequence of the scarcity of labor is that wage rates in a free market can fall no lower than corresponds to the point of full employment. At that point the scarcity of labor is felt, and any further fall in wage rates would be against the self-interests of employers, because then a labor shortage would ensue. Thus, if somehow wage rates did fall below the point corresponding to full employment, it would be to the self-interest of employers to bid them back up again.

These facts can be shown in the same supply and demand diagram I used to show the irrelevance to wage determination of workers being willing to work for subsistence. Thus, Figure 14–3 shows that if wage rates were below their market equilibrium of W1, which takes place at the point of full employment, denoted by E—if, for example, they were at the lower level of W2—a labor shortage would exist. The quantity of labor demanded at the wage rate of W2 is B. But the quantity of labor available—whose employment constitutes full employment—is the smaller amount A. Thus, at the lower wage, the quantity of labor demanded exceeds the supply available by the horizontal distance AB.

The shortage exists because the lower wage of W2 enables employers to afford labor who would not have been able to afford it at the wage of W1, or it enables employers who would have been able to afford some labor at the wage of W1 to now afford a larger quantity of labor. To whatever extent such employers employ labor that they otherwise could not have employed, that much less labor remains to be employed by other employers, who are willing and able to pay the higher wage of W1.

At the artificially low wage of W2, the entire quantity AB of labor is employed by employers who otherwise could not have afforded to employ that labor. The effect of this is to leave an equivalently reduced quantity of labor available for those employers who could have afforded the market wage of W1. The labor available to those employers is reduced by AC, which is precisely equal to AB. This is the inescapable result of the existence of a given quantity of labor and some of it being taken off the market by some employers at the expense of other employers. What the one set gains, the other must lose. Thus, because the wage is W2 rather than W1, the employers who could have afforded the market wage of W1 and obtained the full quantity of labor A are now able to employ only the smaller quantity of labor C, because labor has been taken off the market by employers who depend on the artificially low wage of W2.

The employers who could have afforded the market wage of W1 are in identically the same position as the bidder at the art auction who is about to see the painting he wants go to another bidder not able or willing to pay as much. The way to think of the situation is that there are two groups of bidders for quantity AB of labor: those willing and able to pay the market wage of W1, or an even higher wage—one as high as W3—and those willing and able to pay only a wage that is below W1—a wage that must be as low as W2. In Figure 14–3, the position of these two groups is indicated by two zones on the demand curve: an upper zone HE and a lower zone EL. The wage of W1 is required for the employers in the upper zone to be able to outbid the employers in the lower zone.

The question is: Is it to the rational self-interest of the employers willing and able to pay a wage of W1, or higher, to lose the labor they want to other employers not able or willing to pay a wage as high as W1? The obvious answer is no. And the consequence is that if, somehow, the wage were to fall below W1, the self-interest of employers who are willing and able to pay W1 or more, and who stood to lose some of their workers if they did not do so, would lead them to bid wage rates back up to W1. The rational self-interest of employers, like the rational self-interest of any other buyers, does not lead them to pay the lowest wage (price) they can imagine, but the lowest wage that is simultaneously too high for other potential employers of the same labor who are not able or willing to pay as much and who would otherwise be enabled to employ that labor in their place.

The principle that it is against the self-interest of employers to allow wage rates to fall to the point of creating a labor shortage is illustrated by the conditions which prevail when the government imposes such a shortage by virtue of a policy of price and wage controls. In such conditions, employers actually conspire with the wage earners to evade the controls and to raise wage rates. They do so by such means as awarding artificial promotions, which allow them to pay higher wages within the framework of the wage controls.

The payment of higher wages in the face of a labor shortage is to the self-interest of employers because it is the necessary means of gaining and keeping the labor they want to employ. In overbidding the competition of other potential employers for labor, it attracts workers to come to work for them and it removes any incentive for their present workers to leave their employ. This is because it eliminates the artificial demand for labor by the employers who depend on a below-market wage in order to be able to afford labor. It is, as I say, identically the same in principle as the bidder who wants the painting at an auction raising his bid to prevent the loss of the painting to another bidder not able or willing to pay as much. The higher bid is to his self-interest because it knocks out the competition. In the conditions of a labor shortage, which necessarily materializes if wage rates go below the point corresponding to full employment, the payment of higher wages provides exactly the same benefit to employers.

On the basis of the preceding discussion, it should be clear that average money wage rates are determined neither by worker need nor by employer greed, but, basically, by the quantity of money in the economic system and thus the aggregate monetary demand for labor, on the one side, and by the number of workers willing and able to work, on the other—that is, by the ratio of the demand for labor to the supply of labor. It should also be clear that in a free labor market, money wage rates can fall no lower than corresponds to the point of full employment.

Two points should be realized in connection with the principle that it is against the self-interest of employers to allow wage rates to fall below the point that corresponds to full employment. First, the operation of the principle does not require that full employment be established throughout the economic system before wage rates cease to fall. On the contrary, the principle applies to each occupation and, still more narrowly, to each occupation within each geographical area. For example, the wage rates of carpenters in Des Moines can fall no further than corresponds to the point of full employment of carpenters in Des Moines. Any further fall would create a shortage of such carpenters and thus would be prevented or quickly reversed, even though there might still be major unemployment in other occupations or in other geographical areas.

Second, the operation of the principle need not be feared as possibly serving to bring about the establishment of subsistence wages through the back door, so to speak. By this, I mean that so long as unemployment exists, there is room for wage rates to fall without the creation of a labor shortage. And in a free market, wage rates would in fact fall in such circumstances. This is because in such circumstances, the self-interest of the employers, and also of the unemployed, would operate to drive them down. It should not be thought, however, that the fall in wage rates in these circumstances meant that the conditions of supply and demand were capable of accomplishing the human misery that Marxism attributes to the alleged arbitrary power of businessmen and capitalists.

A drop in wage rates to the full employment point does not imply any drop in the average worker’s standard of living. That is, it does not imply any reduction in the goods and services he can actually buy—any reduction in his so called real wages—because the elimination of unemployment that the fall in wage rates brings about means more production and a fall in costs of production, both of which mean lower prices. Indeed, it is likely that real wages actually rise with the elimination of unemployment, even in the short run, because not only do prices fall as much as, or even more than, wages, but also the burden of supporting the unemployed is eliminated, with the result that disposable, take-home pay drops less than gross wages and less than prices. When these facts are kept in mind, it is clear that insofar as market conditions require a fall in wage rates, they are, if anything, at the same time operating to raise the average worker’s standard of living further above subsistence, not drive it down toward subsistence.

Copyright © 2011 by George Reisman. This article is adapted from a section of Chapter 14, specifically pp. 613-18, of the author’s Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and Senior Fellow at the Goldwater Institute. His web site is http://www.capitalism.net/. His blog is georgereismansblog.blogspot.com. Send him mail. (A PDF replica of the complete book Capitalism: A Treatise on Economics can be downloaded to the reader's hard drive simply by clicking on the book’s title, immediately preceding, and then saving the file when it appears on the screen.)

1. See Eugen von Böhm-Bawerk, Capital and Interest, 3 vols., trans. George D. Huncke and Hans F. Sennholz (South Holland, Ill.: Libertarian Press, 1959), 2:245. See also above, pp. 162–63.

How to Eliminate Social Security and Medicare*

2011-04-06T11:47:00.000-07:00

Expenditures under the Social Security and Medicare programs account for approximately one-third of total federal government spending.1 It is obvious that any major reduction in government spending requires major reductions in spending for these programs. Unfortunately, Social Security and Medicare are generally regarded as sacred and thus virtually untouchable, with the result that few if any proposals have been made that would greatly reduce the spending they entail.2

At present, the age at which full—“normal”—Social Security benefits can be obtained, given the individual’s lifetime earnings and contributions to the system up to that time, is 66. This represents an increase of 1 year from the age in force from the system’s inception until 2003, at which time it was increased by 2 months, reaching 66 after a series of 5 more 2-month increases in the years 2004-2008. Commencing in 2021, the full-benefit retirement age is scheduled to begin increasing by a second series of 2-month additions, until a full-benefit retirement age of 67 is reached in 2027.

From the beginning of the system, and scheduled to continue indefinitely, it has been possible to choose to receive Social Security benefits starting at age 62, though at a reduced rate. This rate is currently 75 percent of the full-benefit amount, down from 80 percent when the full-benefit retirement age was 65, and is scheduled to fall to 70 percent when the full-benefit retirement age rises to 67. By continuing to work and postponing the receipt of benefits until age 70, it has been possible to obtain premium benefits that are currently, i.e., for retirees in 2011, 32 percent higher than the “full” benefit amount. This premium is scheduled to fall to 24 percent when the full-benefit retirement age rises to 67.

The age for enrollment in Medicare is still 65, and, under existing law, is not scheduled to increase. Indeed, enrollment at any later age is frequently penalized.

The Social Security system, together with Medicare, could be eliminated by means of the following steps, each one of which would result in substantial cost savings. First, following a grace period of perhaps two or three years, to provide sufficient warning and time to adjust, there should be a phased increase to 70 in the age at which individuals are eligible to receive full Social Security benefits and Medicare. At the same time, the early benefit retirement age for Social Security should be increased from 62 to 66.

The increases in age could take place in 6-month increments over a period of 8 years, with the exception of an initial increment of 1½ years in the case of Medicare. Thus, assuming that the reform I’m proposing were implemented prior to 2021, with the Social Security retirement age still at 66, in the first year of its implementation the early Social Security retirement age would be raised to 62½, while the full-benefit retirement age, along with the Medicare retirement age, rose to 66½. In the second year, the respective retirement ages would be 63 and 67. And so it would continue, year after year, for a total increase of 4 years over an 8 year period.

In this period, apart from adjustments for increases in the consumer price index, retirement benefits would remain unchanged as the respective ages increased at which they could begin to be obtained. Thus, by the end of the process, individuals receiving early retirement benefits at age 66 would receive no greater benefits than individuals had previously obtained at age 62. In the same way, individuals at age 70would receive full benefits no greater than individuals had received at age 66, before the process of reform began.

Thus, when completed, after 8 years, the effect of just this phase of the reform would be a substantial reduction both in the number of people receiving Social Security and Medicare benefits and in the average per capita benefit received by those who remained in the Social Security program. Members of the age group 65-69 would no longer receive Medicare benefits. Members of the age-group 62-65 would no longer receive Social Security at all. Members of the age-group 66-69 enrolled in the program at that time, would receive benefits 25 percent less than their predecessors had received, before the start of the reform, because just as early retirement benefits starting at age 62 had been 25 percent less than the full benefits starting at age 66, so now early retirement benefits starting at age 66 would be 25 percent less than full benefits starting at age 70. Indeed, the reduction in the benefits of the 66-69 age-group would be further increased to the extent that they would no longer contain any premiums for retirement after 66. The elimination of premium benefits would ultimately work to reduce the aggregate benefits of all later age-groups as well, insofar as they too would eventually no longer reflect the incorporation of premium benefits to anyone.

As of December 2009, of the approximately 33.5 million people receiving Social Security retirement benefits, approximately 4.4 million, or roughly 13 percent, were in the age-group 62-65. This group received retirement benefits of $54.7 billion, which represents about 11.7 percent of the aggregate Social Security retirement benefits of $468.2 paid in 2009.3 It is not unreasonable to assume that the closing of Social Security to new enrollees in the 62-65 age-group would achieve comparable percentage reductions in the number of people receiving Social Security retirement benefits and in the overall cost of the program. To this must be added the effect of the 25 percent reduction in the benefits of the 66-69 age-group plus the effect of the elimination of premiums for late retirement.

Based on the Social Security benefits paid to the members of the 62-65 and 66-69 age-groups in 2009 relative to total Social Security retirement benefits in that year, the resulting overall reduction in the cost of such benefits can be estimated at approximately 18 percent. The benefits paid to the members of the 66-69 age-group were $116.9 billion, representing 25 percent of the total. A 25 percent reduction in these benefits represents a reduction of 6.25 percent in overall benefits. Thus, the total reduction in benefits is the sum of 11.7 percent, the share of Social Security retirement income previously received by the members of the 62-65 age-group, plus 6.25 percent, i.e., approximately 18 percent in all. This percentage is the measure of the reduction in the yearly cost of Social Security that can be expected at the end of 8 years.

Based on data supplied by the Medicare Payment Advisory Commission (Medpac), the cost savings in Medicare that would result from a rise in the eligible age from 65 to 70 can be estimated at perhaps as much as 15 percent of Medicare’s spending.4

The second step in the elimination of Social Security would be the elimination of the category of early retirement. This could be accomplished by the early retirement age continuing to increase by a further set of 8 increments of 6-months each, which would bring it to the point of coinciding with the by-then established full-benefit retirement age of 70. Based on the data from 2009, this would result in cutting the cost of Social Security by a further 18.75 percent, raising the total cost saving, at the end of 16 years, to almost 37 percent per year.

Compensation for the Loss of Social Security and Medicare Benefits

As compensation for their loss of Social Security and Medicare benefits, individuals in the 66-69 age-group who remained at work, which many of them would now no doubt have to do, would be made exempt from federal income taxes on an amount of income equal at least to the maximum income then subject to the payment of Social Security taxes. (This amount is currently $106,800.) These individuals would also be exempted from the payment of Social Security taxes, including employer contributions on the part of those who were self-employed.

The exemptions would be adjusted for increases in the consumer price index and be automatically extended to older ages as the Social Security/Medicare retirement age advanced beyond 70. Indeed, right from the very beginning of the reform, the exemptions would apply to all individuals 66 or older eligible for Social Security retirement benefits who abstained from taking them in any given year. For example, even in the very first year of the reform, someone 75 or 80, who did not accept those benefits in that year, would have these tax exemptions in that year.

It should be realized that these federal income tax exemptions would apply to incomes that for the most part would not otherwise have existed, with the result that the government would not incur any significant loss of revenue by offering them. Indeed, the result of millions of people in their sixties remaining in employment and off Social Security and Medicare would not only be a major reduction in government spending for Social Security and Medicare, but also a substantial rise in government tax revenues as well.

The rise in tax revenues would come about because people in the 62–69 age bracket, now gainfully employed instead of on Social Security and Medicare, would pay more in the form of sales, excise, and property taxes, as the result of their having and spending higher incomes than they would have received from Social Security. And they would pay more in the form of state and local income taxes as well. For example, instead of someone receiving $10,000 or $20,000 a year in Social Security income, he would earn $20,000 or $30,000 or more in employment income. The federal government would save the $10,000 or $20,000 Social Security expenditure (plus more or less considerable Medicare expenditure), and, in addition, state and local governments would collect significant additional tax revenues out of the expenditure of the newly earned employment incomes.

It must be pointed out here that the phaseout of the Social Security and Medicare programs, or the undertaking of any other measure that would be accompanied by an increase in the number of people seeking employment, calls for an intensification of efforts to abolish or restrict as far as possible prounion and minimum-wage legislation. This is necessary in order to make it possible for the larger number of job seekers to find employment. Union pay scales and a government-imposed minimum wage operate to prevent this by arbitrarily and forcibly holding wage rates above free-market rates, thereby holding the quantity of labor demanded below the supply available.

Raising the Social Security/Medicare Retirement Age Beyond 70 and Closing the Programs to New Entrants

The next step in the elimination of Social Security/Medicare would be raising their retirement age beyond 70. This could be accomplished by further incremental annual increases, this time of one calendar quarter with the passage of each year. Thus, by the end of an additional 20 years, the Social Security/Medicare retirement age would be 75. At that point, based on the same data as cited previously, the annual savings in the cost of Social Security retirement benefits would be slightly more than 59 percent, while the annual savings in Medicare expenditures would be almost 31 percent.

Raising their retirement age 1 year more, over an additional 4 year period, would bring the total lapse of time from the initial implementation of the phaseout reform to 40 years. Under this arrangement, everyone age 36 and above at the start of the phaseout reform would be able to look forward to enrolling in Social Security and Medicare no later than at age 76, if that is what he wanted. At the same time, if he wished the equivalent of being able to retire at age 70 on a Social Security income, all that would be required of him would be to make provision for a maximum of the 6 years between age 70 and age 76 at a level equal to what he would previously have received under the Social Security Program.

Forty years is a sufficient period of time to enable everyone age 35 or below at the time of the initial implementation to make adequate provision for his own retirement at age 70, or even at age 65 if that is what he wanted. At this point then, the Social Security and Medicare programs would be closed to new enrollees.

Thereafter, with the passage of each year, the cost of the programs would steadily diminish. Based once more on the same data as referenced previously, after an additional 9 years, by which time the minimum age of those still receiving Social Security and Medicare would be 85, the annual cost of the programs could be expected to be reduced by 88 percent and 66 percent respectively. With the passage of 10 years more, by which time the minimum age of those still receiving benefits was 95, the annual cost of Social Security would be reduced by 99 percent and that of Medicare by a further 16 to 17 percent, for a cumulative reduction of 82 to 83 percent.

The failure of Medicare expenditures to diminish further is the result of the fact that approximately 17 percent of Medicare expenditures are made on behalf of people under the age of 65—14.9 percent on behalf of those who are disabled and 2.1 percent on behalf of those with end-stage renal disease, who require dialysis.5

Just as payments on behalf of the elderly do not account for all Medicare expenditures, so too expenditures made under the heading of Social Security are not exclusively for the benefit of retired workers. While expenditures providing retirement income were $468.2 billion in 2009, there were in addition expenditures of approximately $89 billion for Survivor’s Insurance and $118.3 billion for Disability Insurance. Thus, the overall total expenditure under the head “Social Security” came to $675.5 billion.6

The complete elimination of Social Security and Medicare would, of course, require the elimination of these aspects of the programs as well. Possible first steps in this direction would be the establishment of means tests for the receipt of such aid along with the return of such programs to the states and localities. These steps could begin early in the phaseout.

The Effect of Eliminating Social Security/Medicare on Real Wages and the General Standard of Living

As previously indicated, from the very beginning of the process of eliminating Social Security/Medicare, everyone 66 and above would have the opportunity of enjoying a life largely free of federal income taxation on earnings derived from employment. Everyone 66 and above would have an employment-income exemption in excess of $100,000 per year, in terms of present purchasing power, for the remainder of his life. The most that anyone would have to do to secure this opportunity in a given year would be to abstain from taking Social Security income in that year, if he were eligible to receive it. Retirement years marked by this freedom from income taxation might thus become truly “Golden Years.”

In addition, the progressive elimination of the Social Security/Medicare system would operate to promote saving and capital accumulation. The saving of individuals would steadily replace taxes as the source of provision for old age. The increased capital accumulation that this made possible would, of course, increase the demand for labor and the productivity of labor, which means that it would increase wage rates and the supply of goods, which latter would operate to reduce prices. Thus, real wages and the general standard of living would rise. The rise would be a continuing one insofar as the rate of capital accumulation was permanently increased as the result of greater saving and a correspondingly greater concentration on the production of capital goods relative to consumers’ goods.

*****

At the same time, however, over the course of the many years that would be required for the burden of Social Security/Medicare to reach the vanishing point, all those people thirty-five and below at the time of the start of the phaseout program, and many of their children, would painfully learn the meaning of having to pay off a national debt. For the financial obligations incurred under Social Security and Medicare are in fact an enormous national debt. They are an enormous national debt incurred to elderly and infirm people incapable of caring for themselves. People incapable in large measure simply because they had been promised that the government would care for them and thus that it was not necessary for them to save.

Two major lessons to be learned from the financial disaster constituted by Social Security/Medicare are that the government should be prohibited from incurring any significant national debt and that a governmental promise of pensions or provision of future medical care is a category of national debt. All levels of government should be constitutionally prohibited from incurring significant amounts of debt beyond a very short term, including, above all, pension obligations of any kind.

Hopefully, there is a special place in Hell reserved for all the political con-men and intellectual shysters of the last generations who endlessly dismissed the significance of national debts with such glib phrases as “we owe it to ourselves” and asserted that national debts need never be paid. These, of course, were the same con-men and shysters who again and again ignorantly denounced saving as cash hoarding and the cause of depressions and mass unemployment.

And in the case of all the government officials who over a period of decades and decades knowingly used the proceeds of Social Security taxes to finance current government spending, these con-men and shysters descended to the status of major criminals, guilty of the crime of embezzlement on a scale unprecedented in all of human history. They diverted literally trillions of dollars of what people were led to believe were their savings, set aside for their future benefit, into current government spending. The spending was for projects desired by these officials and designed to keep them in office by fostering the illusion that the officials had performed the miracle of providing seemingly valuable current benefits at no corresponding cost. Of course, the reason for the apparent lack of cost was that the costs were covered by the proceeds of embezzlement.

Social Security and Medicare have caused a massive diversion of savings into government consumption not only by diverting the proceeds of Social Security and Medicare taxes into current government spending, but by first, and more fundamentally, undermining one of the most important motivations for private saving and investment, namely, the need to provide for one’s old age. The effect of Social Security and Medicare has been to remove the apparent need for much of that saving. Not surprisingly, in the conviction that the government was now providing for people’s old age, the rate of saving in the United States has declined precipitously over the years, falling all the way to zero in some years.

The government, of course, made no such actual provision. For the accumulation of actual physical capital assets based on decades of private saving and investment, that in a free economy would have been the source of future financial security, it substituted its promise to levy taxes on future generations, while it consumed the funds that should have gone into saving and investment and a resulting accumulation of capital assets.

It must be realized that this lost private saving and investment and its corresponding accumulation of capital assets was essential just to maintain the stock of capital assets, let alone increase it. This is because in old age and retirement, people consume the wealth they have accumulated to provide for that period of their lives. If the generations following them are not engaged in making their own, fresh provision for old age and retirement, the consumption of a current generation of the elderly serves to deplete the overall stock of capital assets in the economic system. From its inception in 1935 to the present day, the Social Security system, reinforced by Medicare since 1965, has served both to undercut people’s motivation to provide for old age and retirement by means of saving and also, as the taxes to finance these programs have increased, their sheer ability to do so. Thus more and more of the savings and capital assets accumulated in the past have been lost.

One can see the effects of this decumulation in the withering of the industrial base of the United States and in the accompanying dramatic decline of formerly major centers of production, such as Detroit, Cleveland, and St. Louis. The wealth that was once present there has disappeared, sucked up into the voracious consumption of the government, under the leadership of ignorant, dishonest, and vicious politicians and officials.

Of course, the customary explanation of the decline in America’s industrial base is the competition of foreign producers paying lower wages. However, the truth is that if American producers had had more capital, they would have been able to produce more efficiently and at lower costs, thereby more frequently offsetting the advantages foreign producers had by virtue of being able to pay lower wages. Indeed, for generations, American producers had been able to do this. Their superiority in terms of capital invested per worker enabled them to offset even enormous differences between American and foreign wage rates through the higher productivity of American workers resulting from greater capital investment.

True enough, foreign investment and the international movement of capital have become much easier since the second half of the last century than it was in the first half. But investing in foreign countries does not reduce the capital invested in the countries in which the investors reside. To the contrary, it increases that capital. This is because the investment greatly increases the productivity of labor and the total of what is produced in the foreign countries, and a major portion of that additional production is capital goods that are exported to the country of the investors. Just as investment in the western states of the United States by citizens of the country’s eastern states served to increase the wealth present in the eastern states, on the foundation of goods received from the western states, so too investment by American citizens as a whole in places like Japan and China serve to increase the capital goods in the United States as a whole, by virtue of the capital goods coming into it from Japan and China. These capital goods can be seen not only in masses of foreign-made components and parts used by American producers, but also in numerous factories, such as the automobile plants built by Japanese and Korean firms in the United States. The influx of foreign capital can also be seen in the fact that it is that foreign capital that largely finances the budget deficits of our spendthrift government and prevents those deficits from consuming still more of the previously accumulated capital of the United States.

Thus, the cause of America’s industrial decline is not investment outside the country. Nor, of course, is it exclusively the result of Social Security and Medicare and the decline in saving and investment that they in particular have caused.

There are numerous additional causes of America’ economic decline. However, all of them share with Social Security and Medicare the fact that they represent instances of government interference in the economic system that serve to undermine capital accumulation and the rise in the productivity of labor. First and foremost among them is the government’s limitless appetite for spending and the unending expansion of its powers and activities that growing spending feeds. The additional spending is financed to an important extent by arbitrary increases in the money supply, i.e., inflation, and the closely related policy of credit expansion and its consequent massive waste of capital. Along with inflation and credit expansion, there is the confiscatory taxation of income that otherwise would have been heavily saved and invested, most notably, profits, interest, dividends, and capital gains, as well as inheritance taxes, which are a tax on capital already accumulated. In addition, there is the granting of monopoly privileges to labor unions and all other government interference and regulation that arbitrarily serve to raise costs of production and reduce output per unit of input, insofar as the output being reduced is the production of capital goods.7

The Special Problems of Eliminating Medicare

The elimination of Medicare, especially after age 70, requires that steps be taken to make medical care for the elderly affordable outside of Medicare (and outside of most private medical insurance plans as well). This requires eliminating as far as possible all of the government intervention that over the generations has been responsible for increasing the cost of medical care. In my essay “The Real Right to Medical Care Versus Socialized Medicine,” I present a detailed explanation of the various ways in which government intervention has been responsible for the rise in the cost of privately provided medical care and a program of pro-free-market reform that would dramatically reduce the cost of such medical care and make it affordable for the most part to people without medical insurance.

Though written in 1994, in order to help prevent enactment of the so-called Clinton Plan, its findings are as applicable today as they were then, and should be considered as an essential part of my proposals for eliminating Social Security/Medicare. The only significant details that would need to be changed are the replacement of the absurdly and unnecessarily high costs of privately provided medical care in 1994, reflecting all of the government intervention in medical care up to that time, with the still far more absurdly and unnecessarily high costs of privately provided medical care today, which incorporate the effect of the massive inflation of the money supply that has taken place in the intervening years.

Reform in the Spirit of Classical Liberalism

An important feature of the program of reform that I have presented is that it need not be accepted in toto. Its advocacy of a rise in the Social Security/Medicare retirement age to 70, and even to 75, could be accepted by those who wished to retain these programs but limit them to an older population than is the case at present. The enactment of either of these limitations would be an important victory. One that would take nothing away from the goal of the ultimate total elimination of Social Security and Medicare and would serve as an important step on the way to the achievement of that goal.

This program will undoubtedly seem much too slow for some supporters of individual rights and freedom. Nevertheless, I believe that it is in fact the most rapid means of achieving its ultimate goal that does not entail a revolutionary overthrow of what have come to be established rights in the law, however wrong-headed the law has been in establishing those rights in the first place. Proceeding in this way is an essential aspect of Liberalism in its classical sense. Fundamentally, rights to entitlements of any kind, that must be paid for involuntarily by other people, are no more legitimate than the alleged property rights of slave owners in their slaves. Yet to avoid civil war, Liberalism would have urged a policy of compensated emancipation rather than one of violent emancipation. Today, in fundamentally similar circumstances, Liberalism must limit as far as possible the disturbance that would otherwise be caused by the elimination of illegitimate, perverted rights.

Individualism Versus Collectivism

At the most fundamental level, what this discussion of reform serves to bring out is the conflict between the philosophies of individualism and collectivism. Social Security and Medicare are monuments to collectivism. Both rest on the premise that the individual cannot make his own provision for old age by means of saving and that instead he must rely on that great collective, Organized Society, i.e., the Government, to make provision for him.

The individual, of course, is the party with by far the greatest interest, indeed, the only really powerful, life-or-death interest, in providing for his old age. The rest of the world can never experience the matter with the intensity with which he will one day experience it if he lives to old age, nor with the intensity that he would experience it relatively early in life if he were accustomed to think clearly about the future.

Many individuals, of course, do not think about the future, or not sufficiently about it. But many in this category, perhaps the great majority of them, would do so if they lived in conditions in which they were familiar with the suffering of others that resulted from bad choices and were not protected from themselves suffering the consequences of their own bad choices.

In any event, it cannot be that a solution for any presumed inadequacies of the individual lies in removing his responsibility for providing for his future and placing that responsibility instead in the hands of a mass of other individuals. For those other individuals must be presumed to be not only equally incompetent, but they also lack the motivation of self-preservation that each individual experiences in matters of his own life and well being. Indeed, the notion that the alleged incompetence of the individual is a basis for turning responsibility over to the collective reduces to the absurdity that those who are incompetent to run their own lives, in which everything is at stake for them, are thereby qualified to run the lives of others, in which virtually nothing is at stake for them.

The consequences of enacting this absurdity are not only economic destruction through the undermining of saving but also the potential for nothing less than a virtual geriatric holocaust. That will be the result when masses of elderly people, without means of their own and dependent instead on the support of masses of anonymous strangers, wake up to find that the strangers have grown tired of supporting them.

A foretaste of this outcome can be found in the “death panels” that many observers discerned in the healthcare legislation enacted in the last Congress. It can be found within the last few days in news stories about efforts to stop dialysis treatments for elderly patients. (See, for example, “When Ailments Pile Up, Asking Patients to Rethink Free Dialysis,” The New York Times, April 1, p. 1.)

With government control of medical care and what is considered proper medical protocol in the treatment of diseases, even those who have managed to provide for their own future are at risk.

Despite their endless posturing and pretense, politicians do not love the masses—of any age. What they love is their own power. They pretend to love the masses as a vehicle for gaining power. History shows again and again that once they gain it, the lives of millions become expendable.

The actual fact is that while the lives of the elderly are of inestimable value, when taken one at a time, to the individual elderly person concerned, they are of no actual value to politicians and government officials. Indeed, from the perspective of the self-interest of all-powerful officials, contemplating the land and the people of their country as their personal possessions, existing for no purpose other than their—the officials’—glorification, the existence of the elderly stands as an actual impediment. For the elderly consume substantial amounts of the resources of the collective that the officials control, and at the same time they produce little or nothing, and no longer have any prospect of ever doing so. If they ceased to exist, the officials would have resources available to put to other uses that they would certainly judge to be more important.

Today, of course, the elderly still have the vote, and that may protect them for a time. But all-powerful government is clearly the direction in which we are moving. We are placing ourselves more and more in the power of government officials who regard us the way a farmer regards his livestock. We will be able to live, in poverty and as slaves, so long as we are useful to them. But when we are too old to be useful to them, we will be left to die. As the Times’ article referenced above put it, we will then be spoken of in terms of such euphemisms as having “chosen `medical management without dialysis,’” i.e., “medical management” without treatment.

If we want to protect the value of individual human life, particularly in old age, when it is most vulnerable, we must reverse direction and start dismantling Social Security and Medicare, two potentially deadly collectivist institutions. We must restore to the individual the responsibility and the power to determine his own future through forethought and saving. The individual must have his own individual property with the freedom to use it for his own well-being, as he sees fit. Government officials must be barred from the process.

* Copyright © 2011 by George Reisman. This article is a revised and expanded treatment of the subject that appears on pp. 976-77 of the author’s Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). George Reisman, Ph.D. is Pepperdine University Professor Emeritus of Economics and a Senior Fellow at the Goldwater Institute. His website is www.capitalism.net.

1. In fiscal year 2012, expenditures for Social Security are projected to be $761 billion, while those for Medicare are projected to be $468 billion. Total federal government spending in 2012 is projected to be $3,699 billion. Source: Fiscal Year 2012, Budget of the U.S. Government Washington, D. C.: U.S. Government Printing Office, 2011), p. 174 (Table S-3).

2. An exception may be the budget proposal currently being developed by a number of Republican members of the House of Representatives, which reportedly seeks to reduce federal government spending by $4 trillion over a period of 10 years, in large part by replacing direct federal spending for Medicare by federal subsidies for the purchase of private medical insurance. (See The Wall Street Journal, April 4, 2011, p. 1.)

3. Source: Annual Statistical Supplement to the Social Security Bulletin, 2010, p. 228 (Table 5.A1.1).

4. See Medpac, June 2010 A Data Book, Healthcare Spending and the Medicare Program, p. 34 (Chart 2-2. Medicare enrollment and spending by age-group, 2006). This chart shows that almost 31 percent of Medicare’s spending is on account of the age-group 65-74. At the same time, Social Security Data show that the 65-69 subgroup accounts for 55 percent of the larger age-group. The larger proportion of people in the younger subgroup offsets to an important extent the higher per capita medical expenses of the older subgroup and suggests the possibility of the degree of cost reduction indicated.

5. See Medpac, ibid., p. 33 (Chart 2-1).

6. See Annual Statistical Supplement to the Social Security Bulletin, 2010, p. 1.

7. For elaboration of this last point, see “The Undermining of Capital Accumulation and Real Wages by Government Intervention,” pp. 636-39 of the author’s Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996).

WHERE PROFIT COMES FROM

2011-01-10T12:00:00.000-08:00

Labor unions like to argue that the payment of higher wages is to the self-interest of employers because the wage earners will use their higher wages to make additional purchases from business firms, thereby increasing the sales revenues and profits of business firms. However, wrong and foolish it may be, this is an argument worth analyzing in some detail, because it can provide a gateway to a discussion of the actual sources of profit in the economic system.

The union argument, of course, ignores the fact that the business firms paying the higher wages and those earning the additional sales revenues and profits that are alleged to result are likely to be different firms. Indeed, insofar as any one, individual firm is considered, this will certainly be the case, if for no other reason than that very little, if any, of the additional wages paid by that one firm are likely to be expended by its employees in purchasing goods specifically from it. Whatever kind of firm it may be, it specializes in just one or, at most, a very few kinds of business. Yet its employees will almost certainly expend their higher wages in buying a wide variety of products, from a wide variety of firms.

The only way that an individual firm might expect to gain comparable additional sales revenues following its payment of additional wages is if the payment of additional wages takes place on the part of very many firms, throughout the economic system. In that case, while its employees spend most or all of their additional wages in buying from other firms, the employees of other firms may very possibly spend enough of their additional wages in buying from it, to provide it with additional sales revenues sufficient to match its additional payment of wages.

But even in this case, firms producing capital goods will not have additional sales revenues. This is because, in the nature of the case, all of the additional sales revenues accrue to the sellers of consumers’ goods. For it is consumers’ goods on which the additional wages are expended, not capital goods. All that the sellers of capital goods will have is additional costs of production, corresponding to their payment of additional wages.

Indeed, in any circumstances, even in the highly unrealistic case in which all firms sold nothing but consumers’ goods, there would be additional costs of production equal to the additional wages paid. The additional wages sooner or later always show up as equivalent additional costs of production. The consequence of additional costs of production equal to the payment of additional wages offsets the existence of additional sales revenues equal to the payment of additional wages.

Insofar as the effect of the payment of additional wages is the combination of additional sales revenues and additional costs of production, there can be no increase in profits in the economic system. In both being equal to the same thing—viz., the additional wages paid—the additional sales revenues and the additional costs are equal to each other. In the face of equal additions to sales revenues and costs, profits, the difference between sales revenues and costs, remain unchanged in the economic system in terms of their dollar amount. Equals added to unequals not only do not affect the amount of the inequality, but serve to reduce the percentage that the unchanged amount of profit constitutes of the now larger sales revenues and costs. Profit as a percentage of sales revenues and cost necessarily declines.

Furthermore, while it is not unreasonable to assume that the payment of additional wages results in equivalent additional expenditure by the wage earners and thus in equivalent additional sales revenues for sellers of consumers’ goods, it is by no means the case that it must result in an equivalent additional expenditure and sales revenues in the aggregate, i.e., for consumers’ goods and capital goods taken together. It might well be the case that the additional payment of wages comes at the expense of purchases of capital goods, notably the materials and machinery business firms buy. In that case, aggregate sales revenues in the economic system will be unchanged.

And if this is the case, then it is almost certain that business profits in the aggregate will substantially decline in amount as the result of an increase in wage payments. This is because expenditures for capital goods, especially machinery and buildings, show up as costs of production in business income statements much more slowly than do wage payments of equivalent amount. For example, an additional $1 billion of expenditure on wage payments is likely to show up as costs of production within a matter of weeks or months. However, that same $1 billion expended on machinery or buildings will show up as equivalent costs of production only over a period of years or even decades, as the machinery or buildings undergo depreciation.

Consequently, a shift in expenditure from machinery and buildings to wage payments would result in an increase in aggregate costs of production in the economic system in the current year, and many years thereafter, of the far greater part of the $1 billion. Profits in the economic system would equivalently fall because, in the conditions of the case, the increase in aggregate costs would occur in the face of aggregate sales revenues that were unchanged.

It should be realized here that by the same token, a decline in wage payments that made possible an equivalent rise in the expenditure for machinery or buildings would result in a substantial increase in profits in the economic system. This is because, in this case, aggregate costs of production in the economic system would fall as depreciation cost, representing a relatively modest fraction of the additional $1 billion that was now spent on machinery or buildings, replaced what would have been current operating costs representing the far greater part or all of the $1 billion otherwise spent in paying wages.

This conclusion, of course, flies in the face of the views of the labor unions and the Keynesians, who believe that reductions in wage rates reduce business profits insofar as they result in a reduction in total wage payments and consequently consumer spending. The truth, as I have just shown, is the exact opposite insofar as the reduction in wage payments serves to increase expenditure for durable capital goods.

Profits and the Average Period of Production

There is an abstract principle that is present in these examples, one that relates to the “Austrian” concept of the average period of production and the closely related Ricardian concept of the necessary lapse of time that takes place between expenditures for means of production and the receipt of proceeds from the sale of the ultimate consumers’ goods that result. The principle is that, other things being equal, a lengthening of the average-period-of-production/necessary-lapse-of-time brings about a transitory decrease in aggregate costs of production in the economic system and increase in profits in the economic system. By the same token, other things being equal, a shortening of the average-period-of-production/necessary-lapse-of-time brings about an increase in aggregate costs of production in the economic systems and decrease in profits in the economic system.

I describe the change in aggregate costs of production as “transitory” because ultimately, if the amount of spending for means of production, i.e., labor and capital goods, remains the same in the economic system year after year, costs of production will equal that amount of spending, irrespective of the length of the average-period-of-production/necessary-lapse-of-time. For example, on the scale of an individual company, $1 billion per year expended on labor and materials will probably result in $1 billion of annual costs of production for that company within little more than a year. That same $1 billion expended year after year in purchasing machinery with a depreciable life of 10 years, will result in annual depreciation costs of $1 billion after 10 years. At that point, 10 years’ of machinery purchases will be in place, with the purchases of each year resulting in $100 million of annual depreciation cost, or $1 billion in all. Similarly, the expenditure of $1 billion year after year for buildings with a 40-year depreciable life must result in $1 billion of annual depreciation cost once 40 years have passed. At that point, there will have been 40 years of building purchases. With each of those 40 years’ purchases resulting in an annual depreciation cost of one-fortieth of $1 billion, the total annual depreciation cost from than point on will be $1 billion.

So long as further lengthening of the average-period-of-production/necessary-lapse-of-time occurs, the process makes a further contribution to aggregate profitability. But once further lengthening ceases, the contribution to aggregate profitability comes to an end. (Mises implicitly recognizes the contribution to aggregate profit made by a lengthening of the period of production. See Human Action, 3d ed. rev. [Chicago: Henry Regnery Co., 1966], pp. 294-97.)

Profits and the Increase in the Quantity of Money/Volume of Spending

Nevertheless, there is a second factor connected with the passage of time in the productive process that can be gleaned from our discussion of the union argument concerning wage payments, and whose contribution to aggregate profitability is capable of being permanent. This factor is the increase in the quantity of money/volume of spending in the economic system.

The increase in wage payments so much desired by the unions could make a contribution to aggregate profits in the economic system insofar as it was financed by an increase in the quantity of money. (A decrease in the demand for money for cash holding would also have this effect. However, inasmuch as decreases in the demand for money for cash holding cannot go on indefinitely and, indeed, ultimately depend on increases in the quantity of money, they require no further separate discussion.)

Moreover, what serves to contribute to profits in the economic system here is in no way peculiar to higher wage payments. It is present equally in greater expenditures for materials and supplies and machinery and buildings, i.e., in greater expenditures for means of production as such.

The contribution to profits in the economic system derives from the fact that additional expenditures for means of production resulting from the increase in the quantity of money serve to raise sales revenues in the economic system immediately or almost immediately while they serve to increase the costs of production deducted from sales revenues only with a more or less considerable time lag. Thus, what business firms spend in buying capital goods is simultaneously sales revenues to the sellers of the capital goods. What they spend in paying wages shows up very quickly as additional sales revenues for sellers of consumers’ goods.

Consistent with the principles of business accounting, in the case of all goods sold out of inventory, additional costs of production appear in business income statements only as and when the goods produced from the means of production purchased for larger sums of money are sold. That often entails a lapse of time of several months, and, sometimes, several years. For example, the additional expenditures made by an automobile company for labor and materials will not show up as costs of production until the automobiles produced in the process are actually sold, at which time cost of goods sold is incurred. Such outlays made in November or December of a calendar year will not show up in the auto firms’ current-year income statements ending on December 31, but only in the income statements of the following year.

In the case of a distillery, producing aged whiskey, such time interval may be 8, 12, or 20 years, or even more. Of course, in the case of the machinery and buildings purchased by business firms, major time intervals are present everywhere before additional depreciation cost comes to equal the additional outlays.

In these intervals, sales revenues are increased without costs being increased, or increased equivalently, and thus profit emerges. And then, if the increase in the quantity of money and volume of spending is continuous, by the time costs do rise to reflect the higher level of expenditures made in purchasing the means of production, there are further increases in the expenditures for the means of production and thus in sales revenues. In other words, there is a continuing contribution to aggregate profit.

It follows from this discussion that a continuing given percentage increase in the quantity of money/volume of spending in the economic system tends to add an approximately equivalent percentage increase to the economy-wide average rate of profit/interest. For example, a continuing 2 percent annual increase tends to add approximately 2 percentage points to the rate of profit/interest on top of what it would otherwise have been. This conclusion follows by conceiving of outlays for means of production in any given year as being paired with receipts from the sale of consumers’ goods in definite future years. If the volume of spending and thus of sales revenues in the economic system were growing at some definite compound annual rate, an equivalent additional rate of return on those outlays would be implied.

For example, if with no increase in the quantity of money/volume of spending, an outlay for means of production of 10 would grow to sales revenues of 11 in a year, but now a 2 percent increase in money and spending makes it grow to 11.22, the rate of return on the outlay of 10 is increased from 10 percent to 12.2 percent, an increase of approximately 2 percentage points. In the same, way an outlay of 10 that would otherwise grow to (11/10) x (11/10) in 2 years, will now, with a compound annual increase of 2 percent in money and spending, grow to (11/10) x (11/10) x 1.02 x 1.02. Again, on an annualized basis, there will be an addition of approximately 2 percentage points to the rate of return. Since every dollar of sales revenues in the economic system can conceptually be paired with outlays for means of production made at one specific time or another in the past, a uniform compound annual increase in money and spending covering the entire time interval must have this effect everywhere.

The increase in the rate of return resulting from the increase in the quantity of money/volume of spending should not be dismissed as inflation. In a free market, under a gold standard, the quantity of money would increase and that increase, as Rothbard has convincingly shown, would not be inflation. Inflation, Rothbard showed, applies only to increases in the quantity of money more rapid than increases in the supply of gold. The modest increase in the quantity of money in a free economy and its gold standard would almost certainly be accompanied by increases in the production and supply of commodities in general that were at least as great and, most probably, significantly greater. The result would be falling prices. However, and this is a very significant finding, these falling prices would not at all be deflationary, because, as I have just shown, they would be accompanied by an increase in the average rate of return on capital rather than a decrease, which last is a leading symptom of any actual deflation.

In a free market and its gold standard, a reasonable scenario would be a 2 percent annual increase in the quantity of gold and spending in terms of gold, accompanied by a 3 or 4 percent annual increase in production and supply in general. The effect would be prices falling at an annual rate of 1 or 2 percent along with an approximate 2 percent addition to the average rate of return. The real rate of return, of course, would be elevated further, to the extent that prices fell.

There is a further very important conclusion to be drawn here, concerning the actual significance of the rate of return, the rate of profit/interest. And that is that to a very significant extent, the nominal rate of return is the reflection of nothing more than the increase in the quantity of money and volume of spending, while the real rate of return is the reflection of nothing more than the rate of increase in production and supply. In other words, at least to this extent, the rate of return cannot possibly be at anyone’s expense. It is the accompaniment and marker of more gold and of more goods in general, i.e., of economic progress and general improvement.

It must be pointed out that profits derived from lengthenings of the average period of production are also ultimately at no one's expense. To the contrary, in adding to the total of the capital employed in the economic system, they serve to increase the quantity and quality of the products produced. To the extent that these products are consumers' goods, the effect is a rise in real wages inasmuch as they are purchased overwhelmingly by wage earners. To the extent that the larger supply of products produced is capital goods, it serves to bring about a further increase in the supply of consumers' goods, and thus in real wages, and yet a further increase in the supply of capital goods, which in turn will have the same result. Continuing increases in the supply both of consumers' goods and capital goods, and thus continuing increases in real wages can occur.

The Rate of Return Under a Fixed Quantity of Money/Volume of Spending

In addition to increases in the quantity of money/volume of spending and lengthenings of the average period of production, there is a third source of profit in the economic system. This is the consumption expenditure of businessmen/capitalists, i.e., the expenditure of businessmen/capitalists that is not for business purposes, not for the purpose of making subsequent sales.

Like the consumption expenditure of wage earners, this expenditure is a source of business sales revenues in the economic system. But, unlike the consumption expenditure of wage earners, it has no counterpart in expenditures that generate costs of production. Its sources are primarily dividends paid by corporations and the draw of funds from partnerships and sole proprietorships. These payments do not show up as costs of production on the part of the firms that pay them. They are simply a transfer of funds from the firms to their owner(s).

Their existence enables business sales revenues in the economic system to exceed the expenditures by business firms for means of production and thus also to exceed the equivalent costs of production generated by those expenditures. In this way, they are a source of profit in the economic system.

Interest payments by business firms are also a source of funds making possible consumption expenditure by businessmen/capitalists. Interest payments, of course, do show up equivalently in costs of production. Nevertheless, their existence helps to explain the existence of business profits pre-deduction of interest. And thus they help to explain the general rate of return on capital, which is calculated gross of interest. This rate of return—the rate of profit pre-deduction of interest—of course, is what determines the rate of interest. (In the terminology of Mises and most other economists of the “Austrian School,” these profits are called “originary interest.” Taken relative to capital invested, they constitute the rate of originary interest.)

Profits resulting from the consumption expenditure of businessmen/capitalists would exist in the absence of further increases in the quantity of money/volume of spending. Their existence, moreover, acts to put an end to any indefinite prolongation of the average period of production. This is because, to be worthwhile, a lengthening of the average period of production requires that businessmen find that the investment of additional capital results in cost savings or revenue increases at the level of the individual firm sufficient to yield something more than the prevailing rate of return on capital. Thus, the higher is the prevailing rate of return, the greater is the obstacle in the way of additional investment being worthwhile. At the same time, the greater is the volume of capital that has already been accumulated in the economic system relative to sales revenues, the smaller is the contribution to costs savings or revenue increases that is likely to be made by the investment of still more capital and a further rise in the ratio of accumulated capital to sales revenues.

The implication of this discussion is that ultimately the rate of return in the economic system is determined by the combination of the rate of increase in the quantity of money/volume of spending and the ratio of the consumption expenditure of businessmen/capitalists to their accumulated capitals.

The second factor is clearly the more fundamental and should be understood as a reflection of time preference. In conditions in which the annual consumption expenditure of businessmen/capitalists is on the order of 5 percent of their accumulated capitals, time preference is lower than in conditions in which it is on the order of 10 percent of their accumulated capitals. It is lower still in conditions in which it is on the order of 2 percent. In the first case, their capitals are sufficient to provide for the consumption of 20 years; in the second, for only 10 years; in the third, for 50 years. A lower time preference is required to make greater relative provision for the future.

Establishing the relationship between time preference and the consumption expenditure of businessmen/capitalists relative to their capitals and, on that basis, to the rate of return on capital, serves to integrate time preference and its determination of the rate of return into “macroeconomics.”

Avoiding Confusions

It’s necessary to anticipate two possible confusions that may arise. One is the conviction that the claim that the consumption of businessmen/capitalists is a determinant of the rate of return on capital implies that to increase its rate of return, a company should increase its dividends and simply be sure that its stockholders consume the proceeds.

If enacted such a policy would, to some very modest extent, serve to increase the economy-wide average rate of return on capital. But the profits earned by the firm in question would be decimated. The extra profits would go to others, not to it. This is because such behavior would reduce its capital, which is an essential means of its competing for profits, by far more than it increased the economy-wide amount of profit.

For example, a huge firm, with a capital of $100 billion might increase its dividend by $10 billion and add $10 billion to the excess of sales revenues over expenditure for means of production in the economic system, and over costs equal to the now reduced expenditure for means of production. This would increase economy-wide profits from, say, $1 trillion to $1.01 trillion, a 1 percent increase. But at the same time, it would reduce the capital of this firm by 10 percent. Thus, the firm would be in a position to compete for its share of a 1 percent increase in profits in the economic system on the foundation of a capital that had been reduced by 10 percent. The profit it earned would thus certainly be much lower than it was before.

The second confusion that may arise is to ignore the fact that the discussion of profit in this article has been almost entirely at the level of the economic system as a whole, not at the level of the individual firm. As indicated in the last paragraph, competition exists at the level of the individual firm and plays a decisive role in determining its profits. Such factors as its relative efficiency and the relative quality of its products are vital for the profitability of the individual firm, but play little or no role in determining profits at the level of the economic system as a whole. This is because there competitive factors cancel out.

Summary

The central question that this article has been concerned with is what permits an excess of sales revenues over costs of production in the economic system as a whole. Here, as we have just seen, such things as producing a larger quantity of products more efficiently, or producing better products that can command premium prices, simply do not provide an explanation. This is because at the level of the economic system as a whole, they cancel out, with the profits of the more efficient, higher quality firms matched by the losses of the less efficient, lower quality firms.

The explanation of profit/interest in the economic system as a whole is provided by:

1) A shifting of expenditures for means of production from products and processes in which they show up more quickly as costs of production to be deducted from sales revenues, to products and processes in which they show up more slowly as costs of production to be deducted from sales revenues. In both cases, the same expenditure for means of production generates the same volume of sales revenues in the economic system, but in the second case costs are lower for a more or less considerable period of time, and thus profits are higher for that period of time. This, of course, represents a lengthening of the average period of production.

2) The increase in the quantity of money/volume of spending. This increase serves to increase sales revenues immediately or almost immediately while increasing the costs deducted from the sales revenues only with more or less substantial time lags. In the interval, profits are generated. The process is perpetuated by continuing increases in the quantity of money/volume of spending. At the same time that more money and spending add to profits and the rate of profit in terms of money, increases in the production and supply of ordinary goods can serve to prevent price increases or even result in price decreases, with the result that the nominal profits generated are accompanied by equivalent or greater real profits. This would be the situation in a free market and the gold standard.

3) The consumption expenditure of businessmen/capitalists. This is the source of sales revenues in excess of expenditure for means of production and of costs of production equal to those expenditures. It is the most fundamental source of profit in the economic system and ultimately rests on time preference.

Further Development of the Theory of Profit/Interest

I discuss all aspects of the present article at greater length, along with a host of other, related matters as well, in my book Capitalism: A Treatise on Economics. It will be helpful to provide a short bridge from this article to that book, in the form of the introduction of some new terminology.

In Capitalism, I refer to expenditure for means of production by business firms as productive expenditure, which is expenditure for the purpose of making subsequent sales. Productive expenditure is in sharpest contrast to consumption expenditure, which is expenditure not for the purpose of making subsequent sales, but for any other purpose.

Productive expenditure, of course, has two components: expenditure for capital goods and expenditure for labor—i.e., wage payments. Productive expenditure plays a twofold role in the generation of aggregate business profits: it is the source both of most of business sales revenues and of the costs business firms deduct from their sales revenues.

Productive expenditure can exceed costs deducted from sales revenues insofar as the costs it generates follow it with time lags. To the extent it does exceed costs, the sales revenues it generates also exceed those costs. There is profit.

Any excess of productive expenditure over costs is net investment. This is because, in accordance with the principles of business accounting, productive expenditure to a substantial extent constitutes additions to business asset accounts, notably, the gross plant and equipment and inventory/work in progress accounts. Expenditures on account of machinery or buildings add to the former; expenditures for materials add to the latter. Expenditures even for labor often represent additions to these accounts—for example the wages paid to workers constructing plant or to workers employed in the production of inventories.

Costs of production, on the other hand, largely represent subtractions from these accounts. Depreciation cost is a subtraction from gross plant and equipment. Cost of goods sold is a subtraction from inventory/work in progress. Thus, while productive expenditure adds to the asset accounts of business, cost of production subtracts from them. The difference between the sum of the additions and the sum of the subtractions is the net change, i.e., net investment.

Net investment reflects the effect both of changes in the length of the average period of production and changes in the quantity of money/volume of spending. The ratio of net investment in the economic system to accumulated capital in the economic system is the measure of the rate of profit/interest insofar as it is the result of these factors. In Capitalism, I call this ratio the “net investment rate.”

The rate of profit/interest in the economic system is explained by the combined operation of the net investment rate and one other rate, which I call the “net consumption rate.” Net consumption is the excess of spending for consumers’ goods over the wages paid by business firms. As explained, its primary source is the consumption expenditure of businessmen/capitalists. Net consumption is also equal to the excess of business sales revenues in the economic system over productive expenditure. Inasmuch as the expenditure to buy capital goods is present equally both in business sales revenues and in productive expenditure, the difference between sales revenues and productive expenditure reduces to the difference between the part of sales revenues constituted by consumption expenditure and the part of productive expenditure constituted by wage payments, i.e., net consumption.

Perhaps the simplest way to conceive matters is by starting with the fact that profit is the difference between sales revenues and costs. Sales revenues minus costs equals sales revenues minus productive expenditure plus productive expenditure minus costs. The first part of the result is net consumption; the second part is net investment. Thus, profit equals the sum of net consumption plus net investment. The further result is that the rate of profit, i.e., the ratio of profit to accumulated capital, equals the sum of the rate of net consumption plus the rate of net investment, with each of these rates being understood as the result of respectively dividing net consumption and net investment by the amount of accumulated capital in the economic system.

This theory of profit/interest has major implications for the understanding of capital accumulation, the determination of real wages and the general standard of living, taxation, inflation/deflation, and the business cycle. It also provides the basis for the overthrow of virtually all aspects of Keynesianism and its system of national income accounting, along with an equally fundamental and thorough refutation of Marxism and the exploitation theory.

Copyright © 2011 by George Reisman. George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics, Senior Fellow at the Goldwater Institute, and the author of Capitalism: A Treatise on Economics. His website is http://www.capitalism.net/.

Raising Taxes Is Not Reducing Government Spending

2010-11-21T21:44:00.000-08:00

Today’s New York Times carries an article titled “The Blur Between Spending and Taxes.” The author is Harvard Professor N. Gregory Mankiw.*

The essential theme of the article is that the government is spending when it decides to forgo tax revenue that it otherwise could have collected. Indeed, tax revenues forgone in the enactment of tax deductions, such as for interest payments on home mortgages or charitable contributions, and tax credits, such as for first-time homebuyers or adoptions, are now commonly described as “Tax Expenditures.” The thought is that the government is spending money in deciding not to take it in taxes and to allow the taxpayers to keep it.

The underlying assumption of those who hold this view is that the government already owns the funds in question whether it has collected them in taxes or not. The government is the alleged owner of funds that belong to the taxpayer and which it abstains from taking. It allegedly spends these funds in allowing the taxpayers to keep them.

The fundamental question is, who is the owner of the funds paid in taxes? Is it the citizens, who have earned the funds and who turn them over to the government under the threat of being fined or imprisoned, or even killed if they physically resist the government, or is it the government?

To the supporters of the principle of individual rights and limited government—the principle on the basis of which the United States was founded—the obvious answer is that the people own the tax revenues and, in paying them, financially support the government. To the supporters of an omnipotent government ruling over a citizenry of rightless serfs, the government is the owner both of the people’s possessions, which, allegedly, are theirs in name only, and, indeed, of the people themselves. It is on the basis of this belief that it follows that the government financially supports the people in not taxing away their wealth.

The defenders of individual rights need to remind the government that it does not pay or enrich anyone by allowing him to keep what is already his.

This truth has major implications for the subject of tax reform, which the Times’ article was written to address. Tax reform needs to consist exclusively of reductions in government spending and in taxes. It should not be based on massive tax increases resulting from the elimination of existing tax deductions and credits. It is actual government spending that must be reduced, not what people have up to now been able to avoid having to pay in support of that spending.

The notion of tax expenditures provides the pretext for massive tax increases in the name of reducing government spending. This notion must be cast aside, so that the target of tax reform will be reductions in actual government spending, which then must be followed by reductions in taxes. This is what must be done on a truly massive scale. To the extent that it is accomplished, the income tax can be progressively reduced, until it is ultimately eliminated altogether. At that point, all questions of income tax deductions and credits will have disappeared.

As matters stand, the notion that the absence of taxation constitutes government spending is setting the stage for the total perversion of genuine tax reform. It is being used in an effort to impose as much as a trillion dollars a year in new taxes disguised as a trillion dollars a year of reduced government spending. In the words of the Times’ article, “Erskine B. Bowles and Alan K. Simpson, the chairmen of President Obama’s deficit reduction commission, have taken at hard look at these tax expenditures—and they don’t like what they see. In their draft proposal, released earlier this month, they proposed doing away with tax expenditures, which together cost the Treasury over $1 trillion a year.”

This is the sum and substance of the concept of tax reform held not only by the Obama administration but also by cowardly Republicans and conservatives. Simpson was a Republican United States Senator from Wyoming for eighteen years. Mankiw, the author of the Times’ article, was chairman of President Bush’s Council of Economic Advisors from 2003 to 2005.

In sum, the danger exists that Left and Right are about to unite to accomplish a colossal political fraud in the form of enormous tax increases sold to an unsuspecting public as reductions in government spending. The American people need to stand up and refuse to accept any form of the absurdity that in not taxing them, the government is spending their money and that the path to lower spending and taxes is raising their taxes. The basis of tax reform must be reduced government spending, not higher taxes.

*The article appears on p. 5 of the Business Section of the November 21, 2010 issue.

Copyright © 2010 by George Reisman. George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics. His website is www.capitalism.net.

Natural Resources and the Environment

2010-10-27T10:10:00.000-07:00

There is a fundamental fact about the world that has profound implications for the supply of natural resources and for the relationship between production and economic activity on the one side and man’s environment on the other. This is the fact that the entire earth consists of solidly packed chemical elements. There is not a single cubic centimeter either on or within the earth that is not some chemical element or other, or some combination of chemical elements. Any scoop of earth, taken from anywhere, reveals itself upon analysis to be nothing but a mix of elements ranging from aluminum to zirconium. Measured from the upper reaches of its atmosphere 4,000 miles straight down to its center, the magnitude of the chemical elements constituting the earth is 260 billion cubic miles.

This enormous quantity of chemical elements is the supply of natural resources provided by nature. It is joined by all of the energy forces within and surrounding the earth, from the sun and the heat supplied by billions of cubic miles of molten iron at the earth’s core to the movement of the tectonic plates that form its crust, and the hurricanes and tornadoes that dot its surface.

Of course, in and of itself, this supply of natural resources is largely useless. What is important from the perspective of economic activity and production is the subset of natural resources that human intelligence has identified as possessing properties capable of serving human needs and wants and over which human beings have gained the power actually to direct to the satisfaction of their needs and wants, and to do so without expending inordinate amounts of labor. This is the supply of economically useable natural resources.

The supply of economically useable natural resources is always only a small fraction of the overall supply of natural resources provided by nature. With the exception of natural gas, even now, after more than two centuries of rapid economic progress, the total of the supply of minerals mined by man each year amounts to substantially less than 25 cubic miles. This is a rate that could be sustained for the next 100 million years before it amounted to something approaching 1 percent of the supply represented by the earth. (These estimates follow from such facts as that the total annual global production of oil, iron, coal, and aluminum, can be respectively fitted into spaces of 1.15, .14, .5, and .04 cubic miles, based on the number of units produced and the quantity that fits into one cubic meter. Natural gas production amounts to more than 600 cubic miles, but reduces to 1.1 cubic miles when liquefied.) Along the same lines, the entire supply of energy produced by the human race in a year is still far less than that generated by a single hurricane.

In view of such facts, it should not be surprising that the supply of economically useable natural resources is not something that is fixed and given and that man’s economic activities deplete. To the contrary, it is not only a very small fraction of the supply of natural resources provided by nature but a fraction that is capable of substantial enlargement for a considerable time to come. Mining operations could be carried on at 100 times their present scale for a million years and still claim less than 1 percent of the earth.

The supply of economically useable natural resources expands as man increases his knowledge of nature and his physical power over it. It expands as he advances in science and technology and improves and enlarges his supply of capital equipment.

For example, the supply of iron as an economically useable natural resource was zero for the people of the Stone Ages. It became an economically useable natural resource only after uses were discovered for it and it was realized that iron could contribute to human life and well-being once it was forged into various objects. The supply of economically useable iron was one thing when it could be mined only by means of digging for it with shovels. It became substantially greater when bulldozers and steam shovels replaced hand shovels. It became greater still when methods were found to separate it from compounds containing sulfur. And so it has been, and can continue to be, with every economically useable natural resource. Their supply has increased and can continue to increase for an indefinite time.

The fact that the earth is made of chemical elements that man neither creates nor destroys implies that from the point of view of physical science production and economic activity can be understood as constituting merely changes in the locations and combinations of the chemical elements. Thus, for example, the production of automobiles represents a movement of some of the world’s iron from such locations as the Mesabi Range in Minnesota to the rest of the country and, in the process, the separation of the iron from elements such as oxygen and sulfur and its recombination with other elements such as chrome and nickel.

The changes in the locations and combinations of the chemical elements that constitute production and economic activity are not at all random but rather are aimed precisely at improving the relationship of the chemical elements to human life and well-being. Iron in automobiles and appliances and in the steel girders that support buildings and bridges stands in a far more useful and valuable relationship to human life and well-being than does iron in the ground. The same is true of oil and coal when brought into a position in which they can be used to heat and light homes and provide power for man’s tools and machines. The same is true of the relationship between all chemical elements that have come to constitute the material stuff of products compared with those elements lying in the ground.

Insofar as the essential nature of production and economic activity is to improve the relationship between the chemical elements constituting the earth and man’s life and well-being, it is also necessarily to improve man’s environment, which is nothing other than those very same chemical elements and their associated energy forces. The notion that production and economic activity are harmful to the environment rests on the abandonment of man and his life as the source of value in the world and its replacement by a non-human standard of value—i.e., the belief that nature is intrinsically valuable.

With man and his life as the standard of value, the environment is improved when it is filled with houses, farms, factories, and roads, all of which serve directly or indirectly to make his life easier. When nature in and of itself is seen as valuable, then the environment is harmed whenever man creates any of these things or does anything whatever that changes the existing state of nature, for he is then destroying alleged intrinsic values.

A final inference that may be drawn is that a leading problem of our time is not environmental pollution but philosophical corruption. It is this that underlies the belief that improvement precisely in the external material conditions of human life is somehow environmentally harmful.

Copyright © 2010 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. 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.

My Blog Resumes

2010-10-26T16:41:00.000-07:00

After almost a year's absence, I've finally found enough free time to write a couple of short articles. In the period ahead, I hope to do more.

George Reisman

Boom-Bust in Microcosm

2010-10-26T16:21:00.000-07:00

The essential features of the boom-bust business cycle can be understood by viewing them in terms of the financial circumstances of a single individual.

Thus, imagine that an ordinary person has been going about his life more or less living within his means. And now, one day, he receives a registered letter from a major bank. The letter informs him that he is the sole heir of a distant relative who possessed a substantial fortune, and that he should come into the bank’s main office in his city to sign the necessary documents and receive all the necessary authorizations to henceforth dispose of this fortune as he sees fit. Naturally, he quickly goes in and takes possession of his new-found fortune.

Whether the fortune in question is $100 million or $10 million, it is certain to have a major impact on this individual’s life from this point forward. For it opens up new worlds to him by enabling him to now afford to buy things he could never dream of buying before. He can now afford a new home, perhaps a mansion. He can buy a whole new wardrobe, travel the world, quit any job that he currently has and does not love. If he is in business, he can expand his business in major ways. If he is not in business, he can start a significant-sized business. And he can now afford to invest and speculate in the stock and real estate markets as well, inasmuch as his new-found wealth makes it possible for him no longer to fear losses of mere hundreds or thousands of dollars; indeed, it appears that he can now afford to lose even a million dollars and still be very rich.

This is the boom period for our individual. His life is easy. He can do so much more than he had ever been able to do before. And his prospects appear limitless. For the rest of his life, he will back upon this period with the greatest fondness and ardently wish to relive it. It is “the good times.”

The Bust

What puts an end to our individual’s life of ease is a second letter. This letter explains that it has now been proven that the relative whose fortune he’s received had obtained it by criminal means. Thus the fortune did not in fact belong to that relative and therefore could not properly be passed on by him to anyone else.

As a result, the bank concludes, our individual is obliged to return the fortune. Accordingly, all of his accounts with the bank in question have been frozen and court orders have been obtained prohibiting him from spending any more of what he has thought of as his inheritance and demanding the return of whatever is left.

Our individual now finds himself buried in a mountain of debt that he cannot repay. He must sell his home or mansion, most likely for less than he had paid for it. (If for no other reason, this will likely be the case simply because of the payment of brokerage fees and the inability to wait very long for the right buyer.) Selling the clothes and many of the other goods he had bought will likely yield only pennies on the dollar. All that he had spent in travelling the world will be a total loss, as will be his expenditures on many other forms of luxury consumption. As for his investments, they may be profitable or unprofitable. However, given our individual’s lack of great financial success prior to his receipt of his inheritance, it is more likely than not that they will have been unprofitable.

The upshot of all this is that our individual’s receipt of his “inheritance” has turned out to be a financial catastrophe for him. By leading him to make massive purchases in the mistaken conviction that he owned a fortune, when in fact he did not, it has led him to live far beyond his means and to squander much or all of the wealth he had prior to his coming into his “inheritance.”

Boom-Bust in the Wider Economy

The pattern of boom-bust in the wider economy is essentially similar to what has been portrayed in the case of this individual. In both cases, the boom is characterized by the appearance of great new and additional wealth that does not in fact exist. The bust is the aftermath of the economic behavior inspired by this illusory wealth.

In the boom-bust cycle of the wider economy, the illusory wealth does not take the form of false inheritances but of newly created paper bank credit that is confused with capital representing real, physical wealth. At the instigation and with the support of the Federal Reserve, in the most recent boom banks created several trillion dollars of new and additional money which they lent out. On the foundation of this fictitious capital, the economic system was led to proceed as though corresponding new and additional physical wealth had come into being. The result, among other things, was the construction of perhaps as many as 3 million new houses for which people could not pay.

In reality, the capital actually available in the boom is insufficient to support the projects that are undertaken on the foundation of the credit expansion. Instead of creating new and additional capital, credit expansion serves to drive up wage rates and the prices of capital goods. This reduces the buying power of capital funds. Ultimately, it creates a situation in which those who normally would have been in a position to lend money find that they cannot lend, or cannot lend as much, because they need the funds to finance their own, internal operations which now must be carried on at higher wage rates and prices of capital goods. At the same time, for the same reason, borrowers find that the funds they have borrowed are insufficient. Thus borrowers need more money while lenders can only lend less. The upshot is a “credit crunch,” in which firms go bankrupt for lack of funds.

In the boom phase, massive debts have been accumulated. As these debts become unpayable, the capital of the firms that have lent the funds is correspondingly reduced. In the process, the capital of the banks that have created the new and additional credit can be wiped out, creating the potential for bank runs and an actual decline the quantity of money in the economic system. The mere specter of such events creates a major increase in the demand for money for cash holding, with the result that spending in the economic system starts to decrease even without an actual fall in the quantity of money.

The conclusion to be drawn is that the key to avoiding “busts” is to avoid the credit expansion and “booms” that cause them. Booms are not periods of prosperity but of the squandering of wealth. The longer they last, the worse is the devastation that follows.

Copyright © 2010 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. 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.

Scholarships for Two Courses Using Reisman's Capitalism as Text and for a Third Using Works of Ayn Rand

2010-09-07T17:23:00.000-07:00

National University of La Jolla, CA has a limited number of scholarships available for three online courses that focus on free-market economics and the philosophical foundations of capitalism. These scholarships are being funded by a grant from the Charles G. Koch Charitable Foundation. The scholarships cover the full tuition for the courses. Two courses (ECO 401 and 402, Market Process Economics I and II, respectively) use Capitalism: A Treatise on Economics by George Reisman as the required textbook. One course (ECO 430 - Economics and Philosophy) uses Ayn Rand’s The Virtue of Selfishness and Capitalism: The Unknown Ideal as the required textbooks. These courses can be taken from anywhere in the world, as long as one has access to the internet. The courses incorporate live chat sessions in which the professor and students interact in a virtual classroom, much as they would in a traditional classroom.

To apply for one or more of these scholarships, send your name, transcript from your high school or university, and an essay of no more than 750 words discussing why you believe you deserve a scholarship and your future education and career plans to Dr. Brian P. Simpson. Send them to bsimpson@nu.edu or 11255 North Torrey Pines Rd.; La Jolla, CA 92037. Please indicate which course or courses for which you are applying for a scholarship. You can apply for one to three scholarships, depending on how many courses you are interested in taking. Note that to receive the scholarship you will have to apply to National University and enroll in the course(s). If you have questions, please contact Dr. Simpson at the email address above or 858-642-8431.

This blog has moved

2010-04-09T11:45:00.001-07:00

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Out Today: Barron's Article by Robert Klein & George Reisman

2009-12-26T10:15:00.001-08:00

Our agreement with Barron's prohibits my reproducing the article here, but the link below will take you to it on Barron's website.

Barrons.com - Central Problem: the Central Bank

A Pro-Free-Market Program for Economic Recovery

2009-11-22T17:49:00.000-08:00

The following is a speech delivered by George Reisman at the Ludwig von Mises Institute's Mises Circle in Newport Beach, California on November 14, 2009.

Good Afternoon, Ladies and Gentlemen:

As you all know, we are in a severe economic downturn. The official unemployment rate now exceeds 10 percent and according to many observers is actually substantially higher. Within the last year or so, our financial system has been rocked to its foundations. The collapse of the housing bubble and the numerous defaults and bankruptcies connected with it brought down major financial institutions, such as Bear-Stearns, Lehman Brothers, and Merrill Lynch. It also brought down numerous small and medium-sized banks and threatened to bring down even such banking giants as Citigroup and Bank of America. The Dow Jones stock average fell from a high of 14,000 to about 6,500. Important retailers such as CompUSA, Circuit City, Mervyns, and Linens ‘N Things went under, as did countless small businesses throughout the country. Practically every shopping mall gives testimony to the severity of the downturn in the form of vacant stores.

The collapse of the housing bubble and the massive losses and mounting unemployment that have resulted from it have unleashed a veritable firestorm of hostility against capitalism, in the conviction that it is capitalism and its economic freedom that are responsible. It is now generally taken for granted that any solution for the downturn requires massive new government intervention, to curb, control, or abolish this or that aspect of capitalism and its alleged evil.

Reflecting this view, in an effort to avoid financial collapse, the government’s response was the enactment of an $800 billion “stimulus package” designed to boost spending throughout the economic system, and the pouring of more than $1.1 trillion of new and additional reserves into the banking system, along with the direct investment of capital in the country’s most important banks and in major automobile firms, in order to prevent them from failing.

As a result of its so-called “investments,” the government now owns a majority interest in the common stock of General Motors, once the flagship company of capitalism. There have been important extensions of government control over the economic system in other areas as well. For example, the stimulus package contains substantial funding for new bureaucracies to control health care and energy production.

The new and additional bank reserves, moreover, are not only massive, but almost all of them are excess reserves. Excess reserves are the reserves available to the banks for the making of new and additional loans, i.e., for new and additional credit expansion. They are the difference between the reserves the banks actually hold and the reserves they are required to hold by law or government regulation.

To gauge the significance of today’s excess reserves, one should consider that total bank reserves as recently as July of 2008 were on the order of just $45 billion, and excess reserves were less than $2 billion. Those $45 billion of reserves supported a total of checking deposits in one form or another on the order of $6 trillion (a sum that included traditional checking deposits, so-called “sweep accounts,” money-market mutual-fund accounts, and money-market deposit accounts inasmuch as checks could be written against them). That was a ratio of checking deposits to reserves in excess of 100 to 1, or equivalently, a fractional reserve of less than 1 percent.

Today, of the $1.1 trillion-plus of total reserves, all but approximately $62 billion of required reserves are excess reserves. As of the week of November 4, excess reserves were $1.06 trillion.

Fortunately, for the time being at least, the banks are afraid to lend very much of this sum, but the potential is clearly there for a massive new credit expansion and corresponding increase in the quantity of money. Recognition of this potential is reflected in the current surge in the price of precious metals. Indeed, since $1.06 trillion of new and additional excess reserves are more than 22 times as large as the $45 billion of reserves that were sufficient not so long ago to support $6 trillion of checking deposits, they might potentially support checking deposits in excess of $132 trillion. In effect, what has happened is that our recent brush with massive deflation has turned out to be an occasion for a massive inflationary fueling period in the effort to avoid that deflation.

Inflation and Deflation: Credit Expansion and Malinvestment

The title of my talk, of course, is “A Pro-Free-Market Program for Economic Recovery.” What this entails changes as the government adds new and additional measures that create new and additional problems. If I were giving this talk a year ago, my discussion would have been weighted somewhat more heavily toward deflation and somewhat less heavily toward inflation than is the case today.

A fundamental fact is that our present monetary system is characterized both by irredeemable paper money, i.e., fiat money, and by credit expansion. There is no limit to the quantity of fiat money that can be created. This is the foundation for potentially limitless inflation and the ultimate destruction of the paper money, when the point is reached that it loses value so fast that no one will accept it any longer.

The fact that our monetary system is also characterized by credit expansion is what creates the potential for massive deflation—for deflation to the point of wiping out the far greater part of the money supply, which in the conditions of the last centuries has been brought into existence through the mechanism of credit expansion.

Credit expansion is what underlay the housing bubble, and before that, the stock market bubble, and before that a long series of other booms and busts, running through the Great Depression of 1929 that followed the stock market boom of the 1920s, through the 19th and 18th Centuries all the way back to the Mississippi Bubble of 1719, and perhaps even further back.

Credit expansion is the lending out of money created virtually out of thin air. It is money manufactured by the banking system, always with at least the implicit sanction of the government, which chooses not to outlaw the practice. Since 1913, credit expansion in this country has proceeded not only with the sanction but also with the approval and active encouragement of the Federal Reserve System, which, as I’ve shown, is now desperately trying to reignite the process as the means of recovering from the current downturn.

The new and additional money is created by the banking system through the lending out of funds placed on deposit with it by its customers and still held by those customers in the form checking accounts of one kind or another. The customers can continue to spend those checking deposits themselves, simply by writing checks or using other, similar methods of transferring their balances to others.

But now, at the same time, those to whom the banks have lent in this way also have money. To illustrate the process, imagine that Mr. X deposits $1,000 of currency in his checking account. He retains the ability to spend his $1,000 by means of writing checks. From his point of view, he has not reduced the amount of money in his possession any more than if he had exchanged $1,000 in hundred-dollar bills for $1,000 in fifty-dollar bills, or vice versa. He has merely changed the form in which he continues to hold the exact same quantity of money.

But now imagine that Mr. X’s bank takes, say, $900 of the currency that he has deposited and lends it to Mr. Y. Mr. Y now possess $900 of spendable money in addition to the $1,000 that Mr. X continues to possess. In other words, the quantity of money in the economic system has been increased by $900. Mr. Y’s loan has been financed by the creation of new and additional money virtually out thin air. This is the nature and meaning of credit expansion.

Now nothing of substance is changed, if instead of lending currency to Mr. Y, Mr. X’s bank creates a new and additional checking deposit for Mr. Y in the amount of $900. (This, in fact, is the way credit expansion usually occurs in present-day conditions.) There will once again be $900 of new and additional money. There will be altogether $1,900 of money resting on a foundation merely of the $1,000 of currency deposited by Mr. X.

The $1,000 of currency that Mr. X’s bank holds is its reserve. If Mr. Y deposits his currency or check in another bank, it is the banking system that now has $1,000 of reserves and $1,900 of checking deposits. On the foundation of these reserves, it can create still more money and use it in the further expansion of credit. Indeed, as we have seen, the process of credit expansion is capable of creating checking deposits more than 100 times as large as the reserves that support them.

Credit expansion makes it possible to understand what caused the housing bubble and its collapse. From January of 2001 to December of 2007, credit expansion took place in excess of $2 trillion. This new and additional money made available in the loan market drove down interest rates, including, very prominently, interest rates on home mortgages. Since the interest rate on a mortgage is a major factor determining the cost of homeownership, lower mortgage interest rates greatly encouraged buying houses.

This artificially increased demand for houses, made possible by credit expansion, soon began to raise the prices of houses, and as the new and additional money kept pouring into the housing market, home prices continued to rise. This went on long enough to convince many people that the mere buying and selling of houses was a way to make a good living. On this basis, the demand for houses increased yet further, and finally a point was reached where the median-priced home was no longer affordable by anyone whose income was not far in excess of the median income, i.e., only by a relatively few percent of families.

In the middle of 2004, the Federal Reserve became alarmed about the situation and its implications for rising prices in general, and over the next two years progressively increased its Federal Funds interest rate from 1 percent to 5.25 percent. This rise in the Federal Funds rate signified a reduction in the flow of new and additional excess reserves into the banking system and thus its ability to make new and additional loans. This served to prick the housing bubble.

But before its end, perhaps as much as a trillion and a half dollars or more of credit expansion and its newly created money had been channeled into the housing market. Once the basis of high and rising home prices had been removed, home prices began to fall, leaving large numbers of borrowers with homes worth less than they had paid for them and with mortgages they could not meet.

The investments in housing represented a classic case of what Mises calls “malinvestment,” i.e., the wasteful investment of capital in inherently uneconomic ventures. The malinvestment in housing was on a scale comparable to the credit expansion that had created it, i.e., about $2 trillion or more. That’s about how much was lost in the housing market. When the money capital created by credit expansion was wiped out, the lending, investment spending, employment, and consumer spending that had come to depend on that capital were also wiped out.

And, particularly important, as vast numbers of home buyers defaulted on their mortgages, the mounting losses on mortgage loans increasingly wiped out the capital of banks and other financial institutions, setting the stage for their failure.

The current plight of the economic system is the result of credit expansion and the malinvestment it engenders. Capital in physical terms is the physical assets of business firms. It is their plant and equipment and inventories and work in progress. As Mises never tired of pointing out, capital goods cannot be created by credit expansion. All that credit expansion can do is change their employment and shift them into lines where their employment results in losses. The empty stores and idle factories around the country are very much the result of the loss of the capital squandered in malinvestment in housing.

Other Consequences of Credit Expansion

The plight of the economic system is also the result of other consequences of credit expansion, namely, the encouragement it gives to high debt and dangerous leverage. This is the result of the fact that while credit expansion drives down market interest rates, the spending of the new and additional funds it represents serves to drive up business sales revenues and what the old classical economists called the rate of profit. This combination makes borrowing appear highly profitable and greatly encourages it. Individuals and business firms take on more and more debt relative to their equity. They expect borrowing to multiply their gains.

In addition, credit expansion is responsible for many business firms operating with lower cash holdings relative to the scale of their economic activity, in many cases, dangerously low cash holdings. Many businessmen develop the attitude, why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.

Thus, when credit expansion finally gives way to the recognition of vast malinvestments and the accompanying loss of huge sums of capital, the economic system is also mired in debt and deficient in cash. Thus, it is poised to fall like a house of cards, in a vast cascade of failures and bankruptcies, first and foremost, bank failures.

The Road to Recovery

The road to recovery from our economic downturn can be understood only in the light of knowledge of credit expansion and its consequences. The nature of credit expansion and its consequences imply the nature of the cure.

The prevailing—Keynesian—view on how to recover from our downturn totally ignores credit expansion and its effects. It believes that all that counts is “spending,” practically any kind of spending. Just get the spending going and economic activity will follow, the Keynesians believe.

This conception of things, which underlies the support for “stimulus packages” and anything else that will increase consumer spending is mistaken. It rests on a fundamental misconception. It ignores the fact that the fundamental problem is not insufficient spending, but insufficient capital due to the losses caused by malinvestment. It ignores the further facts that credit expansion has brought about excessive debt and, however counterintuitive this may seem, insufficient cash. Too little capital, too much debt, and not enough cash are the problems that countless business firms are facing today as a result of the credit expansion that generated the housing bubble.

Just as a reminder: the way that credit expansion brings about a situation of too little cash while itself constituting a flood of cash is that it makes it appear profitable to invest every last dollar of cash in the expectation of being able easily and profitably to borrow whatever cash may be needed.

What this discussion implies is that an essential requirement of economic recovery is that the widespread problems in the balance sheets of business firms must be fixed. Business firms need more capital, less debt, and more cash. When they achieve that, business confidence will be restored.

Ironically what could achieve at least less debt and more cash in the hands of business, and thus actually do some significant good is if when people received government “stimulus” money, they did not spend very much of it, or, better still, any of it at all. To the extent that all people did with money coming from the government was pay down debt and hold more cash, they would be engaged in a process of undoing some of the major damage done by credit expansion. They would be reducing their burden of debt and increasing their liquidity, thereby increasing their security against the threat of insolvency. Such behavior, of course, would be regarded by Keynesians as constituting a failure of their policies, because in their eyes, all that counts is consumer spending.

The 100-Percent Reserve

The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits. Ideally, the 100-percent reserve would be in gold. And that’s ultimately what we should aim at, for all of the reasons Rothbard explained. [1] But even a 100-percent reserve in paper would do the job of totally preventing all future credit expansion and, equally important, all declines in the money supply.

(Because the 100-percent gold reserve standard is the long-run ideal of advocates of sound money, I cannot help but feel a sense of great satisfaction in the fact that a major step toward its achievement is what turns out to be urgently needed as a matter of sound current economic policy.)
In the simplest terms, to establish a 100-percent-reserve system in terms of paper, the government would simply print up enough additional paper currency so that when added to the paper currency the banks already have, every last dollar of their checking deposits would be covered by such currency. (Strictly speaking, a significant part, and for some months now the far greater part, of the reserves of the banks are not in actual currency but in checking deposits with the Federal Reserve. For the sake of simplicity, however, we can think of the checking deposits held by the banks with the Federal Reserve as a denomination of currency, since, for the banks, they are fully as interchangeable with currency as $50 bills are with $100 bills and vice versa.)

To illustrate the process of achieving a 100-percent reserve, imagine that total checking deposits are $3 trillion. In that case, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. Through various programs, such as purchasing bad assets, the Fed has in fact already brought the total reserves of the banks up to over a trillion dollars, but almost all of those reserves, as we’ve seen, are excess reserves, a ready foundation for a massive new credit expansion, since excess reserves can be lent out.

What my example implies is adding to the $1.1 trillion of reserves the banking system now has, a further $1.9 trillion and making all $3 trillion of reserves required reserves. This would mean that the banks could not engage in any lending of these reserves and thus would be unable to finance credit expansion or any increase in the supply of checking deposits on the strength of them. The money supply in the hands of the public and spendable in the economic system would thus not be increased. That would happen only if and to the extent that the 100-percent reserve principle were breached.

Under a 100-percent reserve, checking depositors could simultaneously all demand their full balances in cash and the banks would be able to pay them all. Depositors’ demand for cash would not create a problem and no amount of losses by the banks on their loans and investments would prevent them from honoring their checking deposits immediately and in full. Thus the checking deposit component of the money supply could not fall and nor, of course could its other component which is the paper money in the hands of the public, usually described as the currency component. Thus, there could simply be no deflation of the money supply. And, as I’ve said, because all reserves would be required reserves, there would simply be no reserves whatever available for lending out, and thus no credit expansion whatever. The expression “killing two birds with one stone” could not have a better application.

In a addition, a significant by-product of a 100-percent reserve system would be that the FDIC would no longer serve any purpose and thus could be abolished.

Now an essential prerequisite of the 100-percent reserve is knowing the size of checking deposits, so that it will be known how much the 100-percent reserve needs to cover. At present, when one allows for such things as “sweep accounts,” money-market mutual funds, and money-market deposit accounts, the magnitude of checking deposits to which the 100-percent reserve would apply can plausibly be argued to range from about $1.5 trillion to $6 trillion. It is very solidly $1.5 trillion, but does in fact range up to $6 trillion in that checks can be written on the additional sums involved, at least from time to time and for some large minimum amount.

To clearly establish the magnitude of checking deposits, bank depositors should be asked if their intention is to hold money in the bank, ready for their immediate use and transfer to others, or to lend money to the bank. In the first case, their funds would be in a checking account, against which the bank would have to hold a 100-percent reserve. In the second case, their funds would be in a savings account, against which the bank could hold whatever lesser reserve it considered necessary. In this case, the bank’s customers could not spend the funds they had deposited until they withdrew them from the bank.

As I’ve said, the long-run goal in connection with the 100-percent reserve would be ultimately to convert it to a 100-percent gold reserve system. At that time, following ideas of Rothbard further, the gold reserve of the Fed would be priced high enough to equal the currency and checking deposits of the country and be physically turned over to the individual citizens and the banks in exchange for all outstanding Federal Reserve money. The Fed would then be abolished. But this is a distinct and much later step in pro-free-market reform.

The 100-Percent Reserve and New Bank Capital

It should be realized that a major consequence of the establishment of a 100-percent-reserve system could be a corresponding enlargement of the capital of the banking system and thus an ability to cover even very great losses and thereby avoid such things as government bank bailouts and takeovers.

Consider the balance sheet of an imaginary bank. It’s got checking-deposit liabilities of $100. Initially, it has assets of $105, which implies that on the liabilities side of its balance sheet it has capital of $5 in addition to its checking-deposit liabilities of $100.

Now unfortunately, malinvestment has resulted in a loss of $20 in the banks’ assets, in the part of its assets consisting of loans and investments. As a result, its total assets are reduced from $105 to $85 and its capital is completely wiped out and becomes negative in the amount of $15.

However, on its asset side the bank still has some cash reserve, say, $10. If $90 of new and additional reserves were added to these $10, to bring the bank’s reserves up to 100-percent equality with its checking deposits, the bank’s asset total would also be increased by $90. This $90 increase on the bank’s asset side would have to be matched by a $90 increase on its liabilities side, specifically by a $90 increase in its capital. Its capital would go from minus $15 to plus $75.

Applying this to the banking system as a whole in transitioning to a 100-percent reserve, we can see that the creation of such a vast amount of new bank capital would be entailed as easily to overcome whatever losses the banks might have suffered in their loans and investments.

As explained, if checking deposits were $3 trillion, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. If this had been done in September of 2008, bringing reserves up to $3 trillion would have required adding $2.955 trillion of new and additional reserves to the $45 billion or so of reserves the banks already had. This vast addition on the asset side of the banks’ balance sheets would have implied an equivalent addition to the banks’ capital on the liabilities side. No matter how bad the banks’ assets were, I think it’s virtually certain that an additional sum of this size would have been far more than sufficient to cover all the losses that the banks had incurred in their bad loans and investments. Their capital would have ended up being increased to the extent the additional reserves exceeded the losses in assets under the head of loans and investments.
The government’s bailout program of stock purchases in the banks would have been avoided, along with all of its subsequent interference in matters of bank management.

Now, as we’ve seen, in fact the Fed has already supplied a vast amount of reserves, about $1.1 trillion, to the banks through various programs such as purchasing bad assets. If the 100-percent reserve principle were adopted now, many or most of those assets could be taken back and the programs that created them cancelled.

Thus, what I’ve shown here is how transitioning to a 100-percent reserve would guarantee the prevention both of new credit expansion and of deflation of the money supply. It could also provide additional capital to the banking system on a scale almost certainly far more than sufficient to place it on a financially sound footing. To avoid what would otherwise likely be an excessive windfall to the banks, it would be possible to match a more or less considerable part of the increase in their assets provided by the creation of additional reserves, with the creation of a liability of the banks to their depositors, perhaps in the form of some kind of mutual-fund accounts. Thus, the newly created reserves might provide a financial benefit to the banks’ depositors as well as to the banks.

Toward Gold

Of course, a 100-percent reserve system in which the reserves are fiat money does not address the problem of preventing inflation of the fiat money. It would still be possible for the government to inflate the fiat money without restraint. That is why it is necessary to have gold in the monetary system, serving as a restraint on the amount of currency and reserves.

Thus, an important ancillary measure in connection with the transition to a 100-percent paper-reserve system would be for the government to demonstrate a serious intent to move to a gold standard. Obliging the Federal Reserve to carry out a program of regular and substantial gold bullion purchases might accomplish this. In any event, it would be an essential prerequisite for someday achieving gold reserves sufficient to make possible the establishment of a 100-percent-reserve gold system. Along the way, this measure should lead to the day when purchases of gold bullion were the only source of increases in the supply of currency and reserves.

Establishing the Freedom of Wage Rates to Fall

Along with stabilizing the financial system through the adoption of a 100-pecent reserve, it’s absolutely essential to establish the freedom of wage rates and prices to fall. This is what is required to eliminate mass unemployment. Whatever the level of spending in the economic system may be, it is sufficient to buy as much additional labor and products as is required for everyone to be employed and producing as much as he can.

Nothing could be more obvious if one thinks about it. Assume, as is the case today, that there is 10 percent unemployment, with only 9 workers working for every 10 who are able and willing to work. The same total expenditure of money that today employs only 9 workers would be able to employ 10 workers, if the average wage per worker were 10 percent less. At nine-tenths the wage, the same total amount of wages is sufficient to employ ten-ninths the number of workers. It’s a question of simple arithmetic: 1 divided by 9/10 equals 10/9.

(Obviously, this is an overall, average result. In reality, some wage rates would need to fall by less than 10 percent and others by more than 10 percent.)

Of course, total wage payments are not fixed in stone. They can change. And in response to a fall in wage rates to their equilibrium level, to eliminate mass unemployment, they would increase. This is because prior to their fall, investment expenditures have been postponed, awaiting their fall. Once that fall occurs, those investment expenditures take place.

Finally, with debt levels sufficiently reduced and cash holdings sufficiently high, and thus business confidence restored, there is no reason to believe that a fall in wage rates could abort the process of recovery as the result of already employed workers earning less and thus spending less before new and additional workers were hired. The cash reserves and financial strength of business firms would enable them easily to ride out any such situation. And thus mass unemployment would simply be eliminated.

What stops wage rates from falling, what makes it actually illegalfor them to fall, and which thus perpetuates mass unemployment, is the underlying pervasive influence of the Marxian exploitation theory. That doctrine is responsible for the existence of such things as minimum-wage laws and coercive labor unions and their above-market wage scales.

The most important fundamental requirement for achieving a free market in labor is the total refutation of the exploitation theory and its complete discrediting in public opinion. Such a refutation will show that it is not government and labor unions that raise real wages but businessmen and capitalists, and that essentially, all that unions do is cause unemployment and a lower productivity of labor and thus prices that are higher relative to wage rates. This knowledge is what is required to make possible the repeal of minimum-wage and pro-union legislation and thus achieve the fall in wage rates that will eliminate mass unemployment.

Summary

In summation, my pro-free-market program for economic recovery is a provisional 100-percent-paper-money-reserve system applied to checking deposits, accompanied by a demonstrable commitment to ultimately achieving a 100-percent-gold-reserve system. The 100-percent reserve in paper would put an end to all further credit expansion and at the same time make the money supply incapable of being deflated. Its establishment would also greatly increase the capital of the banking system. It would do so by more than enough to cover all the losses on loans and investments incurred in the aftermath of the collapse of the housing bubble and thus make possible the elimination of government ownership of common stock in banks and its interference in bank management. What it would not do is control the increase in paper currency and paper-currency reserves. That will require a 100-percent gold reserve system.

Finally, the freedom of wage rates and prices to fall must be established through the repeal of pro-union and minimum-wage legislation, and more fundamentally, the education of the public concerning the errors of the Marxian exploitation theory and their replacement with actual knowledge of what determines wages and the general standard of living. To say the least, this will certainly not be an easy agenda to follow, inasmuch as it must begin in the midst of a Marxist occupation of our nation’s capital.

Thank you.

[1] Rothbard deserves credit for his ideas on money, especially for his views on the subject of the 100-percent-gold-reserve system. This acknowledgement, however, should not be construed in any way as an endorsement of Rothbard’s belief in a system of “competing governments” or his belief that the United States was the aggressor against Soviet Russia in the cold war.

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.

University Course Using Reisman and Rand as Texts

2009-11-06T21:12:00.000-08:00

Maoist in the White House

2009-10-18T15:27:00.000-07:00

Anita Dunn, is described by the online encyclopedia Wikipedia as “one of the major decision makers of the Obama campaign” and as one of Obama’s “four top advisers (along with David Axelrod, David Plouffe, and Robert Gibbs).” She currently holds the position of “White House Communications Director.” She is married to the President's personal lawyer, Robert Bauer. In 2008, Newsweek named Dunn and Bauer the new "power couple" in Washington, D.C.

This last June, at a high-school commencement exercise, Dunn had this to say:

“… the third lesson and tip actually comes from two of my favorite political philosophers Mao Tse Tung and Mother Teresa, not often coupled with each other, but the two people that I turn to most to basically deliver a simple point which is you’re going to have make choices, you’re going to challenge, you’re going to say why not…. In 1947, when Mao Tse Tung was being challenged within his own party on his plan to basically take China over, Chiang Kai-Shek and the nationalist Chinese held the cities, they had the army, they had the air force, they had everything on their side and people said how can you win, how can you do this, how can you do this, how can you do this against all of the odds against you, and Mao Tze Tung said, you fight your war and I’ll fight mine.” (Dunn’s remarks appear in an online video at http://thecaucus.blogs.nytimes.com/2009/10/16/white-house-vs-fox-chairman-mao/)

Back in late 2002, on the occasion of retiring Senator’s Strom Thurmond’s 100th birthday, Trent Lott, then the Majority Leader of the US Senate, said, "I want to say this about my state: When Strom Thurmond ran for president, we voted for him. We're proud of it. And if the rest of the country had followed our lead, we wouldn't have had all these problems over all these years, either." (See http://archives.cnn.com/2002/ALLPOLITICS/12/09/lott.comment/)

Because Thurmond had campaigned in 1948 on a platform advocating racial segregation and Lott’s statement was—correctly—taken as an implicit endorsement of segregation, the result of his statement was an outcry from the media, various public figures, and other Senators, of such dimensions that he was soon forced to resign as Senate Majority Leader.

This was despite his protestation and apology that “A poor choice of words conveyed to some the impression that I embraced the discarded policies of the past. Nothing could be further from the truth, and I apologize to anyone who was offended by my statement." Thurmond had subsequently abandoned his segregationist position and, consistent with this, Lott said, "My comments were not an endorsement of his positions of over 50 years ago, but of the man and his life."

Nevertheless, perhaps there simply was no valid explanation or justification for Lott’s comment, and his resignation, therefore, was appropriate. But at least Lott was greatly embarrassed by what he had said and did offer a public apology of some kind.

My question is, where is the outcry against Anita Dunn? Her remarks were not limited to a casual comment that had vicious implications. Rather they constituted a prolonged, blatantly explicit, and far more fundamental endorsement of an incalculably worse person and program than did those of Trent Lott. She has dared to say that one of her “favorite political philosophers” is one of the greatest mass murderers in the history of the world, a man whose takeover of China was responsible for as many as 70 million deaths during his reign. She has dared to present the words of this monster as a source of inspiration to youth!

Perhaps she would like to rephrase her remarks. Perhaps she would like to substitute Adolf Hitler for Mao Tse Tung. Perhaps she would like to say something like this:

“In the days when the Führer was being challenged even within his own party on his plan to exterminate the Jews of Europe, the Jews and their allies controlled many major businesses, they controlled many major banks, they owned many major newspapers and magazines. They were protected by the rule of law, by trial by jury, and by laws against robbery, kidnapping, and murder. They had everything on their side and people said to Hitler how can you win, how can you do this, how can you do this, how can you do this against all of the odds against you, and Hitler said, you fight your war and do your destruction and I’ll fight mine and do my destruction.”

If the United States had an honest press and media, one committed to the principle of individual rights, their outrage would drive Anita Dunn out of Washington, D.C. just by hurling her words back at her. They would make her such a “hot potato” that no one would dare to defend her in her infamy.

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.

Ludwig von Mises's Birthday

2009-09-29T15:58:00.000-07:00

Today is the 128th birthday of Ludwig von Mises. Please see the tribute to him that appeared on this blog three years ago.

Replies to Readers of My Article on the Real Right to Medical Care

2009-08-08T16:36:00.000-07:00

From a reader in Cambridge, ON, Canada:
RE:The Real Right To Medical Care....

[T]hanks for the fantastic article on real medical care vs. socialized
medicine. I am writing this email because I am a young Canadian who has a socialized medical system. While I cannot argue your logic for a true free market medical care system, I did finish your piece feeling like there is one hole. Not to say the idea is flawed, by no means, but if individuals have a right to life, and had an illness that was fatal if not treated but could not afford said treatment, where does that leave doctors? You mention charity, and I'm sure to a degree that would exist, but if you were a practicing medical doctor, and knew you could save a life with a simple procedure, how many could you turn away based on cost? While I wholeheartedly agree with the principles you outline in your piece, I found it fascinating, I did get the sense that the issue was not broached for that reason. Now I realize this may only be a small percentage of the population in a truly free market, but a life is a life at the end of the day. I hope you find the time for at least a modest response, if I somehow missed you stating said circumstance in your piece, please simply direct me to said section.

Dear Reader:

Thank you for your note. The right to life is not a right to be kept alive by other people, against their will. If there were such a right, then you and I and everyone else not in poverty would have to be devoting our lives to keeping alive countless numbers of impoverished people all over the world. To the contrary, paraphrasing Ayn Rand, the right to life is the right of an individual to take all of the [peaceful, non-coercive] actions that sustain and promote his life. This understanding of the right to life is incompatible with the notion of people having a right to be kept alive at others’ expense.

Of course, people may wish to give to charity within the limit of their perceiving that doing so enhances their own lives. The funds raised through charity together with the time doctors were willing to provide to charity patients would undoubtedly be concentrated on cases in which all that was necessary were relatively simple, inexpensive procedures that would save life or limb. But this cannot be a solution for all those medical problems requiring more complex and costly treatments that are beyond the means of patients and of the willingness and ability of people to provide charity.

What the solution for these medical problems is, is economic progress, which continuously improves medical care and makes it less and less expensive, while at the same times making practically all other goods and services better and less expensive as well, thereby freeing up more income to be spent on medical care if necessary. The foundation of economic progress, of course, is individual freedom and capitalism.

Always, however, there will be some people who will die because still more and better care, that others might have provided, was beyond their reach. There is simply no way to avoid this. It’s an aspect of the fact that man is mortal.

Trying to avoid it by compelling everyone to devote his life to keeping other people alive, beyond his perception of the personal, value to his own life of doing so, destroys the incentives to produce and advance, and thus ultimately does no good to anyone.

Because of this destruction, attempts to enforce such an obligation always stop short after a time. In fact, this is what we are seeing right now in the United States in the proposed roll backs in Medicare and denial of treatment to the elderly. It’s what already has taken place in Great Britain, and, I believe, in Canada and everywhere else that medical care has been collectivized long enough.

The government simply lacks the means to provide everyone with unlimited medical care. Eventually, it has to impose limits. But its limits entail depriving people of medical care who could have afforded it, if left free to use their own resources for that purpose. Its limits entail aborting further progress in medical in order to hold down the cost of operating its collectivized system.

There are two sorts of limits to medical care. One is reality, which encompasses the state of scientific and technological knowledge, the state of capital accumulation, the resulting productivity of labor, and the relative performance of different individuals cooperating together under economic competition and the pursuit of individual self-interest. Under capitalism, as the result of the pursuit of self-interest and competition, this limit is continually pushed outward and the level of care for everyone continually improves. (See my book Capitalism, chap. 9, for further discussion of this.)

The other kind of limit to medical care is arbitrary government fiat. The government takes over medical care and it decides who is to receive care and to what extent. Under government control, the limit to medical care tends to be frozen, indeed, declining. Progress in medical care is largely prohibited as a threat to the government’s budget and decline accompanies the coming to the fore of doctors who are content to be mere tools of government policy; it also accompanies the general economic decline that results from related government policies that are hostile to capital accumulation and economic efficiency.

There’s undoubted more to be said. But I hope that these remarks serve to address the matters you raised.

Sincerely,
George Reisman

From a reader in Perth, Western Australia
Subject: stupid Samaritan patsy

"It should be obvious that such an arrangement entails the utter perversion of the right to medical care."

Dear Dr Reisman,

I find it astounding that a man who can write some many thousands of words on a topic, in apparently grammatically good English, can have the whole concept so wrong.
Altruism, empathy - those are the core concepts of society, not the market place. Health care is part of the altruistic nature of society, and it arose not out of purely commercial needs, it arose because most people on this planet have empathy for those who are sick, those who are unwell. People form collective societies for exactly that reason, to share the common burdens and chance misfortunes in life equally and fairly between those can and those who can't afford it.

I assume you are basically an anarchist with your attitude. All people are free from obligations to any other person, no matter what their circumstances. Hence the idea of Government to provide common services is unnecessary. I guess you probably believe that education should also be a purely commercial domain as well.

It scares me that you may have been teaching these attitudes to your economics students, the world is a poorer place if you have done so. Did you ever lecture or write on the economics of altruism or is it so far away from your moral centre that you can't understand the concept?

You are one of the people who left the man in the ditch for the stupid Samaritan patsy to come along and waste his good economic resources of food, water and labour on the man who for no reason of his own was in dire needs.

Your attitude may seem intellectually clever, put it is morally poor.

As a contrast, here in Australia we have fine collective system of medical care that works extremely well for the citizens of Australia. It is affordable, and we have better health care than the USA.

So, Dr Reisman, I think you need to look at the poor, the unemployed, those born with impediments such as lower intelligence, mental or physical disabilities and try to apply your huge mind to putting yourself into their position. It is probably difficult for you to do so, but should you be successful, you will hopefully feel remorse for your shockingly selfish position on health care.

Dear Reader:

Altruism is a philosophy of misery, suffering, poverty, and the hatred of man for man. It is the philosophy that ruled the Dark Ages and underlay such accompaniments as the Iron Maiden, the rack, and burning people alive at the stake.

Civilization is founded on the philosophy of egoism and recognition of the individual's right to the pursuit of his own, selfish happiness and the corollary recognition that the means of accomplishing this is voluntary, peaceful social cooperation under the division of labor. The gains from the division of labor give to each individual a rational self-interest in the existence of other people and in their individual freedom and right to the pursuit of their own happiness. This is the arrangement that progressively increases the supply of goods and services and improves life for everyone. (For elaboration, see Ludwig von Mises's Socialism and my Capitalism.)

Under this arrangement—i.e., capitalism—the individual comes to regard other people with benevolence, because their existence improves his existence. In such conditions, people are prepared, within limits, to help others who suffer through no fault of their own. Thus, they help victims of earthquakes, floods, and all other natural disasters. They help people who cannot help themselves, including those who are stuck in a ditch. But that is not their primary goal or, as a rule, a major goal. It is secondary and rests upon their pursuit of their own happiness.

In contrast, when altruism prevails, each individual must regard all other individuals as a source of loss and misery. Their existence is a constant claim against his wealth and time and thus against his ability to enjoy his life. In such circumstances, the individual easily reaches the conclusion that he would be better off if those others did not exist. He would then be free of the burdens they impose.

Historically, the United States was characterized by the individual’s freedom to pursue his own happiness (a basic right enumerated in our Declaration of Independence). Thus, not surprisingly, it was also known for the goodwill and benevolence of its citizens. In contrast, the Dark Ages and the Soviet Union, two leading exemplars of altruism, were known for their hatred and barbaric treatment of human beings. What results from the prevalence of altruism is conveyed in a widely told story in the Soviet Union. It was the story of the Russian who is asked by God to wish for something that he would like God to do for him, on the understanding that whatever God does for him, he will do twice as much for his neighbor. After hearing this offer, the Russian asks that God pluck out one of his eyes, so that his neighbor can lose both eyes. (The story was reported by Hedrick Smith, in his book The New Russians, New York: Random House, 1990, p. 204.)

So much for altruism.

George Reisman

P. S. For elaboration on the contrasting natures of egoism and altruism, see the writings of Ayn Rand, in particular, Atlas Shrugged and The Virtue of Selfishness.

P.P.S. Concerning education, I believe that it should be stricly private. Schools would be legally free to operate on a commercial or non-commercial basis, as they chose. Individual would be free to support non-commercial schools and to provide scholarships for students attending for-profit schools. The main thing is that the government should not be allowed to attempt to improve students' minds on a foundation of pointing a gun at anyone's head, such as unwilling taxpayers, unwilling parents, and unwilling students.

Finally, I am not an anarchist but a supporter of government that is limited to the defense of the rights of the individual against the initiation of physical force, including fraud.

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

Stopping the Obama Plan

2009-08-04T22:04:00.000-07:00

PLEASE LISTEN TO THE ASSAULT ON SENIORS OVER 65 IN THE OBAMA HEALTHCARE PLAN--"THEY JUST AREN'T WORTH IT!"

http://fredthompsonshow.com/premiumstream?dispid=320&headerDest=L3BnL2pzcC9tZWRpYS9mbGFzaHdlbGNvbWUuanNwP3BpZD03MzUxJnBsYXlsaXN0PXRydWUmY2hhcnR0eXBlPWNoYXJ0JmNoYXJ0SUQ9MzIwJnBsYXlsaXN0U2l6ZT01

See also the two videos on this excellent post on the subject: http://exposingliberallies.blogspot.com/2009/08/reality-of-obama-care.html

And see http://www.defendyourhealthcare.us/

I hope you will pass these links along to your own lists.

The Real Right to Medical Care Versus Socialized Medicine

2009-08-02T19:32:00.001-07:00

I've just posted on the TJS web site www.capitalism.net a reprint of my 1994 essay THE REAL RIGHT TO MEDICAL CARE VERSUS SOCIALIZED MEDICINE. I wrote this essay to help defeat the Clinton plan for socialized medicine. In all essentials it’s as valid today as it was then. It’s a demonstration that government intervention inspired by the philosophy of collectivism is the cause of America's medical crisis and that a free market in medical care is the solution for the crisis. I urge everyone who wants to help defeat the essentially similar Obama scheme to read it.

Credit Expansion, Crisis, and the Myth of the Saving Glut

2009-07-04T15:41:00.000-07:00

Contents

Introduction

Credit Expansion, Standard Money, and Fiduciary Media

The Stock Market and Real Estate Bubbles

Evasion of Responsibility for the Bubbles

The Saving Glut Argument

The Non-Existence of a Saving Glut

Current Account Deficits as a By-Product of the Increase in the Quantity of Money

Net Saving as a By-Product of the Increase in the Quantity of Money

Summary and Conclusion

Introduction
Readers who are already familiar with the nature of credit expansion and the concepts of standard money and fiduciary media should skip the first section. Readers who are also already familiar with the role of credit expansion and fiduciary media in generating the stock market and real estate bubbles should skip the second section as well and proceed directly to the third section “Evasion of Responsibility for the Bubbles.”

Credit Expansion, Standard Money, and Fiduciary Media
Since the mid-1990s, the United States has experienced two major financial bubbles: a stock market bubble and a housing bubble. In both instances, the bubble was inaugurated and sustained by a process of massive credit expansion, i.e., the lending out of newly created money by the banking system, operating with the sanction and support of the country’s central bank, the Federal Reserve System.

The concept of credit expansion rests on two further concepts: standard money and fiduciary media. Standard money is money that is not a claim to anything beyond itself. It is that which, when received, constitutes payment. Under a gold standard, standard money is gold coin or bullion. Under a gold standard, paper notes, which were claims to gold, payable on demand, were not standard money. They were merely a claim to standard money, which was physical gold. The dollar was defined as a physical quantity of gold of a definite fineness, i.e., approximately one-twentieth of an ounce of gold nine-tenths fine.

Today in the United States, standard money is the irredeemable paper currency issued by the United States government. That money is not a claim to anything beyond itself. Receipt of such money today constitutes final payment.

The total of standard money today is the sum of the outstanding quantity of paper currency plus the checking deposit liabilities of the Federal Reserve System. Since the Federal Reserve has the power to print as much currency as it likes, and thus is always in a position to redeem its outstanding checking deposits in currency, these checking deposit liabilities can properly be viewed as a kind of different denomination of the paper currency, much like hundred dollar bills that are to be redeemed for notes of smaller denomination, or one-dollar bills that are to be redeemed for notes of larger denomination. Thus the total supply of standard money is to be understood as the sum of the supply of paper currency in the narrower sense plus the checking deposit liabilities of the central bank.

These two magnitudes, currency plus checking deposit liabilities of the central bank, when taken together, are known as the “monetary base.”

In December of 1994, the monetary base was $427.3 billion. In December of 1999, it was $608 billion. In December of 2007, it was $836.4 billion. In all years prior to 2008, the overwhelming portion of the monetary base consisted of currency. For example, in December of 2007, currency was $763.8 billion, while, as just noted, the monetary base as a whole was $836.4 billion.

A portion of the currency outstanding and a portion of the checking deposit liabilities of the Federal Reserve constitute the reserves of the banking system. These reserves are the standard money that the banks possess and can use to meet the withdrawals of depositors requesting currency. The reserves are also used to meet the demand of other banks seeking to redeem net balances accruing in their favor in the process of the clearing of checks.

In December of 1994 such reserves were $61.36 billion; in 1999, they $41.7 billion; in December of 2007, they were $42.7 billion.

Normally, as the overall quantity of money in the economic system increases, bank reserves increase more or less in proportion. The fact that reserves were almost one-third lower in December of 1999 than in December of 1994, and then barely higher in December of 2007 than they were in December of 1999, despite major increases in the quantity of money over these years, is a major anomaly. It reflects the long-standing, deliberate policy of the Federal Reserve System of reducing and even altogether eliminating reserve requirements.

As a recent scholarly paper noted,

The Depository Institutions Deregulation and Monetary Control Act of 1980 had begun phasing out interest-rate ceilings on deposits and
modified reserve requirements in complex ways. Combined with subsequent administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1—savings deposits, small time deposits, money market deposit accounts, and retail money market mutual fund shares—utterly free of reserve requirements and allowed banks to reclassify many M1 checking accounts as M2 savings deposits. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.[1]

The concept of standard money underlies the concepts of fiduciary media and credit expansion. As I wrote in Capitalism, “Fiduciary media are transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists.”[2]

The overwhelmingly greater part of our money supply today consists of fiduciary media in the form of checking deposits of one kind or another. For example, as of December 2007, the total money supply of the United States, i.e., currency plus bank deposits of all kinds that are subject to the writing of checks, including the making of payments by debit card, was $6901.9 billion;[3] at the same time, the monetary base was $836.4 billion. Accordingly, the amount of fiduciary media in the United States was equal to the difference, which was $6065.5 billion. This was the sum of money representing transferable claims to standard money, payable on demand by the various banks that issued them, accepted in commerce as the equivalent of standard money, but for which no standard money actually existed.

The only standard money that the banks had available with which to redeem their checking deposits was $42.7 billion in standard money reserves. These $42.7 billion of reserves were the standard-money backing for a total of $6108.2 billion checking deposits, i.e., deposits equal to the sum of $42.7 billion + $6065.5 billion. To say the same thing in different words, there was full, 100 percent standard-money backing for $42.7 billion of deposits, and no standard-money backing whatever for $6065.5 billion of deposits, which latter constituted fiduciary media.

The quantity of fiduciary media in existence at any time represents the cumulative total of all of the credit expansion that has taken place in the country’s money supply up to that time. It represents the sum of all of the loans and investments that the banking system has made based on the foundation of the creation of money out of thin air. The difference between the amount of outstanding fiduciary media at two points in time represents the credit expansion that has taken place in the interval.

The simplest way in which to understand the process of the creation of fiduciary media and credit expansion is to imagine a deposit of standard money in the form of currency into a checking account. After making the deposit, the depositor has just as much spendable money in his possession as he did before making it. Instead of a roll of currency, he has a checking balance of equal amount. Either way, he can spend the same amount of money. Before making his deposit, he would have had to peel off bills from his roll in order to make payments. Now, instead, he writes checks and makes payment by check. Instead of his roll of currency diminishing each time he peels off a bill, his checking balance diminishes each time he writes a check. In the one case, the spendable money in his possession is his roll of currency; in the other it is his checking balance.

Up to this point in our imaginary scenario, there has been no creation of fiduciary media and no credit expansion. The money supply does not exceed the quantity of standard money. In the one case, before making his deposit, the standard money is in the possession of an individual. After the individual makes his deposit and holds money in the form of a checking balance, the same quantity of standard money is in the possession of his bank. Under such conditions, the quantity of money in the economic system is equal to the quantity of standard money held either by individuals as holdings of currency, or by banks as reserves against the checking deposits of those individuals and equal in amount to the size of those checking deposits.

Fiduciary media and credit expansion enter the picture insofar as the banks in which standard money has been deposited proceed to lend out the standard money that has been deposited with them. To the extent they do this, borrowers from the banks now have spendable money in their possession which is in addition to the spendable money in the hands of the banks’ checking depositors. There has been a creation of new and additional money, which new and additional money represents fiduciary media and an equivalent expansion of credit.

The currency which the banks lend out can easily, and almost certainly will, be deposited. When it is deposited, the same process of the creation of fiduciary media and credit expansion can be repeated. Indeed, under the conditions largely created by Greenspan, checking deposits came to stand in a multiple of more than 160 times the standard money reserves of the banks. In December of 2007, there were $6901.9 billion of checking deposits backed by a mere $42.7 billion of standard money reserves.

In modern conditions, of course, banks do not lend currency. Rather, they simply create new and additional checking deposits for their borrowers. When the borrowers spend those checking deposits by writing checks of their own, the people who receive the checks in turn deposit them in their banks. Those banks then call upon the banks that have created the deposits, for payment. This entails a shifting of standard money reserves from the one set of banks to the other.

To the extent that all banks have engaged in the process of checking deposit creation, the reserve balances due from any bank may be more or less closely matched by the reserve balances due it from other banks. This is because the checks written by its customers to the customers of other banks will be more or less closely matched by checks written by the customers of other banks to customers of this bank. In such a case the only movement of reserves will be the net amount due in the clearing.

From December of 1994, prior to the start of the stock market bubble, to December of 2005, shortly before the end of the housing bubble, the quantity of fiduciary media increased from $1.91 trillion to $4.93 trillion. This represented a compound annual rate of increase in excess of 9 percent over the eleven-year period. From December of 1999, shortly before the start of the housing bubble, to December of 2005, the amount of fiduciary media increased from $3.25 trillion to $4.93 trillion, which represented a compound annual rate of increase of 7.21 percent.

The increase in the quantity of fiduciary media over the period as a whole is significant, not just the increase that took place over the period of the housing bubble itself. This is because fiduciary media created in the years prior to the housing bubble played an important role in financing that bubble. And the same was true of the role of fiduciary media created in the years prior to the stock market bubble in financing that bubble.

As interest rates rose in the latter parts of these two bubbles, vast checking balances created earlier, that had been held as though they were savings accounts, and on which a modest rate of interest was being earned, were drawn into the financing of stock market purchases in the one case and housing loans in the other. The transformation of these deposits from de facto savings accounts into de facto checking accounts was based on the combination of their having had the potential for check writing all along, together with a rise in the rates of return that could be earned by switching their use from a vehicle for savings into a vehicle for buying investments. The rise in rates of return in the one case was in the gains to be had from stock market investment; in the other, in rates of interest on various vehicles for financing housing and real estate purchases.

It might be thought that what I have said of the transformation of deposits on which checks could be written would largely apply also to genuine savings deposits, on which checks could not be written. For the rise in rates of return would provide the same incentive to move funds from them into more lucrative investments. This is true. But nevertheless, there is a crucial difference.

Before the savings deposits can be spent, they must first be converted into checking deposits. All of the checking deposits that come under the heading of M1, most notably those held at commercial banks, require that those banks hold significant reserves, typically in an amount equal to 10 percent of a bank’s total deposits in excess of $44 million. Savings deposits in contrast have not required the holding of any reserves whatever for many years, and even when they did require the holding of reserves, it was at a far lower percentage than applied to checking deposits.

As a result, any movement of funds from savings into checking accounts entails an increase in required reserves. To obtain these additional reserves, banks must sell various assets, the effect of which would be to reduce their prices and to raise their effective yields to the new buyers. Unless the Federal Reserve intervened to provide new and additional reserves equal to the increase in the need for reserves, the effect would be not only a rise in interest rates but a general tendency toward a contraction of credit. This last would result from the loss of reserves by banks whose reserves were already at the bare minimum necessary to conduct operations.

In contrast, the use of savings held in accounts with already existing check-writing privileges to make purchases does not require any additional reserves. The problem of a need for additional reserves arises only insofar as a net movement of funds might occur, through the clearing, from checking accounts of a kind requiring no reserves to checking deposits of a kind that do require reserves. Checking deposits with no legal reserve requirements are money-market deposit accounts and retail and institutional money market funds. Checks drawn on such accounts and then deposited in other such accounts do not require any additional reserves. Additional reserves are required only when and to the extent that checks drawn on such accounts and deposited in conventional checking accounts exceed the volume of checks coming from conventional checking accounts and deposited in such accounts.

To the extent that the Federal Reserve is willing to supply the necessary additional reserves to meet the greater need for reserves arising from such a movement of funds, all checking deposits come to stand on an equal footing as sources of spendable money. And so too do savings deposits that end up being convertible into checking deposits with no net increase in the scarcity of reserves because the Fed has enlarged the supply of reserves to the same or even greater extent than the increase in the amount of reserves required as the result of such conversion.

Consistent with the fact cited earlier that total reserves were substantially lower in December of 1999 than they had been in December of 1994 and grew only slightly from December of 1999 to December of 2007, it must be pointed out that additional reserves can be supplied by the Fed by means of its reducing or eliminating reserve requirements at various points in the banking system. Thus, for example, when the Fed eliminated the requirement that once existed that a 3 percent reserve be held against savings deposits, all of the reserves previously held to meet that requirement became equivalent to a supply of new and additional reserves of that same amount.

The same was true when the Fed allowed commercial banks on weekends and holidays to “sweep” substantial parts of their outstanding checking deposits into types of accounts that did not require reserves. This too made a substantial portion of already existing reserves the equivalent of new and additional reserves. Indeed, the amount of such new and additional reserves constituted such an excess of reserves above the now diminished reserve requirements, that the Fed was obliged to reduce the outstanding amount of reserves by means of resorting to “open-market operations” in which it sold some of its holdings of government securities in exchange for newly excess reserves.

The Stock Market and Real Estate Bubbles
Credit expansion was the source of the funds that fueled both the stock market and the real estate bubbles. In the case of the stock market bubble, credit expansion provided funds for the purchase of stocks. The sellers of the stocks then used the far greater part of their proceeds to purchase other stocks, whose sellers did likewise. In this way, the new and additional money created by credit expansion traveled from one set of stocks to another, raising the prices of the great majority of them. It continued to do this so long as the credit expansion went on at a sufficient rate.

Ultimately, a sufficient rate would have had to be an accelerating rate. This is because rising share prices resulted in people feeling richer and thus believing themselves able to afford more luxury goods. It also led to a stepped up demand for physical capital goods by firms coming into possession of the new and additional money by virtue of sales of stock of their own. The issuance of such stock and use of the proceeds to finance the purchase of physical capital goods was encouraged by the fact that the rise in stock prices made it more and more attractive in comparison with acquiring capital goods through the purchase of stocks in other companies.

Thus, an important later effect of the credit expansion was a tendency for funds to be withdrawn from the stock market, for the purchase of luxury consumers’ goods and also of physical capital goods. To offset this withdrawal of funds, more rapid credit expansion would have been necessary.

When, instead of an acceleration of the credit expansion, there was a diminution in its rate, the basis of the market’s rise was doubly undercut. Since the funds provided by credit expansion had come to represent an important part of the demand for stocks, the reduction in credit expansion constituted a reduction in that demand. Coupled with the outflows of funds just described, the result was that share prices began to plummet. Their fall was compounded by the unloading of shares by people who had purchased them for no other reason than their expectation of a continuing rise in stock prices.

The more recent, real estate bubble originated in the Fed’s panic-response to the collapse of the stock market bubble it had caused earlier. To overcome the effects of that collapse, it progressively reduced its target federal-funds rate, i.e., the rate of interest banks pay one another on the lending and borrowing of funds that qualify as reserves against commercial-bank checking deposits. In this way, it launched a new and more momentous credit expansion.

For the three years 2001-2004, the Federal Reserve created as much new and additional money in the form of additional bank reserves as was necessary to drive and then keep the federal-funds rate below 2 percent. And from July of 2003 to June of 2004, it drove and kept it even further down, at approximately 1 percent.

The new and additional money created by the banking system on the foundation of these new and additional reserves appeared in the loan market as a new and additional supply of loanable funds. The effect was a reduction in interest rates across the board.

Because interest is a major determinant of monthly mortgage payments, the fall in interest rates made home ownership appear substantially less expensive. As a result, a great surge in the demand for mortgage loans and the in the purchase of homes took place. Instead of pouring into the stock market as in the previous bubble, the funds created by credit expansion now poured into the real estate market and drove up the prices of homes and commercial real estate rather than the prices of common stocks.

In the stock market bubble and even more so in the real estate bubble there was both large scale overconsumption and malinvestment. These are the two leading features of booms as explained by the monetary theory of the trade cycle developed by Ludwig von Mises. In both cases, the rise in the price of major assets—most notably, stocks and homes respectively—led people to believe that they were richer and could thus afford to consume more. In both cases, particular branches of industry were greatly overexpanded relative to the rest of the economic system, resulting in a subsequent major loss of capital. In the stock market bubble, the malinvestment was mainly in such things as the “dot.com” enterprises that later went broke. In the real estate bubble, it was in housing and commercial real estate.

Evasion of Responsibility for the Bubbles
Credit expansion is what was responsible for both the stock market and the real estate bubbles. Since its establishment in 1913 and certainly since the expansion of its powers in World War I, responsibility for credit expansion itself has rested with the Federal Reserve System. The Fed is the source of new and additional reserves for the banking system and determines how much in checking deposits the reserves can support. It has the power to inaugurate and sustain booms and to cut them short. It launched and sustained the stock market and real estate bubbles. It had the power to avoid both of these bubbles and then to stop them at any time. It chose to launch and sustain them rather than to avoid or stop them.

To be responsible for a bubble and its aftermath is to be responsible for a mass illusion of wealth, accompanied by the misdirection of investment, overconsumption, and loss of capital, and the poverty and suffering of millions that follows. This is what can be traced to the doorstep of the Federal Reserve System and those in charge of it. It is destruction on a scale many times greater than that wrought by Bernard Madoff, the swindler who first made his clients believe they were growing rich, only to cause them ultimately a loss of more than $50 billion. Madoff is one of the most justly hated individuals in the United States.

In contrast to the $50 billion of losses caused by Madoff, the losses caused by the Federal Reserve System and those in charge of it amount to trillions of dollars, probably to more than $10 trillion if the stock and real estate bubbles are taken together. Instead of affecting thousands of people as in the case of Madoff, tens of millions have been made to suffer hardship. Indeed, practically everyone has been harmed to some extent by what the Federal Reserve has done: the owners of stocks that have plunged, pensioners, the unemployed and their families, towns and cities suffering the consequences of business failures and plant closings.

It is difficult to imagine living with the knowledge that one is personally responsible for such massive destruction. Such knowledge might easily drive someone to suicide or at least to some means, such as drink or drugs, of not having to allow it into consciousness.

Alan Greenspan, who was Chairman of the Federal Reserve’s Board of Governors from 1987 to 2006, the period encompassing both bubbles, is clearly the single individual most responsible for the bubbles. The present Chairman, Ben Bernanke, also bears substantial responsibility, though not to the same extent as Greenspan. While Chairman only since January of 2006, Bernanke has been a member of the Federal Reserve Board since 2002. Thus he was present in a major policy making position during most of the housing bubble and crucial years leading up to it.

Neither Greenspan nor Bernanke have resorted to drink or drugs to conceal their responsibility from themselves. Instead they have resorted to specious claims about the cause of the bubbles, the housing bubble in particular.

One can read through their widely disseminated public statements and not find a single explicit reference to credit expansion and fiduciary media, nor to malinvestment and overconsumption. To avoid recognition of any need to discuss these phenomena, Greenspan seems to have wiped his mind clean of all knowledge of how Federal Reserve interest-rate policy affects interest rates in the economic system.

In what appears to be his closest reference to credit expansion, he wrote, in an article in The Wall Street Journal of March 11, 2009:

There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise.
After all, the prices of long-lived assets have always been determined by discounting the flow of income or imputed services by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates—such as the fed-funds rate—to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

In these passages Greenspan invents a version of the opposition to Federal Reserve sponsored credit expansion that no opponent of credit expansion or “easy money” has ever held. No opponent of credit expansion has ever claimed that reductions in the federal-funds rate need directly affect long-term interest rates. To the contrary, the significance of reductions in the federal-funds rate is that what is required to bring them about in the actual market for those funds is an increase in member-bank reserves. The increase in those reserves is then the foundation of credit expansion to a vast multiple of the additional reserves. That credit expansion is what then serves to lower long-term interest rates, such as mortgage rates.

The way the process works is as follows. To actually achieve the lower federal-funds rate that it announces as its target, the Federal Reserve goes into the market and buys government securities from banks or the customers of banks. It pays for those securities by means of the creation of new and additional standard money. When the Fed purchases securities from banks, the banks directly and immediately have equivalently more reserves in their possession. When it purchases securities from the customers of banks, the banks gain equivalently more reserves as soon as those customers deposit the checks they have received that are drawn by the Fed on the Fed. These checks are then forwarded to the Fed and the reserve accounts of the banks in question are equivalently increased.

Depending on the amount of their increase, the immediate effect of the additional reserves is to reduce or eliminate deficiencies in the required reserves of some, many, or all of the banks that have had such deficiencies, to replace deficiencies of reserves with excesses of reserves, and to increase the excess reserves of some, many, or all of the banks that have had excess reserves. The effect of this in turn is to reduce the demand for federal funds, i.e., funds that qualify as reserves, while increasing their supply. This combination is what brings down the federal-funds rate in the market for federal funds.

What is far more significant is that the creation of new and additional excess reserves by the Fed—reserves beyond the amount legally required to be held—places the banking system in a position in which it can expand the supply of checking deposits and thus fiduciary media to a multiple of the additional reserves. And thanks largely to Mr. Greenspan that multiple came to be enormous. By December of 2005, it exceeded 126 times. Two years later, it exceeded 160 times.

Thus for each dollar of additional excess reserves created, a credit expansion was made possible on the order of a vast multiple. The new and additional fiduciary media corresponding to the credit expansion were the source of the funds for stock purchases in the stock market bubble and for housing and commercial real estate purchases in the housing bubble. Their pouring into the home mortgage market was what drove down mortgage interest rates. Between December of 1999 and December of 2005, almost $1.7 trillion of new and additional fiduciary media were created and lent out.

As market interest rates started rising in the second half of 2004 and then through 2005, increasing amounts of deposits earning a modest rate of interest and on which checks could be written, came to be used more and more as checking accounts rather than savings accounts. They were drawn into the spending stream in response to the higher comparative rates of return that could be earned through investment in securities. This allowed the life of the housing bubble to be extended until 2006.

The Saving Glut Argument
Along with denying the causal role of Federal Reserve expansionary monetary policy in the housing bubble, Greenspan advances the claim, greatly elaborated by Bernanke, that what was actually responsible for the bubble was an excess of global saving. He argues in his Wall Street Journal article that

[T]he presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

In a series of lectures beginning in March of 2005 and continuing into the current year, Bernanke elaborates on this claim. At a lecture given at the Bundesbank in Berlin, Germany, on September 11, 2007, titled “Global Imbalances: Recent Developments and Prospects,” he argued that stepped up saving in developing countries was largely responsible for “the substantial expansion of the current account deficit in the United States, the equally impressive rise in the current account surpluses of many emerging-market economies, and a worldwide decline in long-term real interest rates.” (For the benefit of non-technical readers, the “current account” balance encompasses the difference between exports and imports both of goods and services, the difference between incomes earned abroad and incomes paid to abroad, plus the difference between remittances from and to abroad.)

These developments, he held, “could be explained, in part, by the emergence of a global saving glut, driven by the transformation of many emerging-market economies—notably, rapidly growing East Asian economies and oil-producing countries—from net borrowers to large net lenders on international capital markets.”[4]

In a speech delivered on April 9 of this year at Morehouse College in Atlanta, Bernanke stressed that “the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006 an amount equal to about $825 billion in today's dollars.” He then proceeded to blame the housing boom on this inflow of foreign savings. “Financial institutions,” he declared, “reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain. One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending.”

Thus, according to Bernanke, it was not credit expansion or anything that he and the Federal Reserve System and Mr. Greenspan were responsible for, but the inflow of foreign savings. That inflow, representing a “global saving glut,” was responsible for the bubble and its aftermath.

Bernanke uses the expression “saving glut” repeatedly: 9 times in his lecture at the Bundesbank in September of 2007, 11 times in his lecture at the Virginia Association of Economics in March of 2005, and 10 times in his Homer Jones Lecture in St. Louis in April of 2005. Despite his constant repetition of the claim, it turns out to have absolutely no substance. Nowhere is the existence of anything remotely approaching a saving glut in any way substantiated.

The Non-Existence of a Saving Glut
The very notion of a saving glut is absurd, practically on its face. As I wrote in Capitalism:

Before the scarcity of capital … could be overcome, capital would have to be accumulated sufficient to enable the 85 percent of the world that is not presently industrialized to come up to the degree of capital intensiveness of the 15 percent of the world that is industrialized. Within the industrialized countries, capital would have to be accumulated sufficient to enable every factory, farm, mine, and store to increase its degree of capital intensiveness to the point presently enjoyed only by the most capital-intensive establishments, and, at the same time, to enable all establishments to raise the standard of capital intensiveness still further, to the point where no further
reduction in costs of production or improvement in the quality of products could be achieved by any greater availability of capital…. [5]

Long before such a point could ever be reached, time preference would put an end to further increases in the degree of capital intensiveness.

It is doubly absurd to believe that the source of a saving glut would be precisely countries possessing very little capital compared to the United States and other industrialized countries. But that is what Bernanke claims. He claims that countries such as Thailand, China, Russsia, Nigeria, and Venezuela are the source of the alleged saving glut.[6]

There are further theoretical considerations that argue specifically against any form of “saving glut” being responsible for the housing bubble.

First, if saving had been responsible, and not credit expansion and the increase in the quantity of money, then the additional saving taking place in the countries providing it, would have been accompanied by a reduction in consumer spending in those countries. People would have had to spend less for consumption in those countries, in part, in order to make available funds for additional spending on capital goods that were exported to the United States. Such export of capital goods to the US would not have fueled a boom here. To the contrary, it would have resulted in lower prices of capital goods in the US. Only the portion of funds saved that was used to finance purchases within the US could have contributed to any higher prices of capital goods and land in the US. And, of course, whatever rise in the prices of capital goods and land that might have taken place in the US would have tended to be matched by a fall in the prices of consumers’ goods in the countries that had stepped up their saving. The only way that the demand for capital goods and land could rise without the demand for consumers’ goods falling would be on the strength of an increase in the quantity of money and the total, overall volume of spending in the economic system.[7]

Indeed, the fact that in the absence of an increase in the quantity of money and volume of spending in the economic system, shifts in spending serve to reduce prices as much as increase them has a parallel in the further fact that increases in the relative size of some of the countries in the world’s economy imply equivalent decreases in the relative size of other countries in the world’s economy. In the absence of an increase in the quantity of money and volume of spending, growth in the relative size of the economies of many Asian countries would not by itself be sufficient for greater saving in those countries serving to increase global spending for capital goods. For that greater spending would be accompanied by reduced spending for capital goods in other countries, i.e., countries that were already in the category of developed economies and now had to yield some portion of their previous relative size.

In the present instance, what this means is that greater spending for capital goods and land in the US, financed by saving in parts of Asia, would be accompanied by less spending for capital goods in the US (and possibly elsewhere) financed by saving in the US or financed by saving elsewhere in the world. If spending for capital goods financed by saving in Asia is not accompanied by reduced spending for capital goods financed by saving elsewhere, the only ultimate explanation is an increase in the quantity of money and volume of spending in the world’s economy. Of course the source of such an increase in today’s conditions is none other than the Federal Reserve System.

Second, contrary to popular understanding, when saving is divorced from the increase in the quantity of money and volume of spending, and takes place without such increase, it does not tend to grow larger from year to year. Nor does consumer spending tend to decrease from year to year. And thus more saving would not serve to raise the prices of capital goods or land from one year to the next. Its effect would essentially be limited to a discrete, one-time only increase.[8] Yet for the prices of capital goods and land to rise from one year to the next on the strength of an increase in the demand for capital goods and land based on an increase in saving, the increase in saving would have to become progressively larger from year to year. And this would mean that the demand for consumers’ goods would have to become progressively smaller from year to year.
For example, imagine that at the expense of an equal fall in the demand for consumers’ goods, the demand for capital goods rose by some given amount, say, 100. This 100 can represent however many billions or hundreds of billions of dollars as may be required to make it realistic in terms of present spending levels. In such circumstances, there would be nothing present that would make the prices of capital goods or land any higher in the second and later years of 100 of additional such spending than in the first year.

Indeed, as the years wore on, the increases in production achieved by a greater supply of capital goods would start reducing prices, including the prices of capital goods themselves, as the supply of capital goods itself was increased on the foundation of a general increase in production. Even land prices would fall to the extent that improvements in the supply of capital goods permitted the adoption of methods of production that allowed the economical use of previously submarginal land or so increased the output per unit of land as to make part of its supply redundant.

In circumstances of an unchanged supply of money and demand for money for holding, each act of greater saving and accompanying greater expenditure on capital goods operates in a manner analogous to the relationship between force and acceleration in the physical world. In the physical world, in the conditions of a friction-free environment, a single application of force to an object imparts continuous motion at a constant velocity. Similarly, in the economic world, in the conditions of an unchanged quantity of money and volume of spending, each act of reduced expenditure for consumers’ goods and increased expenditure for capital goods, causes the economic system to adopt a greater relative concentration on the production of capital goods and a reduced relative concentration on the production of consumers’ goods. This produces an inertial effect on capital accumulation.

The first result of the greater relative concentration on the production of capital goods is a greater production of capital goods, alongside a smaller production of consumers’ goods. These additional capital goods, however, obtained on the foundation of additional saving, are the basis of an increase in the ability to produce both consumers’ goods and further capital goods. That is to say, the additional capital goods make possible a general increase in production, an increase in the production of consumers’ goods and a further increase in the production and supply of capital goods as well. The process of an increasing supply both of consumers’ goods and capital goods, based on the foundation of a single fall in consumption and increase in saving, can go on indefinitely if it is accompanied by further scientific and technological progress. In these circumstances, a further fall in the demand for consumers’ goods and rise in the demand for capital goods would be analogous to a further application of force to an object and would result in an acceleration of the increase in production.

A further point must be mentioned here. And that pertains to the durability of capital goods and its implications for capital accumulation, saving, and spending. Thus, if the average life of the capital goods in our example of 100 of additional spending for capital goods were, say, 10 years, then a diminishing process of saving would go on for 10 years with no further fall in the demand for consumers’ goods nor rise in the demand for capital goods. Net saving and equivalent net investment in the economic system would take place in a pattern 100, 90, 80, …10, as the 100 of additional spending for such capital goods was accompanied by successive increases in annual depreciation charges. The additional depreciation charges would be 10 in the year following the first year’s expenditure of an additional 100 for such capital goods. In the next year, when there were two such batches of capital goods, depreciation would be 20. At the end of the tenth year, the depreciation charges on ten such batches of capital goods would be 100, and net saving and net investment would disappear, unless, of course, there were a further decline in consumption expenditure and increase in demand for capital goods.

What is particularly important to realize here is that the net saving of years 2 through 10 would not serve at all to raise the demand for capital goods and land nor their prices, but would contribute to the supply of capital goods being larger, production in general consequently being greater, and prices in general, including the prices of capital goods, being lower as a result. Such results, and those of the process of saving and capital accumulation in general that were described a moment ago, cannot be reconciled with the conditions of a bubble. They should not be cited as the basis of explaining a bubble.

Third, if somehow saving were responsible for the housing bubble, why did it suddenly collapse? Why did people suddenly stop saving and stop making funds available for the purchase of homes? Obviously, the explanation was that the bubble did not depend on saving but on credit creation and its acceleration and that when the ability to create sufficiently more credit came to an end, the props supporting the bubble were removed and it collapsed.

Fourth, if saving were responsible for the bubble, why have banks and countless other firms found themselves confronting an acute lack of capital? Saving provides new and additional capital. How can it be that an alleged process of saving has resulted in widespread major capital deficiencies? This situation of insufficient capital is the result of malinvestment and overconsumption, which are the consequences of credit expansion, not saving.

Fifth, if saving had been responsible for the increase in spending on capital goods and land, the rate of profit would have modestly fallen from the very beginning, and continued its fall until net saving came to an end. It would not have risen, let alone risen dramatically, as it did during the bubble.[9]

This is the implication of the discussion, above in this section, of the second reason why saving was not responsible for the bubble. In particular it is the implication of the example of 100 more of spending for capital goods financed by 100 of saving derived from 100 less of spending for consumers’ goods. In that example, in which there is no increase in the quantity of money or total volume of spending, the global economic system would have had the same total aggregate business sales revenues, with the sales revenues coming from the sale of consumers’ goods diminished by the amount of saving, and those coming from the sale of capital goods equivalently increased. At the same time, however, it would have had a tendency toward a rise in the aggregate costs of production deducted from those sales revenues.

The rise in costs would have been the result of such things as additional depreciation charges on the new and additional capital goods purchased, or additional cost of goods sold following additional purchases of materials and labor on account of inventory. In the example of 100 more being spent for capital goods each year with an average life of 10 years and accompanying depreciation charges in the respective amounts of 10, 20, …, 100 in the 10 years following the rise in demand for capital goods, aggregate profit in the economic system would have been falling year by year by an amount equal to the increase in depreciation.

A falling aggregate amount of profit together with the increasing amount of capital invested in the economic system, would have progressively reduced the economy-wide average rate of profit. It would have been a case of a falling amount-of-profit numerator divided by a rising-amount-of-capital denominator.

Totally contrary to what one would expect from these effects of a rise in saving, the reality, of course, was a sharply higher average rate of profit in the economic system so long as the bubble lasted. This can be explained only on the foundation of credit expansion and an expanding quantity of money and volume of spending, not on the basis of saving.

If none of these five reasons are sufficient to dispel the notion that a saving glut was responsible for the bubble, then hopefully it will be sufficient to point out that there simply was no saving glut, but rather only a very modest rate of saving, a mere trickle of saving. For it turns out that over the 13 year period 1994-2006, the rate of saving in the US, together with all foreign saving entering the country in connection with deficits in the current account, never exceeded 7 percent, and in 8 of those 13 years was 3 percent or less. In 5 of those years it was a mere, 1 or 2 percent. And what is of special significance is that in the years of the housing bubble, 2002-2006, it was especially low: 2 percent in 2002, 1 percent in both 2003 and 2004, 3 percent in 2005, and 4 percent in 2006.

To see this result, it is necessary to begin by removing all fictional elements in the reported amounts of domestic net saving and GDP. These fictional amounts consist of various “imputations.” The leading imputations that are relevant here are those that arbitrarily convert what is in fact consumption expenditure into investment expenditure. These have the effect of reducing reported consumption and equivalently increasing reported saving.[10], [11]

The two most important such imputations are these: 1) the treatment of the purchase of single family homes that the buyer intends to occupy and that thus will not be a source of any money revenue of income to him, as though they were nonetheless income producing assets and therefore represented an investment; 2) the treatment of government expenditure for fixed assets such as buildings, as though it were an investment expenditure rather than a consumption expenditure.

When such imputations are removed from the calculation of net saving and from GDP, the very modest extent of saving that has been going on over the last decade or more is clearly shown. Indeed, since 2002, domestic net saving has been negative to the extent of several hundred billion dollars each year.

The following table describes the situation:

The table has 6 columns. Column 1 lists the years 1994 through 2006, the period encompassing both the stock market and the real estate bubbles. Column 2 shows the current account deficit in those years. This deficit is taken as representing the foreign savings coming into the United States. (For this reason it is shown as a positive number.) Column 3 shows net saving in the United States in those years when such savings are calculated free of imputations. Column 4 is the sum of Columns 2 and 3. It shows total saving in the United States as the sum of foreign saving entering the country together with domestic saving. Column 5 is GDP year by year, with all imputations removed. Column 6 is the sum of imputation-free foreign and domestic saving divided by such GDP, presented in decimal format.

The notion that there was a saving glut behind the housing bubble is simply a fiction. Its proponents could manufacture as much of a glut as they like simply by reclassifying such things as expenditure for automobiles, major appliances, furniture, and clothing as investment expenditures, on the grounds that these goods too are durable, like houses. That would equivalently reduce consumption expenditure and increase reported saving in the economic system.

Current Account Deficits as a By-Product of the Increase in the Quantity of Money
Bernanke and Greenspan et al. focus on deficits in the current account as representing the counterpart of foreign saving and investment, which they believe must be present to finance the deficits. There is certainly a very close relationship between foreign saving and investment on the one side and the financing of deficits in the current account on the other. The following example may help to highlight this relationship.

Thus imagine Saudi Arabia back in the days when geologists had determined that the country possessed vast oil reserves but before it had any oil wells, pipelines, refineries, or facilities for the handling of supertankers. Those things had yet to be built.

Now how could those facilities be built? The only way was by means of the arrival of shiploads of equipment and construction materials from Europe and the United States. In addition, large quantities of various consumers’ goods were required for the foreign engineers and other workers who were required to carry out the construction. All these goods coming into Saudi Arabia were imports of foreign goods. But Saudi Arabia had hardly anything to export before its ability to produce oil was developed. Thus, in the interval, there was a massive excess of imports over exports. That excess represented foreign investment in Saudi Arabia. Its physical form was all of the facilities under construction and then, ultimately, the completed facilities for producing oil.

Foreign investment very often, perhaps most of the time, has this kind of close connection to the existence of an excess of imports over exports and, more broadly, an excess of outlays of all kinds on current account over receipts of all kinds on current account. (As previously explained, the balance on current account includes not only the difference between the imports and exports of goods, but also of services. In addition, it includes the difference between incomes paid to abroad and incomes paid from abroad, and finally, the difference between remittances to and from abroad.)

Nevertheless, it should be realized that the essential, core concept of the current account, namely, the so-called balance of trade, which is the difference simply between the import and export of goods, was developed long before the emergence of any significant international investment. It was developed and employed by a school of writers known as the mercantilists, who were current from the 16th to the third quarter of the 18th Century, when the school was laid to rest by Adam Smith.

The main concern of the mercantilists was the accumulation of gold and silver within the borders of their country and the prevention of any loss of gold or silver by their country. Gold and silver were the money of the day everywhere and, it was believed, needed to be accumulated within the country in order to be available if and when the government might need them, in order to finance military operations outside the country or any other activities in which circumstances might operate to draw precious metals away from the country.

Inasmuch as already by that time, most of the European countries had no gold or silver mines within their territory, the only way they could gain gold or silver was by means of the export of goods. The import of goods was seen as constituting a loss of gold or silver by the country. Accordingly, the goal of mercantilist policy was to maximize exports while minimizing imports. That would allegedly ensure the greatest possible accumulation of the precious metals within the country.

Centuries later, in the chapter “On Foreign Trade” in his Principles of Political Economy and Taxation, Ricardo developed the principle that the supply of the precious metals tends to be distributed among the different countries essentially in proportion to the relative size of their respective economies. He wrote: "Gold and silver having been chosen for the general medium of circulation, they are, by the competition of commerce, distributed in such proportions amongst the different countries of the world as to accommodate themselves to the natural traffic which would take place if no such metals existed, and the trade between countries were purely a trade of barter."

The operation of this principle can, of course, be modified by the operation of other principles working alongside it. Thus a country with a relatively small economy, but with an exceptional reputation for the security of property and the enforcement of contracts, might well have a quantity of money within its borders far in excess of what corresponded to the relative size of its economy. By the same token, countries with larger economies but in which property rights and the enforcement of contracts were in retreat, could possess a proportion of the world’s money supply substantially less than what corresponded to the relative size of its economy.

It follows from Ricardo’s principle that countries with gold and silver mines will experience a chronic excess of imports over exports. The gold and silver that they mine cannot all be retained within their borders. If they were retained, the country would have a disproportionately large supply of the precious metals. This would serve to raise prices in that country relative to prices abroad. The effect would be an outflow of the precious metals until their buying power at home did not fall short of their buying power abroad by more than the costs of shipping them abroad.

Today, the US dollar is in a position similar to that of gold under an international gold standard. The dollar is a virtual world money—not completely, but substantially. The United States is the country with the “dollar mines.” When dollars are created in the US, a substantial portion of them will flow abroad. And this applies not just to currency, but also to checking deposits and all other short-term financial instruments easily convertible to currency.

Most of the dollars that “flow abroad” need not actually circulate abroad but to a large extent serve as mere precautionary holdings of money, and, to an important extent, as reserves for financial institutions that create various moneys other than dollars. These other moneys that are created on the foundation of additional dollars circulate abroad.

Now the fact that the United States compared to almost all other countries in the world still has the most reliable protection of property rights and enforcement of contracts, is responsible for the fact that much or most of the money that “flows abroad” does not in fact leave the country. Rather it passes into the ownership of foreign individuals, firms, and governments who continue to hold it within the United States.

The increase in such foreign owned assets within the United States has the appearance of foreign investment. Actually, it is nothing more than the by-product of credit expansion and the increase in the quantity of money within the United States.

There is no genuine surge in foreign saving. There is domestic credit expansion and money supply increase that serves to increase imports and shift ownership of a substantial portion of the additional money supply, and short-term claims to money, to foreigners.

Ironically, Bernanke himself helps to confirm this interpretation of the increase in the current account deficit. He says: “First, the financial crises that hit many Asian economies in the 1990s led to significant declines in investment in those countries in part because of reduced confidence in domestic financial institutions and to changes in policies—including a resistance to currency appreciation, the determined accumulation of foreign exchange reserves, and fiscal consolidation—that had the effect of promoting current account surpluses.” (Bundesbank Lecture, Berlin, Germany, September 11, 2007.)
What Bernanke describes here is not any sudden increase in foreign saving but rather decisions to change the way in which a portion of previously accumulated savings are held, i.e., to hold them to a greater extent in the form of US dollars and short-term claims to dollars.

In the same passage, Bernanke presents a second reason for the alleged growth in foreign savings, namely the sharp increase in the price of oil that had taken place. He says, “sharp increases in crude oil prices boosted oil exporters' incomes by more than those countries were able or willing to increase spending, thereby leading to higher saving and current account surpluses.”

Here, Bernanke overlooks the role of credit expansion and the increase in the quantity of money in bringing about the higher price of oil. He also overlooks the effect of the higher price of oil on the real incomes and ability to save of everyone who had to pay that higher price.

The role of credit expansion and the increase in the quantity of money in causing the rise in oil prices was confirmed by the subsequent plunge in oil prices once credit expansion was brought to an end and appeared to be about to turn into massive credit contraction. It has since been further confirmed by the recent rise in oil prices following the growing belief that the government’s program of renewed credit expansion will be sufficient to eliminate the danger of a financial collapse and will serve to maintain and increase the demand for oil.

Net Saving as a By-Product of the Increase in the Quantity of Money
My discussion of the fallacy of a saving glut as being responsible for the housing bubble and its aftermath would not be complete if I did not point out that the continued existence of net saving is itself a by-product of the increase in the quantity of money and volume of spending in the economic system. In the absence of increases in the quantity of money and volume of spending, economy-wide, aggregate net saving would tend to disappear. It would cease when total accumulated savings came to stand in a ratio to current incomes and consumption that people judged to be sufficiently high that they had no further need to make still greater relative provision for the future.

What keeps net saving in existence is that the increase in the quantity of money and volume of spending tends continually to raise incomes and consumption in terms of money. In order to maintain any given ratio of accumulated savings to a rising level of income and consumption, it is necessary to increase the magnitude of accumulated savings. At the same time, the increasing quantity of money provides the financial means of spending more and more each year for capital goods as well as consumers’ goods and for thus maintaining the desired balance in the face of growing magnitudes of spending.

Thus it is the increase in the quantity of money and the volume of spending that it supports that is responsible for net saving continuing in being. In the absence of the continuing increase in the quantity of money, net saving would disappear, and capital accumulation would take place simply by means of a continually increasing purchasing power of the same capital funds. That growing purchasing power would be created by the increase in the production and supply of capital goods and the fall in prices of capital goods that would result.

Summary and Conclusion
The real estate bubble, like the stock market bubble before it, was caused by credit expansion. The credit expansion was instigated and sustained by the Federal Reserve System, which could have aborted it at any time but chose not to. As a result, the Federal Reserve System and those in charge of it at during the real estate bubble bear responsibility for major harm to tens of millions of Americans.

In order to avoid having to accept this responsibility, a specious doctrine has been advanced by Alan Greenspan and Ben Bernanke, the former and present Chairman of the system, and others. That is the doctrine of a “global saving glut.” Not credit expansion but the saving glut was responsible, they claim.

The truth is that time preference puts an end to further saving long before it could outrun the uses for additional saving. This makes a saving glut impossible. In addition, there are five major reasons why saving could not have been responsible for the real estate bubble in particular. First, if saving had been responsible, rather than credit expansion and the increase in the quantity of money, there would have been a corresponding decline in consumer spending in the countries allegedly doing the saving. The fact is that there was no such decline.

Second, saving implies a growing supply of capital goods, more production, and lower prices, including lower prices of capital goods and even of land. These are results that are incompatible with the widespread increases in prices typically found in a bubble.

Third, if somehow saving had been responsible for the housing bubble, the spending it financed would not suddenly have stopped. Such stoppage is a consequence of the end of credit expansion and the revelation of a lack of capital.

Fourth, if large-scale saving rather than credit expansion had been present, banks and other firms would have possessed more capital, not less. They would not be in their present predicament of having inadequate capital to carry on their normal operations. This situation of insufficient capital is the result of malinvestment and overconsumption, which are the consequences of credit expansion, not saving.

Fifth, in the absence of increases in the quantity of money and overall volume of spending in the economic system, saving also implies an immediate tendency toward a fall in the economy wide average rate of profit. This is another result that is incompatible with what is observed in a bubble or boom of any kind, which is surging profits so long as “the good times” last.

Especially noteworthy is the fact that in the real estate bubble, there simply was no saving glut. In the 13 year period 1994-2006, the rate of saving in the US, together with all foreign saving allegedly entering the country in connection with deficits in the current account, never exceeded 7 percent, and in 8 of those 13 years was 3 percent or less.

What has served to conceal how low the actual rate of saving has been is the fact that major fictional items have been counted in saving, which add hundreds of billions of dollars every year to its reported amount. The most notable instance is that purchases of single family homes that the buyers intend to occupy and that will thus not be a source of any money revenue or income to them, are treated as though they were nonetheless purchases of income producing assets and therefore represented an investment. Similarly, government spending on account of buildings and structures is treated as investment. Such overstatement of investment correspondingly understates consumption expenditure in the economic system. And when the artificially reduced amount of consumption is subtracted from any given amount of national income or GDP, saving appears to be equivalently larger.

The alleged saving entering the American economy via deficits in its current account is in fact largely not saving at all, but the by-product of US credit expansion and money supply increase. Dollars today are a virtual global money. And in conformity with Ricardo’s principle concerning the distribution of the precious metals throughout the world based on the relative size of the economies of the various countries, most of the additions to the supply of dollars and short-term claims to dollars cannot remain in the possession of Americans but must gravitate into the ownership of foreigners. This creates a deficit in the balance of trade and in the whole of the so-called current account. While it may appear that increased foreign holdings of dollars and short-term dollar-denominated securities represent foreign investment, the truth is that much or possibly even all of the alleged foreign saving entering the United States is nothing other than a consequence of US credit expansion and money supply increase.

Finally, net saving itself, as a continuing phenomenon is nothing more than a by-product of the increase in the quantity of money, in that it would come to an end if the money supply were to stop increasing.

The conclusion to be drawn is that the housing bubble was indeed the product of credit expansion, not a “saving glut.”

Notes

[1] David R. Henderson and Jeffrey Rogers Hummel, Greenspan’s Monetary Policy in Retrospect, Cato Institute Briefing Paper 109, Cato Institute, Washington, D.C., November 3, 2008, pp. 4f.

[2] George Reisman, Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) p. 512.

[3] This figure is arrived at by taking the sum of M1, sweep accounts, money market mutual fund accounts both retail and institutional, and one half of savings deposits as the measure of money market deposit accounts, the data for which are apparently otherwise unavailable. The same procedure is used as the basis of all other statements of the money supply or changes in the money supply.

[4] Italics in original.

[5] Reisman, Capitalism, p. 57.

[6] “Homer Smith Lecture,” St. Louis, MO, April 14, 2005.

[7] For a comprehensive explanation of the role of the quantity of money in determining the volume of spending in the economic system, see Reisman, Capitalism, chaps. 12 and 19.

[8] For an explanation of the role of saving in capital accumulation, see ibid., pp. 621-642.

[9] For a thoroughgoing discussion of the determinants of the rate of profit and its relationship to saving and capital accumulation, see ibid., chaps. 16 and 17.

[10] For a comprehensive explanation of the distinction between capital goods and consumers’ goods and investment or, better, productive expenditure and consumption expenditure, see ibid., pp. 445-456.

[11] For a detailed critique of the imputed income doctrine, see ibid., pp. 456-459.

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.

GENERAL MOTORS, RIP

2009-06-02T21:23:00.000-07:00

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

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

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

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

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

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

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

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

Google Relents—Finally

2009-05-31T15:50:00.000-07:00

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

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

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

"Your blog is marked as spam

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

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

"Your blog is marked as spam

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

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

"Your blog is marked as spam

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

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

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

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

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

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

***

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

Letter to Krugman

2009-05-30T11:14:00.000-07:00

Letter to Krugman
May 4th, 2009

Dear Prof. Krugman:

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

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

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

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

Cordially,
George Reisman, Ph.D.
Pepperdine University Professor Emeritus of Economics
Author of Capitalism: A Treatise on Economics
Web site: www.capitalism.net
Blog: www.georgereisman.com/blog/

IF THIS BLOG IS SILENCED

2009-05-03T12:48:00.000-07:00

IF THIS BLOG IS SILENCED BY GOOGLE, PLEASE BE SURE TO VISIT http://www.capitalism.net/ FOR INFORMATION ON ITS NEW LOCATION.

Injustice as Routine

2009-05-01T21:21:00.000-07:00

I want to take note here of two outrageous injustices that have occurred within the last few days. One, reported in the main front-page headline of today’s New York Times is that the United Automobile Workers Union and its pension fund is to become the largest stockholder in Chrysler when the firm emerges from bankruptcy. This is the very same union that brought about the collapse of Chrysler in the first place. Its philosophy and policy of grabbing ever more in wages and benefits while doing almost everything possible to prevent the company from earning the wherewithal to pay those wages and benefits made it impossible for the company to survive in the face of competition not subject to such union bloodsucking.

A further aspect of this same injustice is the government’s naked overriding of Chrysler’s contractual obligations to its bondholders in order to place the U.A.W. and its pension fund ahead of more senior debtors in the Chrysler bankruptcy. Those bondholders who stood up for their contractual rights were denounced by President Obama for refusing to make “sacrifices,” i.e., of their contractual rights. Many of them then gave in, fearful no doubt as to how the government might use its vast array of arbitrary powers against them if they refused, e.g., how the IRS would treat their income tax returns, how the EPA, SEC, FTC, et al. would treat their application for permissions of this or that kind.

The second injustice I want to note is that in this age of alleged “diversity,” a young woman, Carrie Prejean—“Miss California”—who apparently was on the verge of being declared “Miss USA,” was denied that title for no other reason than that one of the pageant’s judges did not like her opinion that marriage was a union between a man and a woman. In response to a question asked of the contestants, she had answered, “No offense to anybody out there, but that's how I was raised and that's how I think that it should be between a man and a woman.” The judge, one Perez Hilton, said "I was absolutely shocked and incredibly frustrated in her, and disappointed. That is not the kind of woman I want to be Miss USA.” So, to be Miss USA, a woman must comply with whatever beliefs such a “judge” wishes to impose. As of this writing there doesn’t seem to much anger and outrage over this travesty of justice.

NOTE: IF THIS BLOG DISAPPEARS, BE SURE TO FOLLOW MY POSTS AT WWW.CAPITALISM.NET (See my previous post for an explanation of this threat.)

Attempt to Silence This Blog

2009-05-01T21:15:00.000-07:00

The enemies of free speech are attempting to silence me. Here is the notice I just received, supposedly from Google. Let Google hear from you about this outrage.

"This blog has been locked due to possible Blogger Terms of Service violations. You may not publish new posts until your blog is reviewed and unlocked.
This blog will be deleted within 20 days unless you request a review."

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

2009-04-24T15:06:00.000-07:00

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

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

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

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

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

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

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

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

“Green” Jobs

2009-04-21T19:47:00.000-07:00

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

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

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

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

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

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

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

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

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

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

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

2009-04-15T10:18:00.000-07:00

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

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

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

Popular Keynesianism

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

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

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

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

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

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

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

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

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

Hoarding and the Rate of Profit

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

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

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

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

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

100 Percent Hoarding and an Infinite Rate of Profit

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

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

More on Hoarding and the Rate of Profit

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

Conclusion

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.

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

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.

The Fundamental Obstacles to Economic Recovery: Marxism and Keynesianism

2009-03-29T20:15:00.000-07:00

In a previous article, I explained how falling prices, far from being deflation, are actually the antidote to deflation. They are the antidote, I explained, because they enable the reduced amount of spending that deflation entails to buy as much as did the previously larger amount of spending that took place in the economic system prior to the deflation.

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

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

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

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

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

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

Happily, this demonstration already exists, in full detail. It can be found in my book Capitalism: A Treatise on Economics, in the 269 pages that comprise Chapters 11, 13-15, and 18, which are respectively titled “The Division of Labor and the Concept of Productive Activity,” “Productionism, Say’s Law, and Unemployment,” “The Productivity Theory of Wages,” “Aggregate Production, Aggregate Spending, and the Role of Saving in Spending,” and “Keynesianism: a Critique.”

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

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

2009-03-07T18:39:00.000-08:00

A recent article in The New York Times quotes President Obama as saying, “I don’t buy the argument that providing workers with collective-bargaining rights somehow weakens the economy or worsens the business environment. If you’ve got workers who have decent pay and benefits, they’re also customers for business.” (March 2, 2009, p. B3.)

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

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

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

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

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

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

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

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

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

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

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

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

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

The reader should keep in mind the coercive nature of collective bargaining. Then he should consider Mr. Obama’s observation that “If you’ve got workers who have decent pay and benefits [as the alleged result of collective bargaining], they’re also customers for business.” This statement makes about as much sense as declaring that people who are successful at sticking up gas stations are also customers of gas stations.

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

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

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

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

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

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

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

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

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

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

ECONOMIC RECOVERY REQUIRES CAPITAL ACCUMULATION NOT GOVERNMENT “STIMULUS PACKAGES”

2009-02-22T20:39:00.000-08:00

Part II: Stimulus Packages

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

The Nature of Stimulus Packages

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

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

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

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

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

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

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

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

Stimulus Packages Mean More Loss of Capital

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rising Prices in the Midst of Mass Unemployment

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

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

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

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

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

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

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

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

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

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

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

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