Washington and Jefferson, Slavery and Marxism

Do not believe the claim made by the media morons that statues of Washington and Jefferson have been toppled because these Presidents owned slaves. Their statues have been toppled because they advocated freedom and created a country based on freedom.

In contrast, the Marxists/Socialists engaged in this desecration are advocates of slavery, out to create a totalitarian dictatorship. At the same time, as part of the same phenomenon, they claim that slavery exists all around us, in the very nature of capitalism.

They claim that the employees of capitalists are slaves: “wage slaves,” they call them. They do this on the basis of their lunatic belief that capitalists gain from the employment of wage earners in the same way that a slave owner gains from the ownership of a slave.

Namely, from the fact that a slave or wage earner is able to produce in a day more than is required to keep him alive and able to work the next day. The existence of this excess or “surplus,” they believe is the explanation of profit.

Thus, capitalists allegedly exploit wage earners in exactly the same way that slave owners exploit slaves.

This may no doubt come as a shock to many multi-millionaires and billionaires busy contributing to Marxist/Socialist terrorist organizations in the belief that doing so buys them protection. There is no protection except to expose these vermin.

And one simple and effective way to do that is to read and publicize this book, which is available in both Kindle and paperback versions at https://amzn.to/2N44uTu.

Among other major subjects, it explains the productive role of businessmen and capitalists and the actual foundations of profit.

WHERE PROFIT COMES FROM

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/.

Credit Expansion, Economic Inequality, and Stagnant Wages

Capital in the form of credit is normally and, certainly, properly, extended out of previously accumulated savings. In sharpest contrast, credit expansion is the creation of new and additional money out of thin air, which money is then lent to business firms and individuals as though it were a supply of new and additional saved up capital funds. Its existence serves to reduce interest rates and to enable loans to be made and debts to be incurred which otherwise would not have been made or incurred. Always and everywhere, to the extent that private banks participate in the process of credit expansion, they do so with the sanction and generally with the active encouragement of the government.

Economists, above all Ludwig von Mises, have shown how credit expansion is responsible for the boom-bust business cycle and how its existence depends on deliberate government policy. Nevertheless, public opinion believes that the business cycle is an inherent feature of capitalism and that the role of government is not that of causing the phenomenon but of combating it. Indeed, as Mises observed, “Nothing harmed the cause of liberalism [capitalism] more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy.”

The truth is that credit expansion is responsible not only for the boom-bust cycle but also for another major negative phenomenon for which public opinion mistakenly blames capitalism. Namely, sharply increased economic inequality, in which the wealthier strata of the population appear to increase their wealth dramatically relative to the rest of the population and for no good reason.

It is not accidental that the two leading periods of credit expansion in history—the 1920s and the period since the mid 1990s—have been characterized by a major increase in economic inequality. Both in the 1920s and in the more recent period, a major cause of the increased economic inequality is that the new and additional funds created in credit expansion show up very soon in the financial markets, where they drive up the prices of securities, above all, common stocks. The owners of common stock are preponderantly wealthy individuals, who now find themselves the beneficiaries of substantial capital gains. These gains are the greater the larger and more prolonged the credit expansion is and the higher it drives the prices of shares. In the process of new and additional money pouring into the financial markets, investment bankers and stock speculators are in a position to reap especially great gains.

Since it’s so important, the main point just made needs to be repeated: credit expansion creates an artificial economic inequality by showing up in the stock market and driving up stock prices. Since the stocks are owned mainly by wealthy people, they are the main beneficiaries of the process. The more substantial and the more prolonged the credit expansion is, the larger are the gains enjoyed by wealthy people more than anyone else.

The new and additional funds injected into the economic system also soon show up in an additional demand for capital goods, such as business inventories and plant and equipment, and in an additional demand for consumers’ durable goods, such as houses and automobiles. The purchase of these latter goods, like the capital goods purchased by business firms, depends largely on credit and is encouraged by lower interest rates. It is also fed by the capital gains being reaped by wealthy individuals, which results in an especially pronounced increase in the demand for luxury housing and for luxury goods in general.

The additional demand for capital goods and consumers’ durable goods serves to increase business sales revenues and thus business profits across a wide spectrum of the economic system. Credit expansion increases profits in the economic system because the expenditure of the new and additional money in buying capital goods and labor increases the sales revenues of business firms immediately, while it increases the costs they must deduct from those sales revenues only with a time lag. This is also true to an extent of inflation that enters the economic system by means of its creators simply spending the new and additional money rather than lending it out—“simple inflation,” as Mises calls it. What is present in both kinds of inflation—credit expansion and simple inflation—is the fact that sales revenues rise as soon as new and additional money is spent, but the costs deducted from the sales revenues of any given year largely reflect outlays of money made in previous years. In those previous years the quantity of money and volume of spending of virtually all types was smaller, including the spending that shows up in the present year as costs in business income statements.

Credit expansion boosts profits more than does simple inflation because the reduction in interest rates it brings about serves to increase the time lag between the making of expenditures for capital goods and labor and their subsequent appearance as costs in business income statements. The low interest rates encourage the purchase of such things as durable machinery and the undertaking of construction projects. The kind of increase that this must bring about in economy-wide profits can be seen in the following examples.

Thus in one case, imagine that a business firm uses newly created money that has come into its hands to increase its newspaper advertising, say. Its additional expenditure will be equivalent additional sales revenue to the newspaper. It will also most likely be an equivalent immediate additional cost to it—a cost that it must deduct from its sales revenues in its very next income statement. Thus, in the same accounting period that the newspaper records additional sales revenues equal to the firm’s additional expenditure, the firm itself must record an equal additional cost of production to deduct from its own sales revenues. Obviously, in this case there is no increase in the economy-wide aggregate amount of profit. This is because economy-wide, aggregate sales revenues and economy-wide aggregate costs have both increased to the same extent.

But now imagine that the firm spends the same amount of money in buying durable machinery that will be depreciated over a ten-year period. Once again, a seller, this time the seller of the machinery, will immediately have additional sales revenues equal to our firm’s additional expenditure. But in this case, our firm will certainly not have an equally large additional cost of production to report in its next income statement. If its expenditure for the machinery was $1 million, say, then while the seller has $1 million of additional sales revenues in his next annual income statement, our firm will probably have merely $100 thousand of additional costs to report in its next annual income statement. This is because the purchase price of the machine is not charged off all at once, but only gradually, over its depreciable life. The implication of this example is that in the current year there will be an addition of $900,000 to economy-wide, aggregate profits. If our firm’s $1 million were part of an investment in the construction of a building with a forty-year depreciable life, the implied addition to economy-wide, aggregate profits would be even greater.

Such boosts to profits go hand in glove with the rise in common-stock prices and greatly reinforce them. Of course, once credit expansion comes to an end, the stimulus it gave to profits and to the stock market both disappear and at that point profits plunge and capital gains turn into capital losses. And at that point, the enemies of capitalism turn to attacking capitalism for causing depressions.

Now as the new and additional money created in credit expansion works its way through the economic system, one would expect the demand for labor and thus wage rates also to rise. This certainly does tend to happen and in the 1920s wages increased substantially in terms both of money and real buying power. They simply did not increase to nearly the same extent as the incomes of the wealthier strata of the population, nor, of course, to the extent that business profits increased.

In addition to the special stimulus given to profits, a second reason for the failure of wages to keep pace with the rise in profits, is that the encouragement given by credit expansion to the purchase of durable capital goods, particularly plant and equipment, tends to take place at the expense of funds that otherwise would be devoted to the purchase of labor services. As a result, the rise in wages is retarded at the same time that profits sharply advance. For this reason too it does not keep pace with the rise in profits.

Despite any appearances to the contrary, the rise in real wages in the 1920s was not the result of credit expansion but of rising production. Credit expansion actually operated to retard the rise in production insofar as it caused the wasteful investment of capital, i.e., what Mises calls malinvestment.

The rise in production is what prevented the prices of goods and services from rising as rapidly as credit expansion raised wage rates in terms of money. The rise in production, in turn, was based on a high degree of availability of capital funds provided by actual savings, as opposed to credit expansion, together with rapid scientific and technological progress. It was this that increased real wages, i.e., the goods and services that wage earners could actually buy with their wages.

In contrast to the experience of the 1920s, in the two great recent credit expansions, i.e., the dot.com bubble of 1995-2001 and its successor the presently collapsing housing bubble that began not long thereafter, there has been very little, if any, rise in real wages. Most commentators appear to attribute this to nothing more than the unrestrained greed of businessmen and capitalists. They apparently go on the theory that if there is anything in the economic system that breathes or moves other than at the command of the government, or other than with the active supervision and control of the government, it is proof that we live in an era of “laissez-faire.” For example, in The New York Times of December 30, 2007, in an article titled “The Free Market: A False Idol After All?,” Times columnist Peter Goodman writes:

For more than a quarter-century, the dominant idea guiding economic policy in the United States and much of the globe has been that the market is unfailingly wise. So wise that the proper role for government is to steer clear and not mess with the gusher of wealth that will flow, trickling down to the [sic] every level of society, if only the market is left to do its magic.

That notion has carried the day as industries have been unshackled from regulation, and as taxes have been rolled back, along with the oversight powers of government.

This alleged laissez-faire environment, such writers pretend, has enabled businessmen and capitalists shamelessly to enrich themselves at the expense of increasingly impoverished wage earners, to whom nothing any longer even “trickles down.” Increased free trade and “globalization,” of course, are attacked as part of the process and as greatly contributing to the stagnation or outright decline in real wages.

In sharpest contrast to such blather, in the real world there are innumerable rules and regulations enacted by the Federal Government to control virtually every aspect of economic activity. They are contained in the more than 70,000 pages of The Federal Register. The overwhelming mass of government interference described therein, and in its counterparts at the state and local level, is a glaring refutation of claims about the existence of any kind of laissez faire in the present-day world. The very description of such interference, in tens of thousands of pages of official text, is a refutation of such size and literal weight as to render any claims about laissez faire or insufficient government controls or regulations utterly nonsensical.

This truly massive body of material also suggests that the actual explanation of the stagnation in real wages is precisely an ever growing burden of government intervention in the economic system. The intervention is in the form of policies that undermine genuine saving and in numerous other ways undermine capital accumulation and the rise in the productivity of labor. Personal and corporate income taxes, the inheritance tax, the capital gains tax, and government budget deficits—all entail the taking away of funds that if left in the hands of their owners would have been heavily spent, indeed, overwhelmingly spent, in the purchase of capital goods and labor services. Instead, those funds are diverted into financing the consumption of the government and those to whom the government gives money.

Inflation and credit expansion greatly exacerbate this diversion of funds, because their effect is artificially to increase the incomes subject to these taxes and to thus to deprive business firms of the funds required to replace assets at prices made higher by the same process that increases their taxable incomes. The progressive aspect of income and inheritance taxes also worsens their effects, because incomes tend to be saved and invested the more heavily the larger they are; at the same time, substantial inheritances are more likely to be retained in the form of accumulated savings and capital than are modest inheritances.

Because of the reduced demand for labor that results from the taxation of funds that would otherwise have been used in employing labor and in buying capital goods, wages are substantially less than they otherwise would have been. At the same time, the buying power of those reduced wages is also sharply reduced in comparison with what it would otherwise have been.

It is worth pointing out that totally apart from the effect of social security in undermining the incentive to save, the sheer rise in tax rates since 1965 to pay for the system has taken away fully eight additional percentage points of the income of every wage earner whose earnings are equal to or less than the amount subject to such taxation. In 1965 the combined social security tax on wage earners and their employers was 7.25 percent, which applied to a maximum annual income of $4800. Today, the combined rate is 15.3 percent, which includes 2.9 percent for Medicare. The 15.3 percent rate currently, i.e., in 2008, applies to all wages and salaries up to a maximum of $102,000 per year. The effect of these major increases both in social security tax rates and in the amount of income
subject to them has been to reduce the take-home wages of many workers by considerably more than 8 percent.

The social security contribution of employers is a loss to wage earners, because it is a cost of employment no different than the payment of take-home wages. Financially, it is a matter of indifference to employers whether they pay this sum to the government or to their employees. The cost to them is the same. It is money that the employees could and would have had, if the government had not taken it from the employers.

The same is true of all other costs borne by employers on behalf of their workers, whether it is health insurance, day care, family leave, or whatever. The costs in question are all costs of employment, which, in the absence of such government interference, the wage earners could and would have had in their own pockets. Compelling employers to pay the costs of such things is at the expense of the workers’ take-home wages. The more such costs are imposed, the lower are take-home wages in comparison with what they otherwise would have been. The increase in such costs over time has correspondingly held down any rise in take-home wages.

Government intervention, as I’ve said, not only holds down the demand for labor and thus wages, particularly take-home wages, but it also reduces the buying power of wages. This is because the supply of capital goods is less, thanks to the diversion of funds from their purchase. The absence of these capital goods prevents the productivity of labor from being increased as much as it otherwise would have been. This in turn holds down the production both of consumers’ goods and of further capital goods. The consequence of a lesser supply of consumers’ goods is prices of consumers’ goods that are higher than they otherwise would have been and thus a buying power of wages that is correspondingly lower than it otherwise would have been.

The consequent absence of further capital goods compounds the negative effect on production, in a process that can be repeated over and over again, with each passing year. What this means is that because fewer capital goods in the form of factories and machines are available this year, the ability to produce capital goods in the form of factories and machines for the following year is reduced, because capital goods in the form of factories and machines are the means of producing further capital goods in the form of factories and machines no less than they are of producing consumers’ goods.

The buying power of wages is also reduced by all of the other laws and regulations that hold down the production and supply of goods in general and thus keep up prices. And again, there is a compounding effect. Environmental legislation deserves an especially prominent place in any list of such laws and regulations. Already, because of the restrictions it has imposed on the production of oil, coal, natural gas, and atomic power, it has served to raise the price of energy to unprecedented levels and to deprive many wage earners of the ability to buy gasoline for their cars or trucks and heating oil for their homes. To the extent that wage earners are able to pay energy prices reflecting a $100- per-barrel price of oil, their ability to buy other goods is correspondingly reduced. If the environmental movement’s agenda of radical reductions (up to 90 percent) in carbon dioxide emissions is imposed, meeting it will require absolutely crippling cutbacks in the production and use of oil, coal, and natural gas which must result in corresponding reductions in production, increases in prices, and absolute devastation for real wages.

The negative effect on production here is again a cumulative one, inasmuch as lack of energy supplies hampers the ability to find and exploit further supplies of energy. The more abundant and cheaper energy is, the greater is man’s ability to move masses of earth and to process them, thereby developing further energy supplies. Thus, government intervention that reduces energy supplies reduces the ability to find and exploit further energy supplies.

Other examples of laws and regulations holding down production are minimum-wage, prounion, and licensing legislation. These cause higher costs, higher prices, the diversion of labor from more productive pursuits to less productive pursuits, and, finally, unemployment. Subsidies of all kinds, tariffs, and consumer-product safety legislation also serve to hold down the production and supply of things and to keep up or add to their costs and prices. Again, to whatever extent production in general is curtailed, so too is the production of capital goods, with a consequent cumulative negative effect on subsequent production.

It should be clear that the resumption of an era of high and progressively rising real wages requires a radical reduction of government intervention into the economic system and the reestablishment of economic freedom.

What we have seen is that credit expansion is responsible not only for the boom-bust business cycle, as Mises showed, but also that it is a major source of artificial economic inequality and sharply increases profits relative to wages. These are processes that come to an end and are actually thrown into reverse as soon as credit expansion stops and the recession/depression that is its ultimate consequence begins. In wasting capital through malinvestment, it undermines the rise in production and accompanying rise in real wages. Despite credit expansion, real wages could still rise through most of American history, because of the substantial economic freedom enjoyed in the United States and did so even in the midst of credit expansion, as in the 1920s. In the last two episodes of major credit expansion, however, and over the last several decades as a whole, real wages have largely stagnated. This stagnation is the result of massive government intervention into the economic system that undermines capital accumulation and both the demand for labor and the productivity of labor. It is not the result of economic inequality, the profit motive, or any other aspect of the capitalist system.

I have explained all of the essential matters discussed in this article in full detail, with all of their presuppositions and implications, in my book Capitalism: A Treatise on Economics.


Copyright © 2007, by George Reisman. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net.

DEFLATION AND THE GOLD STANDARD

November 5, 2007*

Calling falling prices per se “deflation” is one of the most serious errors one can make in economics. It’s tantamount to confusing becoming richer with becoming poorer. It leads people to believe that increases in production, which are the foundation of enrichment, but which also operate to make prices fall, are at the same time the source of depression and impoverishment.

To get matters straight, we need to clarify some things.

Prices can fall either because of more supply (i.e., more goods and services being produced and sold) or because of less demand (i.e., less money in existence and/or less overall spending of money in the purchase of goods and services).

A depression is characterized not only by falling prices, but also by a plunge in business profits (which may even become negative in the aggregate) and by a sharply increased difficulty of repaying debt. It is also characterized by mass unemployment.

While a gold standard very definitely can and probably will be accompanied by falling prices, it is not accompanied by plunging profits, a greater difficulty of repaying debt, or mass unemployment. The conjunction of these latter with falling prices is the result of a decrease in the quantity of money and volume of spending. A decrease in the quantity of money and volume of spending is the result not of a gold standard but of the incompleteness of a gold standard. It is the result of a fractional-reserve gold standard, in which gold represents only a portion of the money supply while the rest is based on debt. In such circumstances, the failure of debtors is capable of causing bank failures, which serves to reduce the quantity of money and volume of spending.

Under a full, i.e., 100-percent reserve gold standard, new and additional gold continues to be mined, and at a rate faster than gold is physically lost, e.g., in such things as shipwrecks and the burial of people with gold dental fillings in their mouths. Thus the quantity of money and volume of spending under a full gold standard increases. However, it does so at a modest rate. Prices fall under a full gold standard to the extent that the increase in the production and supply of goods and services other than gold outstrips the increase in the quantity of gold and the spending of gold.

Despite the fall in prices, the increase in the quantity of gold money and spending under a full gold standard serves to increase the economy-wide average rate of profit and interest. It does so for the simple reason that in the nature of the case there tends to be more money and spending in the economy at the time when products are sold than there was at the earlier points in time when money was expended for the means of producing those products. Thus the margin by which sales revenues outstrip costs is correspondingly increased.

Furthermore, despite the accompanying fall in prices caused by the more rapid increase in the production and supply of goods and services other than gold, the increase in the quantity of gold and the volume of spending in terms of gold serves to make the repayment of debt somewhat easier. For example, suppose that sales revenues in the economic system are rising at a two percent rate because of increases in the supply and spending of gold, but that prices are falling at a three percent rate because the supply of goods and services other than gold is increasing five percent per year. The average seller in this case will have five percent more goods to sell at prices that are only three percent less. His sales revenues will rise by two percent. He will be able to earn progressively increasing sales revenues and income despite the fall in his selling prices, because the increase in the supply of goods and services he has available to sell outstrips the fall in his selling prices to the extent of the increase in the quantity of gold money and spending.

The modest elevation of the rate of profit resulting from the increase in the quantity of gold is the opposite of what happens in a depression. So too is the greater ease rather than greater difficulty of repaying debt.

Thus, the truth is that a full gold standard, with its falling prices, is as much the enemy of deflation as it is of inflation.

As for mass unemployment: If there is a deflation, in the correct sense of a decrease in the quantity of money and/or volume of spending, then falling prices, so far from being the cause of deflation/depression are the way out of it. In such circumstances, a fall in wage rates and prices is precisely what’s needed to allow a reduced quantity of money and volume of spending to buy all that a previously larger quantity of money and volume of spending bought. If, for example, as in 1929, there was originally roughly $50 billion in payrolls employing 50 million workers at an average annual wage of $1,000 per year and now, because of deflation, there are only $40 billion of payrolls employing 40 million workers, full employment could be restored if the average wage rate fell from $1,000 to $800 per year. In that case, $40 billion could employ as many workers as $50 billion had done.

Viewing the fall in wage rates and prices that is needed to recover from deflation as itself being deflation and thus preventing the fall in wage rates and prices, as occurred under Hoover and the New Deal, serves only to perpetuate the unemployment and depression.

Confused concepts result in catastrophic consequences.

GEORGE REISMAN

P.S. For elaboration of the points made in this discussion, see my article "The Goal of Monetary Reform," The Quarterly Journal of Austrian Economics, Fall 2000, vol. 3, no. 3, pp. 3–18, and my book Capitalism: A Treatise on Economics, pp. 544–46, 557–59, 573–80, 809–20. See also my Mises.org Daily Article "The Anatomy of Deflation," August 22, 2003

*This essay was originally a posting to the Ludwig von Mises Institute’s discussion list.

Copyright © 2007, by George Reisman. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net.