Road to Permanent Prosperity

RPP CoverThe Road to Permanent Prosperity

DEWEY B. LARSON

Copyright (c) 2008 by the International Society of Unified Science.
All Rights Reserved.

01 Introduction

CHAPTER 1

Introduction

Modern man, homo sapiens, as he calls his species with a characteristic lack of modesty, has left evidence of his presence in various locations on earth for fifty thousand years or more. During this long interval his fortunes have fluctuated widely, periods of relative prosperity have alternated with grim struggles for survival, but there has been an unmistakable general trend towards a better understanding of the problems of existence, and human life is far different today from what it was in the Old Stone Age. When we stop to analyze this progress, however, it is apparent that the forward movement has been far from uniform. In most fields of activity the gains have been meager and painfully slow. Indeed, in some of these fields it is questionable whether we have advanced much beyond the point where our ancestors stood at the dawn of recorded history. Politically, war and the threat of war are still the same psychological and material burden on the nations of today as they were on the rival tribes of the prehistoric era. Economically, the great majority of the human race still live under one version or another of the same primitive communal economic organization that developed from man’s first awkward efforts at group living, and where more advanced systems have evolved they are imperfectly understood and ineptly handled. Ethically, the conduct of the populace in general is still far below the standards of even the earliest of the great moral and religious teachers.

In striking contrast, progress toward understanding and control of the physical environment has been outstanding, and during the last few centuries knowledge in this field, the province of physical science and its applied branches, has been expanding at a rate that might well be termed explosive. Recent spectacular achievements in certain special areas have merely dramatized this rapidly accelerating forward movement, which is taking place all along the physical front. This situation wherein one branch of knowledge is continually reaching out for new worlds to conquer while its fellows still grapple unsuccessfully with the problems of the Cave Dwellers is a strange anomaly in our present-day society, and the reasons for the extraordinary disparity deserve much more serious consideration than they are commonly given.

A comparison like this is usually shrugged off with the assertion that the problems in these other fields are more difficult than physical problems, and that the slower rate of progress is due to this factor. We are entitled, however, to take this kind of a contention with a grain of salt. It is one of those statements that can neither be proved nor disproved, the kind of an explanation that is made to order for those who wish to rationalize failure to reach their goals. From a purely detached point of view it is hard to understand why the maintenance of full productive employment, for instance, should warrant being classified as a more difficult task than the design and manufacture of an airplane. If exactly the same methods had been applied to the solution of both problems we might perhaps be justified in concluding that the problem which resisted these methods was the more difficult, but where totally different methods have been utilized we are certainly not out of order in suspecting that failure in one case and success in the other is a reflection of the relative adequacy of the methods used, rather than of the relative difficulty of the problems.

One of the most significant discussions now in progress turns on how far the methods by which the astonishing results in pure and applied science have been achieved may be transferred to other human activities.2

—James B. Conant

Of course, many economists contend that scientific methods are not applicable in their field. Frank H. Knight, a prominent economist of the post-World War I era, wrote extensively on the subject, and expressed the opposing view clearly. He characterized “the notion that social problems can be solved by applying the methods by which man has achieved mastery over nature” as “false, and illusory.” In support of this conclusion, however, he makes this statement: “But obviously, the basic problems are value problems, to which natural science has little relevance… It [science] shows how to do things, how to achieve a concretely defined objective, not what objectives to pursue.”3

The implication of this statement is that the identification of “what objectives to pursue” is the primary task of economics, and that the issue of “how to reach a concretely defined objective” is irrelevant. Paul Samuelson makes the same point by defining the objective of economics as obtaining the answers to three questions, all of which are addressed to the issue of “what objectives to pursue.” He lists the following:

  1. What commodities shall be produced and in what quantities?
  2. How shall goods be produced?
  3. For whom shall goods be produced?4

We need look no further to see why progress in economics has been so slow compared to the rate of advance in the scientific fields. The inevitable result of the policy of concentrating attention on identifying the objectives is that economics is now long on commendable objectives and short on methods by which to reach those objectives. Clearly there is a wide gap here that needs to be filled by systematic study of the factual side of economics, which we may define as obtaining the answers to two very different questions, as follows:

  1. How does the economic system operate?
  2. How can we manipulate it to attain our defined objectives?

The economists challenge the assertion that there are factual answers to these questions, and even deny that there are factual data that can be applied to a resolution of the issues. From Heilbroner and Thurow we get this assessment of the situation:

One of the most important attributes of modern history is lodged in a striking difference between two kinds of knowledge: the knowledge we acquire in physics, chemistry, engineering, and other sciences, and that which we gain in the sphere of social or political or moral activity. The difference is that knowledge in some sciences is cumulative and builds on itself, whereas knowledge in the social sphere does not.5

Frank Knight agrees. He tells us that “The data with which the social sciences are concerned are themselves not objective in the physical meaning—are not data of sense observations… They consist of meanings, opinions, attitudes and values, not of physical facts.”6 This has been the opinion of the leading economists ever since the beginning of systematic study in this area. One of the early theorists, Alfred Marshall, explained, “Economics is a study of men as they live and move and think in the ordinary business of life,”7 and on this basis he asserted that “the actions of men are so various and uncertain, that the best statement of tendencies which we can make in a science of human conduct, must needs be inexact and faulty.”8 Heilbroner and Thurow say that “economists observe the human universe, just as scientists observe the physical universe, in search of orderly relationships.”9 Jacob Viner, a contemporary of Knight, contended that there are no relationships in economics comparable to those found in science.

We have no logical justification for belief in the existence of important economic functions that are simple, stable through time and space, and characterized by stable and fixed parameters. The social order is in these respects different in kind, or different in so high a degree as for most practical purposes to be equivalent to a difference in kind, from the physical or even the biological order of nature.10

As these statements demonstrate, the economists, by and large, look upon the subject matter of economics as a study of human behavior. They view it as an uncertain and elusive field where exact correlation of cause and effect is impossible. Business, scientific and technical people, on the other hand, find that the economic forces that they encounter in the course of their daily tasks move steadily and relentlessly forward to their inevitable consequences regardless of human desires and opinions. We have found that if we accommodate ourselves to these natural forces, they can be made to serve our purposes; if we do not, they mow us down without a trace of compassion. The very best of intentions are of no avail; the utmost of human determination is futile. Either we stay on solid economic ground or we go down to certain defeat.

Forces of this kind are no strangers to us. Throughout our everyday work we are dealing with physical forces that display exactly the same characteristics. If we wish to erect a building, we must design the structure in conformity with the physical principles that govern the various elements. If we neglect or refuse to do so, there is no argument about it. The building collapses and that is the end of the matter. We cannot protest the decision; we cannot appeal to higher authority. So far as our experience would indicate, there is no essential difference between the physical laws and the economic laws with which we come in contact. Neither can be challenged or ignored with impunity. Neither is affected in the slightest degree by our approval or disapproval.

It is apparent that we are concerned with aspects of the economic process that are quite different from what the economists see. They are focusing their attention on the objectives of economic actions, which are the results of human decisions, whereas we are primarily concerned with the effects of those actions, which are controlled by natural laws independent of human preferences and opinions. Our observation is that when an economic action is once taken, the ensuing events march inexorably forward to definite and certain consequences that are wholly independent of the hopes and desires of those who initiated the action. Here, then, is another side of economics, a field that has been overlooked or disregarded. What we now propose to do, in this work, is to apply scientific methods to an examination of this hitherto unexplored, or at least under-explored, field.

Economists, like the workers in other non-scientific fields, are what the medical profession calls general practitioners. There are different ideas as to methods, to be sure, and individuals have their own personal fields of special interest, but there is no division of labor, which is at all comparable to that in the scientific ranks. For example, J. M. Keynes, the most influential of the modern economists, made his own basic studies and constructed his own theories, thus performing functions analogous to those of the pure scientist. He then applied his findings and his theories to economic problems and arrived at methods for handling these problems, which he believed were appropriate on the basis of the theories, which he had devised, thus performing functions analogous to those of the engineer. Finally, he took over the role of advocate and worked strenuously and effectively to get his theories and recommendations adopted by governmental agencies and others concerned.

Many other less publicized members of the economic profession have covered similar ground, still others confine their activities to one or two of these three fields, but they are all recognized as “economists.” They get their training in the same college classes and from the same textbooks, they read the same journals, and they belong to the same professional societies. No distinction such as that between pure scientists and engineers is ever made, nor does the economist normally recognize that in waging a partisan battle for the adoption of his favorite economic “reform” program he is stepping outside the field of economics and into that of politics, the determination of public policy.

The final stage of economic planning, the decision-making process, requires consideration of the social and political aspects of the issues under consideration, as well as the economic aspects. These are items of a nature very different from the factual considerations that enter into a determination of how the system operates, and they call for a very different approach to the subject matter. In the absence of any definite sub-division of the field, it is practically inevitable that either one or the other of these different approaches should dominate the thinking and the activities of the economic profession.

It is interesting to note that there was actually a trend in the scientific direction at one time. In the early days of economics in the United States, the authors of two of the most widely used textbooks were scientists: General Francis A. Walker, one of the early presidents of the Massachusetts Institute of Technology, and Simon Newcomb, the celebrated astronomer. (Incidentally, General Walker was the first president of the American Economic Association.) However, the close relation between economics and social problems tended to draw many of those primarily interested in such problems into the economic field, with the result that economics has become a branch of sociology rather than a branch of science, a classification which both the standard library systems and the college curricula recognize.

Unfortunately, the triumph of the sociological viewpoint in economics has had the result of distorting the economist’s picture of what is taking place in the world. The individual who looks at economic activities through sociological spectacles sees people in their social settings and classifications, not in their economic environment. For instance, he sees capitalists, a social class, rather than suppliers of capital, an economic class. If he were dealing with social problems, this might be quite appropriate, but it is fatal to the validity of his conclusions regarding economic matters, as the suppliers of capital are not necessarily, or even usually, capitalists in the social sense. Indeed, there is no economic reason why they should ever be capitalists.

The picture is further distorted because the sociologically oriented economist usually has a strong bias against capitalists (the social class), which prevents him from recognizing the true place of suppliers of capital (the economic class) in economic life. In the subsequent analysis we will find many other examples of this same situation: the socio-economist sees a social picture rather than an economic picture, and when he tries to make economic sense out of what he sees, all too often there is confusion.

Following the usual sociological pattern, the literature of the economic profession is primarily partisan. The great majority of economic writers, past and present, have been special pleaders rather than unbiased searchers for the truth, exponents of a particular point of view rather than impartial judges of the facts. “Economists, in books and articles and letters to the editor, tirelessly urge this policy or that,”11 says one of their own number.

If the policies that were adopted on the strength of their theories had been successful in practice, the economists would have a good case in favor of continuing to advocate measures based on these theories. But the reality is far different. The pessimistic assessment of the present situation in the economic field by Heilbroner and Thurow has already been quoted. Samuelson likewise concedes that the economic profession has failed to accomplish its principal objectives; it “cannot find the combination of policies that allows full employment, stable prices, and free markets.”12 He admits that “what may be needed are new approaches to the problems of productivity, wages, and price formation.”13

J. K. Galbraith blames the economy for not conforming with the theories. As he puts it, the American economic system operates “in defiance of the rules”14 laid down by the economists, and those rule-makers cannot account for what Galbraith admits is, at least at times, a “brilliant” performance. Joan Robinson, a devout Keynesian, tells us flatly, “It is impossible to understand the economic system in which we are living if we try to interpret it as a rational scheme”.15

When those who have undertaken the task of analyzing our economy not only admit that they are unable to discover the true rules by which it is governed, but come to the conclusion that it has no rational basis at all (which means that the remarkable results that the system achieves must be accidental), then common sense warns us that it is no longer sound policy to continue relying on the methods and procedures that have brought us to this dead end.

We need to recognize that the basic elements of economics are purely factual. The underlying reason for all economic activity is the iron law that man must work or starve, a law that the human race as a whole cannot evade, no matter how distasteful it may be. Similarly, the primary economic processes are governed by fixed and immutable principles, which are beyond the reach of human powers. Any action taken in defiance of, or in ignorance of, these principles must inevitably fail in its intended purposes, no matter how commendable the objective of that action may be.

Under present conditions relatively few people recognize the existence of these matters of fact in economics. The socio-economists present their arguments for or against proposed measures which involve factual questions—price controls, public works programs, minimum wage laws, employment measures, etc.—almost entirely on the basis of the desirability of the objectives at which the measures are aimed, with little or no reference to the question as to whether such measures are capable of reaching those objectives. With very few exceptions, legislators decide whether to vote for or against legislation of this nature on exactly the same basis that they use in deciding how to vote on purely policy measures, never realizing that in the former case the hard facts of economic life may nullify, or even reverse, the effects which they are trying to produce by passing such laws. Far too many economic experiments initiated with enthusiasm and high hopes have ended in bitter disappointment because their authors ignored or disputed the existence of permanent and unchangeable laws and principles in the economic field.

We live in a period in which most of the conventional wisdom of the past [in economics] has been tried and found wanting. Economics is in a state of self-scrutiny, dissatisfied with its established premises, not yet ready to formulate new ones. Indeed, perhaps the search for a new vision of economics… is the most pressing economic task of our time.

—Heilbroner and Thurow1

02 The Scientific Approach

CHAPTER 2

The Scientific Approach

The primary thesis of this volume is that the fundamental principles governing the economic system are purely factual and should therefore be removed from the branch of sociology now designated as economics, and should be reconstituted into a new discipline which, for want of a better term, we may call  economic science . This new branch of knowledge should be handled by scientists by means of the accepted methods of factual science, and should be recognized as an integral part of the scientific field, a subject that is taught in a College of Science, where one exists, rather than a College of Liberal Arts, and is indexed under Science—classification 500—rather than under Sociology—classification 300.

There is no implication here that factual science is basically on a higher level than non-science or that it involves any superior manifestation of human ability. As Joseph Schumpeter puts it, “There should be no susceptibilities concerning “rank” or “dignity” about this; to call a field a science should not spell either a compliment or the reverse.”16 The argument for transferring the factual aspects of the non-physical subject matter to science is not based on any special abilities that scientists may have, but on the superiority, in application to factual material, of the methods that scientists utilize, methods that are very difficult to fit into the working practices of disciplines that deal mainly with opinions and judgments.

In this connection it should be noted that the special merits of the scientific approach to factual questions are not restricted to those fields of human activity that are primarily factual, they apply to the factual areas of all fields, and they are not applicable to the non-factual sectors of any of these fields, even those that are popularly supposed to lie entirely within the scientific domain. It logically follows that for best results the factual aspects of all fields of activity should be treated by scientists, and through the agency of those scientific methods whose efficacy in dealing with factual matters has been clearly demonstrated. In other words, the conclusion to be drawn from the foregoing discussion is that the factual portions of all branches of human knowledge should be separated from the non-factual remainder and should be turned over to science, just as music, for example, makes no attempt to deal with the fundamentals of sound, upon which all music is based, but leaves such matters in the hands of science as a sub-division of physics.

This brings us to the question as to just what constitutes the scientific method. What is there in the working habits of the scientific profession that is absent in other fields? Curiously enough, even the scientists themselves do not always agree on this point. They do not question that the spectacular results achieved in the physical fields are products of the scientific method, but there is no uniformity in the definition of this method. Most individuals, both within and without the scientific profession, are inclined to associate the term “scientific” with the painstaking, systematic, mathematical approach which characterizes the work of the scientist as he is usually pictured. But even a casual survey of the history of science shows that many brilliant and successful scientists have followed a totally different working procedure, and some important scientific discoveries have originated from intuition or pure chance, with little or no systematic work having been done. Although most scientific studies do follow a rather definite pattern, these historical data show that we must rule out the idea that this pattern is the essence of the scientific method. What, then, is the distinctive feature of science?

The answer to this question is readily accessible to anyone who undertakes research work in both the physical and the non-physical areas. He will find that he can apply the same working procedures in both cases. Whatever his personal technique may be—whether he works slowly and deliberately with meticulous attention to detail, or whether he relies more on intuitive processes to carry him swiftly forward, touching only the high spots as he advances—he can apply his favorite technique equally as well in one field as the other. He will find subject matter of essentially the same nature in both areas. The subject matter customarily treated in non-scientific studies differs substantially from that normally treated in science, but, as will be brought out in the discussion that follows, the same types of subject matter actually exist in both cases, and the differences in the character of the topics generally treated in the two fields are merely the results of selectivity on the part of the investigators. He will find that the results obtained outside the physical fields, where meaningful results do emerge from the investigations, are equally as significant as the physical discoveries. From the standpoint of immediate practical application to present-day problems the results in the economic and political fields, for example, may well be of even more importance than the sensational physical achievements.

Up to this point there is little, if any, distinction that can legitimately be drawn between scientific and non-scientific studies. But there is a very important difference in what happens after the work has been done and some significant results have been obtained. In physical science there is general agreement that the judgments which are passed on new ideas originating from such findings should be based on purely objective criteria, the most important requirement being that these ideas must be consistent with the observed facts. In the non-physical fields, on the other hand, there are no objective tests, which are regarded as authoritative, and acceptance or rejection of any new idea is primarily a matter of personal preference.

Like all other human institutions, the existing scientific organization is imperfect, and it moves slowly and erratically toward its defined goal rather than smoothly and swiftly, but because the facts of observation are, at least in principle, accepted as the ultimate authority, there is a definite mechanism in operation whereby the areas of disagreement are continually narrowed, and the accepted body of thought in the physical field is enabled to move ever closer to the ultimate truth. In the non-physical fields, where objective tests are lacking, as matters now stand, there are no means by which the relative merits of conflicting ideas can be evaluated on any consistent basis, or by which correct answers can be recognized as such if they do appear. Consequently, the gains in those fields are limited to those produced by trial and error, and whatever progress is made by reason of one action that proves successful is all too often nullified by ill-advised measures that act in the opposite direction. Sustained forward progress similar to that in the physical field is impossible without an effective means of separating the false from the genuine.

Here is the essential feature of the scientific procedure: the real difference between science and non-science. Physical science has been established as a permanent and ever-growing body of knowledge not because scientists are more competent than other human beings, or because there are any superior investigative methods applicable only to physical phenomena, or because the field in which scientists work is any more amenable to logical treatment. It has acquired this status because physical science alone among the major branches of human knowledge has set up objective tests by which the relative merits of conflicting ideas can be judged, and confines itself to subject matter that can be thus tested; that is, to purely factual subject matter.

The essential characteristic of the scientific method is that the process of study and investigation is always directed toward the objective of meeting the ultimate test of comparison with the observed facts. On this basis, only factual subject matter can be taken into consideration and only logical and mathematical reasoning can be utilized in treating it. Emotional judgments and wishful thinking are barred. Wherever the term “scientific methods” is used in the discussion in this volume it refers to methods, which meet the foregoing requirements, irrespective of whether the work is mathematical or non-mathematical, exact or approximate, general or specific, valid or invalid. It is not necessary to meet the acid test of factual comparison in order to qualify as scientific. Much of the work of science fails to pass the test, and is discarded. A great deal more is simply work in progress that has not yet reached the point where it is ready to face a rigid evaluation. The feature that it must have in order to be classified as scientific is that the work must be aimed at passing the factual test.

Because of the existence of a criterion of validity and its general acceptance as the ultimate authority, controversies and differences of opinion do not go on forever in physical science as they do elsewhere. In each case a decision is eventually reached as to which explanation is true, and this truth is then incorporated into the accepted body of knowledge. As defined by the scientific profession, “truth” is taken to be synonymous with agreement with observation and measurement. On this basis, anything that is in full agreement with the observed facts is true, within the limits to which the correlation has been carried, anything that approaches full agreement is a close approximation to the truth, anything that conflicts with the results of authentic observations is not true, and anything that cannot be adequately tested by means of the comparisons currently available is merely hypothesis.* (It should be understood that the expression “results of observation” as used in this connection refers only to actual measurements and qualitative observations, and does not include inferences drawn therefrom or theories formulated to explain the factual findings, unless those theories are validated independently.)

This test of validity does not necessarily arrive at an immediate and unequivocal answer in every case, inasmuch as a concept or theory does not normally explain all of the facts within its scope of application, and even if it did, the factual observations and measurements are not infallible. However, the mere existence of an accepted method of test centers the attention of the scientific profession on any unresolved question and keeps the issue in the limelight until sufficient additional information has been accumulated to enable reaching a firm decision one way or the other. As a consequence, the areas of dispute are limited, and in essence the workers in the field of physical science speak with a single voice. It is not necessary for the student of science or engineering to look at the name of the author of his textbook. With very minor exceptions he finds the same information in any text, which he may consult.

As a consequence of the methods by which it is obtained and verified, scientific knowledge is permanent. Once a law of science is definitely established it is good forever. We may find as a consequence of more accurate or more extensive observations that the field to which the law is applicable is more limited than was thought originally, but this does not alter the validity of the law in its proper sphere, and the new information represents an extension of knowledge, not a revision. Theories and concepts may be revised, but not knowledge. As Lecomte du Nouy points out, “Science has never had to retract an affirmation based on facts that are well established within accurately defined limits.”17

Being permanent, scientific knowledge is cumulative. Each bit of information gathered in the ceaseless search for the truth adds to the total. It may refute erroneous conceptions where the facts were not accessible previously, or it may point out hitherto unsuspected limits to the area in which certain accepted principles are valid, but it does not overthrow any laws that have once been definitely established. Science is not vulnerable to the kind of an indictment made of economics by Franklin D. Roosevelt: that it changes its laws every five years.18

It is true that there is considerable variation in the details of the methods and procedures utilized by scientists, but these variations are not very significant. We might compare the selection of methods to the selection of a travel route. If we start from New York for some unidentified destination, which we cannot recognize when and if we get there, one route is as good as another. But once we have specified that our objective is Chicago, we put ourselves in a position where we are able to determine the relative merits of different routes. We must still admit that we can reach our destination by any one of many paths, and it is therefore incorrect to speak of the route from New York to Chicago, but we can see that certain routes are shorter and more advantageous than others. Just as the bulk of the traffic between these two cities will follow these more efficient routes, the great bulk of the research and experimental work in the physical sciences follows the pattern which experience has demonstrated to be the most efficient.

In the course of developing this most efficient pattern, it has become apparent that there are some very substantial advantages to be gained by functional specialization. Application of any kind of knowledge to human advantage involves three different operations, each of which requires a different type of treatment in order to secure the best results, and each of which calls for quite different talents on the part of those who perform the tasks. Let us consider the building of a bridge, for example. First, we need a great deal of basic information. We must know just what stresses are generated by the various factors that affect the structure—its own weight, traffic, winds, etc. We must know just how the various materials of construction resist these stresses. We must know the strength of the available materials under different conditions, and the means whereby we can take full advantage of that strength, and so on. This is the province of the pure scientist.

Next on the scene is the engineer, the practitioner of applied science, who extracts from his handbooks and other sources the particular portions of the information developed by the specialists in pure science that apply to the project at hand, and with the benefit of this information determines just what can be done to accomplish the desired objective. He then proceeds to devise practical methods of procedure, utilizing that ingenuity which has given the engineering profession its name. Finally he evaluates the advantages and disadvantages of the different alternatives and makes recommendations as to the course to be followed.

In the last step, these reports and recommendations are reviewed by a third group, a non-scientific group that we may call the decision-makers. These individuals—corporation executives, government officials, others responsible for the general direction of the operations involved, or in major matters, the general public itself—make the final decisions between alternatives. Science takes an impartial attitude toward the final decision. The pure scientists normally have no connection with it al all, and the engineers recognize an obligation to present the alternatives in an unbiased manner. The only concern of the scientists of either the pure or applied branches, as scientists, is that all of the known facts which have a bearing on the situation be recognized in their true light and that these facts be given due consideration in arriving at a decision.

One of the first essentials in applying factual scientific methods to the non-scientific fields is to separate these distinct, and frequently conflicting, functions, as a preoccupation with the question of what ought to be done, a question of opinion and judgment with strong emotional overtones, to the exclusion of the question of what can be done, a question of cold-blooded and unemotional fact, is one of the principal factors that has made economics a branch of sociology rather than a branch of science.

Of course, the scientific process does not always operate in a strictly scientific manner. Scientists are also members of the general public, and they do not always distinguish clearly between their different roles in the social organization, but in general the procedure for handling those activities which lie within the domain of physical science effectively separates the determination of what can be done and how it can be accomplished from the decision-making process itself. This has the very valuable result of confining the ultimate decision to a selection from among effective and feasible alternatives, rather than leaving it wide open, as in most non-scientific areas, where all too often the final decision favors a program which cannot possibly operate in the intended manner, and would not produce the desired result even if it were operable.

It will no doubt come as a surprise to most readers to be told that outside the realm of physical science there is no accepted method of separating the true from the false. If he gives any consideration at all to the matter, the average layman probably assumes that conflict with the observed facts automatically stamps a proposition as untrue regardless of the classification into which it falls. But even a brief survey is sufficient to show that this is not the case. Religious, political, sociological, economic, and other non-scientific writings are full of diametrically opposite statements about matters which are subject to observation or measurement, but such conflicts in those areas cannot be resolved by appeal to the facts because the facts are not accepted as the superior authority. This is obvious in the case of religion. An observed fact which conflicts with a religious doctrine is meaningless, so far as the adherents of that religion are concerned, since the religious doctrine is by definition superior to physical manifestations such as those subject to observation, and the inferior cannot overrule the superior.

The same attitude carries over into the other non-scientific fields to such an extent that many observers have been constrained to comment upon it. What has been said about economics is particularly appropriate to the present discussion. “No political or economic program, no matter how absurd, can, in the eyes of its supporters be contradicted by experience,”19 says L. von Mises. Keynes points out that “In the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age,” and he remarks, “One recurs to the analogy between the sway of the classical school of economic theory and that of certain religions.”20

As a result of this prevailing attitude there is no recognized method whereby valid ideas in these non-scientific fields can be separated from those that are not valid. A theory once proposed can never be definitely discarded. As long as it has an emotional appeal to someone it is given serious consideration, and has a certain degree of respectability. The originators of these theories do not submit their conclusions to the test of comparison with the facts, nor do they organize their activities with a view to passing such a test. This point has not gone unrecognized in professional economic circles. For instance Professor Douglas Hague made this significant admission, “I support Joan Robinson’s claim that the great obstacle to applying scientific method in the social sciences “is that we have not yet established an agreed standard for the disproof of an hypothesis.”21 Ernest Nagel makes this comment:

It is also generally acknowledged that in the social sciences there is nothing quite like the almost complete unanimity commonly found among competent workers in the natural sciences as to what are matters of established fact, what are the reasonably satisfactory explanations (if any) for the assumed facts, and what are some of the valid procedures in sound inquiry… In contrast, the social sciences often produce the impression that they are a battleground for interminably warring schools of thought, and that even subject matter which has been under intensive and prolonged study remains at the unsettled periphery of research.22

In economics, these weaknesses of theory and practice are so obvious and of such long standing that they have become a “cause of anxiety” in professional circles, according to a news report of a meeting of the American Economic Association. Speakers at this meeting, the reporter says, were disturbed by “the inability of economists to arrive at a deeper and more reliable understanding of the functioning of national economies (despite the continuous increase in the elegance and complexity of economic analysis) or to discover workable solutions for the key problems of the day.”23 Some members of the profession have arrived at the conclusion that these shortcomings are impossible to overcome. Knight, for instance, renounces all hope of the kind of success enjoyed by physical science. “I must say,” he tells us, “that prediction or control, or both, do not and cannot apply in a literal sense in social science.”24

Such appraisals of the present status of economics coming from within the economic profession itself confirm the contention of this work that a basic change in methods and procedures will be necessary before satisfactory progress toward our economic objectives can be made. If this were some field of abstract knowledge on the order of paleontology or non-Euclidean geometry, we might well view the situation with equanimity, and leave matters in the hands of the profession immediately concerned, trusting in the principle that the right will prevail in the long run. But in a matter so vital to our personal welfare we cannot afford to take this philosophic long-range view. The present-day comforts and conveniences of which we are deprived by the inefficient utilization of our facilities under the handicap of unrealistic theories and policies are gone forever.

One of the conspicuous features of economic theory as it now stands is its fragmentation. In general, economic thought has developed independently in the various areas involved, without any kind of a common denominator, and as a result the theories in the different areas not only lack the mutual support that would be achieved by a better integration or continuity of the theoretical framework, but are actually contradictory in many cases. For example, James Tobin reports that “The intellectual gulf between economists” theory of the values of goods and services and their theories of the value of money is well known and periodically deplored.”25 This is only one of many such contradictions.

Because of this lack of a comprehensive basic theory, the theoretical viewpoint of the modern economist is a mixture of valid ideas and concepts with others that are totally or partially wrong, each individual economist having his own special assortment. And since the economic profession as a whole has no better criterion of validity than the individual, it all too frequently happens that the valid ideas of an economic theorist are the ones that are rejected, while the economic community embraces the erroneous theories wholeheartedly. For instance, Keynes’ appraisal of the results achieved by wage bargaining between workers and employers, which are essentially correct, is rejected by most economists, while his concept of the multiplier, which is completely erroneous, is almost universally accepted.

We in the United States, by virtue of many factors, some for which we can take credit and others that are largely fortuitous, have been able to develop the world’s most efficient economic system. It is now our responsibility to make that system work smoothly, and to devise whatever improvements are required to keep it abreast of changing conditions. The socio-economists have thus far been unable to provide us with the information and theoretical background that we need in order to carry out this responsibility, but we cannot justify accepting this defeat as final. We have at our disposal more efficient methods than those which have thus far been applied to the task, and the primarily purpose of this present work is to demonstrate that by the use of these methods we can accomplish our objectives.

This is the background against which the proposal for the establishment of an independent economic science is being advanced in this work. The questions that need to be answered—questions as to how the economic system operates, what causes the various difficulties to which it is now subject, what measures are required in order to overcome those difficulties, and so on—are purely factual questions. The methods described and utilized herein, those that the scientists call “scientific,” are unquestionably the most efficient means thus far devised for handling matters of a factual nature, and it is the contention of this volume that inasmuch as the need for improvements in the handling of these economic questions is obvious and acute, the mere existence of more efficient and powerful techniques is a strong argument for applying them to the factual aspects of economics.

This suggestion does not conflict with the objectives of those who agree with Alvin Hansen that “Economics… must in a sense, become a branch of moral philosophy.”26 On the contrary, splitting the present mass of diverse material into a factual economic science and a socio-economics would strengthen their position, so far as the portion of the subject matter remaining in the sociological classification is concerned. It is the attempt to apply “economic ethics” to matters of cold and impersonal fact that creates confusion and impedes progress in the economic field.

Unquestionably, the most important economic problem now facing the United States is the matter of unemployment, not only because employment is the originating force in the economy, but also because elimination, or at least reduction, of unemployment is a prerequisite for solution of many other economic and social problems. The analysis of the operation of the economic system carried out on the scientific basis described in the foregoing pages has revealed, however, that employment is governed by a set of natural laws and principles that are independent of those that govern the operation of the exchange system. The entire employment discussion, including the definition of the employment laws and principles, has therefore been separated from the remainder of this report of the results of the investigation, and was published in 1976 under the title The Road to Full Employment.

The mere fact that the employment problem can be disassociated from the other aspects of economic life, and subjected to independent analysis, is a clear indication of the vast difference between the findings of this factual scientific study and the conclusions that have previously been reached by orthodox economic methods. Present-day economics regards unemployment and inflation as merely two aspects of the same thing. In fact, almost all of the proposals for improvement of the economic situation that are currently in vogue, aside from those which would make work at public expense, or attempt to solve the job problem by reducing the labor force, plan to accomplish their objective indirectly through inflationary stimulation of business activity.

We know how to reduce unemployment by raising aggregate demand, but we do not know how to do so without creating unacceptable levels of inflation.27 (Heilbroner and Thurow)

A critical investigation of the employment situation by means of the scientific methods and procedures outlined in the previous pages shows that these authors and their colleagues are totally—and we may say, tragically—wrong in this respect. The scientific analysis carried out in this work reveals that employment and business stability are fundamentally separate, and are governed by different principles. There is no necessary connection between the two. In general, the high level of business activity that results from inflation favors a high level of employment, and unfavorable business conditions are normally accompanied by increased unemployment, but the relation is indirect, and, except during the extremes of the business fluctuations, is uncertain. A large amount of employment may exist when business is enjoying a substantial degree of prosperity, and prices are rising, as experience has clearly demonstrated. Conversely, our analysis shows that it would be entirely possible to maintain full productive employment during the worst business depression, if the appropriate actions were taken.

The dilemma that the nation now faces, according to the almost unanimous judgment of the economists, the necessity of choosing between the twin evils of inflation or unemployment, is thus wholly imaginary. Factual analysis shows that the current stage of the business cycle is not the determinant of the amount of unemployment, as accepted economic theory asserts; it is merely one of many factors that affect the true determinant. As brought out in The Road to Full Employment, there are many possible economic actions that have the same effect on employment as the inflationary price rise that the economists now regard as the only weapon in their arsenal, and since most of these alternatives have no inflationary effects, the employment program can be completely independent of the business stabilization program. With the help of the information provided by a factual economic science we can have both full productive employment and business stability.

03 Economic Objectives

CHAPTER 3

Economic Objectives

It was pointed out in the preceding chapters that economics, as now constituted, has both factual, purely economic, aspects, and non-factual, mainly sociological, aspects. As a consequence of this dual nature of the subject, present-day economists have both economic objectives, applying to matters specifically related to the organization and operation of the economic system, and social, or sociological, objectives, which apply to matters specifically related to human welfare.

As indicated by the quotation from Samuelson in Chapter 1, it is the social goals that are the economists’ main concern. The question as to how goods should be produced is primarily technological, while the questions as to what goods should be produced, and for whom they should be produced are mainly social, or we may say, socio-economic. But the true purpose of the economic organization is to get the goods that the consumers want into their hands in return for their labor. Any measure having a different purpose is aiming at a non-economic, or at least not purely economic, objective. For instance, a measure designed to increase the income of a particular group—the “poor” perhaps—is directed at a social objective, not an economic objective, because from the standpoint of economics all consumers are alike. A measure designed to protect the public from the harmful effects of a certain product is likewise aimed at a social objective. All goods are alike from the economic standpoint.

These comments about the nature of the objectives of the economists do not imply that there is anything wrong with social objectives, or that they are in any way inferior to purely economic objectives. The point that is here being emphasized is that the factual objectives, the real economic objectives, are now being pushed aside while the economists pursue their social goals. The answers to their “fundamental problems,” when and if obtained, will not tell us how the economic system operates or how we can manipulate it to serve our purposes. They are merely advice as to what our purposes ought to be.

This advice is something that we no doubt need, just as we need advice from other branches of sociology, based on the results of studies and investigations, and in undertaking to fill this need the economists are aiming at a worthwhile objective. But the human race is not so constituted that an individual can envision sociological objectives, and dedicate himself to the task of promoting the economic “reform” measures that he believes will accomplish those objectives, and at the same time maintain the emotional detachment necessary for carrying out a factual analysis of the subject. The inevitable result is that the socio-economist fixes his attention on what he thinks ought to be, rather than on the scientific objective of ascertaining what is.

Since the factual aspects thus recede into the background, they come to be regarded as items to be manipulated in support of the “reform” proposals, rather than  items to which these proposals must conform if they are to be successful. “The tendency is strong, unfortunately,” says F.N. Harbison, “to marshal facts which best support deep-seated convictions rather than to use them to question where the truth may lie.”28 Galbraith gives us a similar explanation for the failure of certain economic studies to produce any significant results: “A vivid image of what should exist acts as a surrogate for reality. Pursuit of the image then prevents pursuit of reality.”29

Such results must be expected. A person cannot commit himself emotionally to a view of how the economy should operate, and at the same time maintain an unbiased position toward the question as to how it does operate. When he enlists under the banner of “reform” it is no longer psychologically possible for him to give impartial consideration to the factual aspects of his subject. Samuelson’s list of “fundamental economic problems” demonstrates this point. None of these problems has a factual answer. We must conclude that questions as to how the economy operates and what can be done to achieve our economic objectives are not “fundamental problems” to the present-day economist. But they must be fundamental problems for someone. As painful experience has so often demonstrated, the making of decisions is futile unless we known how to carry those decisions into effect. The economists’ concentration on defining objectives has therefore left a vacuum.

What we are proposing is not that economic science should take over the functions that the economists are now performing, but that it should address itself to the tasks that the economists are leaving undone; that is, fill the vacuum that they have left by becoming sociologists—or, as they prefer to say, social scientists—and losing sight of the factual aspects of economics. Economic science, as defined in this work, does not attempt to make decisions on Samuelson’s fundamental problems, or other matters of public policy, nor does it even attempt to influence such decisions. Its task is to supply the information that will enable an intelligent choice of objectives and will enable formulation of effective measures for attaining those objectives. Before the decision as to the objective is made, economic science can provide information about the working of the economy, which will identify the possible alternatives and will enable evaluating and comparing them. After the basic decisions are made, it can determine the various practical means by which the selected objectives can be reached, and the advantages and disadvantages of each, thus facilitating the second type of public policy decision: the decision as to what specific steps should be taken to attain the objectives.

To illustrate these points, let us formulate the analogous problems involved in the physical example cited earlier, the construction of a bridge. The first problem, the question as to what should be done, becomes merely a matter of whether or not the bridge should be built. The second, the how problem, involves selecting the design and choosing the materials of construction. The third problem, for whom, reduces to questions as to the location of the bridge structure and its approaches, as each alternative will be more advantageous to certain individuals and less advantageous to others.

The pure scientist is not involved in these questions at all. He supplies some basic information that will be useful in this connection, but only in exceptional cases will this information be developed for the specific job. Normally it is part of the great accumulation of scientific knowledge. The engineer will take part in the consideration of these problems, particularly the second and third, and will submit his analysis of the various alternatives together with his recommendations. But he will not take a partisan stand in favor of one alternative or another, and he will not expect to make the decisions. All of these problems are problems of the community, and the decisions will be made by the general public, or their representatives, not by the scientist or the engineer.

“Economic problems” of the kind specified by Samuelson are likewise problems of general public policy, analogous to such questions as to where a bridge should be built, whether we should construct a new post office or remodel the old one, whether we should widen a crowded highway, and so on, not to the questions for which the scientist or the engineer provides specific answers. The problems appropriate to science have answers that can be discovered, and once these answers are found and definitely verified they are final, regardless of whether or not they meet with anyone’s approval. The answers to this list of “fundamental problems,” on the other hand, cannot be discovered. They must be decided upon, and no individual or group can make a decision that will be binding on all individuals or groups, or which is not subject to future reversal. No such decision can be final. These problems and their answers are not matters of fact; they are matters of opinion, and therefore outside the scope of economic science.

In order to get the proper perspective on the economic issues we need to examine them in their economic setting, not in their social setting, their political setting, or their geographical setting. For example, there is an important distinction between capitalists, a social class, and suppliers of capital, an economic class that has already been mentioned. Similarly, such concepts as land, entrepreneur, laborer, etc., as they are used in present-day economics, are primarily social concepts, not economic concepts. This work will eliminate the purely social concepts from the discussion, and will redefine those that have both social and economic significance to bring them into line with their true economic significance.

Elimination of social distinctions avoids the confusion which results from joining dissimilar concepts. The function of “owner,” for example is economically distinct from that of “manager.” It is true that there are many combination owner-managers, and it is not at all unusual for the owner to retain some of the managerial duties even where he employs a manager. But there is no necessary connection between owning and managing, as the rise of a professional managerial class in modern times clearly demonstrates, and any definition which assigns both functions to one economic entity, such as an entrepreneur, cannot adequately cope with economic situations in which these functions are handled separately.

A combination of functions is quite characteristic of economic life, particularly in its simpler forms. The farmer, for instance, is a supplier of labor, a producer, a consumer, and usually a supplier of capital. In order to get a correct picture of the economic processes in which he participates, we have to recognize these different roles. We cannot look upon him simply as an individual performing certain functions appropriate to farming, or as a unit of the society in which he exists. Such viewpoints are appropriate from a social standpoint, but for economic purposes we must look upon him as a producer when he acts in that capacity, a supplier of labor insofar as he personally takes part in the productive work, a supplier of capital insofar as he owns the land or equipment, and so on.

The function of the producer is to utilize labor and the services of capital to produce goods. It is essential to distinguish clearly between the person or agency that performs this function and the suppliers of labor and capital. The worker who operates a lathe takes part in the production process, to be sure, and so does the supervisor who oversees his work, but neither is individually acting as a producer in the economic sense. Both of these individuals are suppliers of labor. The enterprise or individual by whom they are employed is the producer. The capital is obtained from another set of individuals: owners or shareholders who supply equity capital (risk capital) and creditors who supply debt capital.

A clear distinction between factual and social issues will enable evaluation of objectives from the standpoint of whether or not they can be obtained by the means it is proposed to use. It is important to recognize that non-economic objectives, such as the purely social objectives that are the primary concern of the present-day socio-economist, cannot be attained by economic means; that is, by manipulating the mechanisms of production and exchange. Lack of recognition of this point is the reason for the failure of many economic programs aimed at what most persons would consider desirable objectives.

As pointed out earlier, none of the items listed by Samuelson as the “fundamental economic problems” has a scientific solution. These are social, political, and technological problems. They may have answers, but they are not factual answers that can be obtained by scientific methods; they are matters of opinion and judgment. For example, consumers constitute an economic class. The questions as to whether the income of consumers can be increased, and if so, how, are therefore economic (and technological) questions that have factual answers. On the other hand, the poor and the rich are social classes. Thus the questions as to how, and whether, to raise the income of the poor at the expense of the rich (a favorite objective of the economists) are social issues that have no factual answers.

The economists’ failure to draw this distinction between the factual and the nonfactual, and to adapt economic thinking to the difference is primarily responsible for their persistent advocacy of “something for nothing” schemes of one sort or another, and their inability to deal with the factual problems of the present-day economy such as inflation and unemployment, a failure that is leading many in the profession to question whether solutions to these problems even exist. Samuelson, for instance, says:

Particularly during the last decade, poor economic performance and the rise of contending schools of economic thought have led many to doubt whether the fiscal and monetary authorities can do anything to improve economic performance.30

The chapters that follow, which do make the distinction between the factual and the non-factual, will cover only one part of the field that is included in present-day “economics,” but by dealing only with factual matters, and using factual methods, they will arrive at those factual answers that have eluded the economists.

The minimum wage issue is a good example. The minimum wage laws now in effect in the United States attempt to accomplish a social objective, assuring an adequate income to all workers, by economic means; that is by modifying the normal operation of the price system, and paying sub-standard workers more than they would normally receive. But the economic mechanism responds to that interference in its own way, not in the manner anticipated by the lawmakers. The usual result is to deny employment to the workers the law was intended to benefit. This point is recognized by the great majority of economists, but the public does not have enough confidence in the conclusions reached by the economists to accept them if, as in this case, they are unwelcome.

The same kind of a reaction of the mechanism takes place in response to the attempts that are continually being made in nearly all countries in the world to improve the living standards of the workers by raising money wages. Here again the economic system responds in its own way. It reacts with inflation, not with higher real wages.

The stumbling block for all such measures is cost. The individual enterprise economic system operates on a minimum cost basis, and whenever an additional cost is imposed on any portion of the mechanism, the system responds in such a way as to restore the minimum cost condition. In the minimum wage case this is accomplished by excluding the sub-standard workers from employment. In the case of money wage increases, it is accomplished by absorbing the increase in the relation between money wages and real wages. The same fate awaits all such schemes, however ingenious they may be. The economic mechanism cannot be outwitted.

Sooner or later the nation, and the world at large, will have to accept the fact that attainment of any social objective, other than those automatically accomplished by processes such as technological progress that work in harmony with the economic mechanism, involves a cost, and provision should be made for meeting that cost from public funds. Otherwise, the attempt to reach the objective will fail, unless it is possible to shift the cost burden to the public through the price mechanism. As will be brought out in the subsequent discussion, attempts to impose the cost on the producers (employers) are futile. The hope that it will be lost in the intricacies of some ingenious scheme for creating synthetic purchasing power out of nothing is likewise doomed to expire in the light of cold reality.

The separation of the factual aspects of economics from the sociological aspects that we are here proposing should also go a long way toward clarifying the present ambiguous position of the economist. The professional workers in the field of economics feel that they should rightfully be accorded the same kind of an authoritative status that the scientists enjoy in their field, but all too often the economists’ recommendations meet the kind of reception indicated by the quotation from Franklin Roosevelt in Chapter 2. “Economists,” says Max Black, “are sometimes treated like witches in otherwise civilized communities.”31

What is being overlooked here is that the scientist and the engineer maintain their authoritative standing only because they confine themselves to factual matters, and do not try to make the decisions. The role of the engineer is well understood, both by himself and by the community, and his recommendations are seldom overruled for physical reasons, although they are frequently overruled for other reasons. An engineering recommendation for a cantilever bridge, based on lower cost and equal or better serviceability under the existing circumstances, may well be rejected by a community that prefers a suspension bridge on esthetic grounds, but this does not imply any doubt as to the soundness of the engineering recommendations. It simply means that other considerations outweigh the engineering aspects in the minds of the citizens who make the ultimate choice.

The world is no more willing to let the economists make the decisions in economic matters than it is to let the engineers make the decisions in physical matters. Where the public rules, such decisions are made by the general public; where others rule, they are made by the rulers, whoever they may be. In any event, they are not made by the engineers or the economists, except to the extent that those individuals are also members of the general public or the ruling group. The difference is that the engineer recognizes the logic of this situation and accepts it as a matter of course; the economist usually, or at least frequently, does not. The sense of frustration, which the economists so often mention, and more often reveal by the way in which they express their views on matters of public policy, has its origin in their conception as to the functions of their profession, a conception that is not accepted by the community at large.

Of course, the economist suffers from the fact that he is so frequently wrong, and in some instances, as in the predictions of economic conditions that would follow the conclusion of World War ii, spectacularly wrong, and he is further handicapped by the inability of the members of his profession to agree among themselves, but the primary reason why the recommendations of the economist are not given the same weight, and the same respectful consideration, as those of the engineer is that the economists’ recommendations are not based solely, perhaps not even primarily, on economic principles. They are dictated to a large, and often controlling, degree by non-economic (mainly social) preferences and prejudices. The average citizen knows, even though he may not stop to analyze the situation very closely, that the advice which he gets from the economist on a subject such as a price control measure, for example, is not like the recommendations of the engineer, designed to aid the public in getting the results which they want; it is designed to accomplish what the economist believes should be done. The mere fact that economists can be, and commonly are, categorized by such terms as “liberal” or “conservative” is a clear indication of the difference. We do not have “liberal” engineers.

As brought out in the foregoing discussion, the ostensibly economic objectives that present-day economists identify as their principal concerns are actually social, or no more than socio-economic at most No general agreement has ever been reached as to what these purely social objectives ought to be, particularly with respect to the degree to which ethical considerations should enter into their conclusions. “Opinions range, or have ranged,” says J. M. Clark, “from the view that economics has nothing to do with ethics, to the view that it must formulate explicitly the ethical standards that furnish its setting and give its analysis meaning.”32 From one school of economic thought we get the dictum: “Economics, as a science, is neutral… it can express neither approval nor disapproval,”33 while at the same time another tells us just as definitely, “hardly any economic theory can be considered ideologically neutral.”34

We can, however, define the objectives of economic science. They are to determine the principles and relations governing economic processes and to apply this information to devising the most efficient means of attaining the economic objectives designated by the appropriate agencies of organized society. What we are undertaking in this work is to apply the time-tested methods of the physical sciences—not the methods which the economists have been calling scientific, the methods of the social sciences, but the methods which scientists actually use, and which they call scientific—to the factual aspects of economics to see whether we can duplicate some of the highly satisfactory results that have been thus obtained in the physical fields.

Subdividing according to the scientific pattern, we can say that the objective of pure economic science is to determine the nature and characteristics of the relations that exist between the various economic entities and processes, and the objective of applied economic science is to determine how the information developed by the scientific investigators can best be applied to accomplish whatever ends the individual, group, or society as a whole may choose to seek.

04 Value

CHAPTER 4

Value

When the fullback carrying the ball through the opponent’s line is finally stopped and the referee’s whistle blows, it is often impossible for the onlooker to determine at the moment just what has happened; whether there has been a gain or a loss, whether the offensive side still has the ball or has lost it on a fumble. All that one can see is a confused jumble of players with an arm sticking out of the pile here and a leg protruding there. We cannot tell which, if any, of the players that we see actually have a grasp on the ball and which are merely part of the pile. But the referee moves in and one by one picks out those who are mere trimmings until he finally gets down to the essential participants in the play and is able to determine just where matters stand.

To the casual observer—and to many of the professionals in the field as well—the economic scene presents a very similar appearance of confusion. All that we can see on the surface is a tangle of finance, markets, corporations, labor unions, foreign trade, money, transportation, credit, wages, profits, and so on almost without end. So in order to get a starting point from which to begin an analysis we need to adopt the tactics of the football referee and clear away the nonessentials and collateral matters one by one until we get down to the fundamental economic processes. When we do this, and examine each item from the standpoint of whether or not the business of making a living, the primary objective of all economic activity, could be carried on without it, we find that none of the items that were mentioned is actually essential. In fact, there are only two things that are indispensable features of economic life: production and consumption.

In the dawn era of human existence on earth life had not progressed beyond these fundamentals. The prehistoric people gathered their food by their own unaided efforts and took shelter wherever they could find it. Long before the beginning of recorded history, however, they had discovered that by devoting part of their efforts to the making of tools they could multiply the effectiveness of their direct labor manyfold. Thus the simple economic life took a step toward becoming more complicated. As time went on, the hunter who had met with exceptional success and had more meat than he could use found that this excess could be traded for the surplus fruit or vegetables in the possession of others, to the advantage of all concerned. Barter thus joined the growing list of economic processes.

At some point it was recognized that Willie Dogtooth had an exceptional skill in making arrowheads, and it dawned upon the hunter that there was a substantial gain to be made by trading meat to Willie for the necessary arrowheads and devoting his own time to hunting, a vocation at which he excelled, rather than continuing to make his own clumsy and inferior weapons. Willie was consequently relieved of the necessity to forage for food and was able to concentrate on his own specialty, the making of arrowheads. Here we have the beginning of specialization of effort, another milestone along the way to a more complex economic life.

All down through the ages this process continued. As man’s general knowledge broadened, more and more new devices were invented to facilitate the task of making a living and to enable enjoyment of a greater variety of comforts and conveniences with the expenditure of less and less effort. But all of this increase in complexity merely added external accessories to the machine. It did not alter the basic purpose of economic activity, and it did not alter the fundamental fact that all of this activity is built around the complimentary functions of production and consumption. The end toward which economic action is directed is consumption, and the prerequisite for consumption is production. Thus the important functional division in economics is not between labor and capital, or between government and industry, or between rich and poor, but between producer and consumer.

This distinction is largely academic in the first stage of economic development where each economic unit—individual, family, or tribe—consumes its own products. But just as soon as the second major stage comes into being with the introduction of barter, all products of effort take on a dual aspect. To the consumers, the individuals who expect to receive the benefits of these products, or goods, as we will call them, they are articles to be consumed and enjoyed, but to the producers they have an entirely different significance. From the producers’ viewpoint they are not goods (articles of consumption) but a means whereby such goods can be obtained. In other words, they constitute purchasing power.

 

A favorite device of the early economists was the “Robinson Crusoe” approach to economic problems, in which the points at issue were first examined from the standpoint of an isolated individual, and the conclusions drawn from this analysis were then extrapolated to the more complex economic situations. This approach has gone out of fashion and is less frequently encountered in current practice, partly because it seems somewhat incongruous in the sophisticated setting of present-day economic theory, but also because there has been great difficulty in reconciling the conclusions drawn from examination of the Crusoe economy with modern economic theories. While this might logically be interpreted as an indication that there is something wrong with the theories, most economists have preferred to question the legitimacy of the extrapolation.

Nevertheless, it can hardly be denied that there is a distinct advantage in studying the simpler situation first, particularly in setting up the basic framework of theory. Frank Knight was emphatic on this point. “The concept of a Crusoe economy seems to me almost indispensable,” he said, “I do not see how we can talk sense about economics without considering the economic behavior of an isolated individual.”35

One of the important advantages of studying simple forms as stepping stones to an understanding of their more complex successors is that many truths that are obscured by a mass of detail in the complex structure are self-evident in the simple situation. It is clear that unless some additional factor has been introduced during the process of development, the relations that are found to exist under the less complicated conditions will still continue to hold good in the more highly developed organization, and this gives us a good working hypothesis concerning the operation of the complex mechanism. On subjecting this hypothesis to the usual scientific tests to determine its validity we will sometimes find that a new element actually has been introduced, altering the original relations. More often, however, these relations are just as valid as ever, but have been so confused and covered up by a profusion of collateral issues that they are difficult to recognize without the help of the clue obtained from a consideration of the simpler situation.

The creation of purchasing power is a good example. It is commonly taken for granted in present-day economic discussions that the production of goods ,and the creation of purchasing power with which to buy those goods are two separate and distinct things; indeed, some of the debate over national economic policies revolves around the question as to how best to go about providing the consumers with more purchasing power so that they can absorb the potential output of our factories. But when we turn to the primitive second stage economic organization where barter is the most advanced economic process, it is obvious that production of goods (including discovery, which is a form of production) is the only method of creating purchasing power.

When we analyze the status of purchasing power in the present-day economy we find that the basic situation is still the same as it was in the days of barter. There is still no other way of creating purchasing power. We may gain access to purchasing power produced by others through gift, theft, or borrowing, and some devices have been invented that provide purchasing power for certain individuals at the expense of others by what amounts to borrowing by governmental agencies or by the economic community—such devices as money inflation and revaluation of existing assets. These devices do not create anything; they merely redistribute what has been produced.

The limitation on creation of purchasing power is an important feature of economic life. In recognizing it we are already in direct conflict with contemporary economic thought. Paul Samuelson tells us categorically, “In social sciences, there is no law like that of the conservation of energy to prevent the creation of purchasing power.”36 Earlier, Frank H. Knight said essentially the same thing: “There is nothing in economics corresponding to momentum or energy, or their conservation principles in mechanics.”37 But these authors are definitely wrong. There is an economic quantity—purchasing power—that corresponds to energy, and there is a law that prevents the creation of purchasing power in any other manner than by production. Many of the shortcomings of modern economics are due to the failure of the economists to recognize the existence of this limitation and to their persistent advocacy of measures and policies that are doomed from their inception because they are in conflict with this principle.

There are many physical quantities, which, under ordinary circumstances, do not change in magnitude, even though they may undergo radical changes in form. Such quantities are said to be conserved, and the expressions of this conservation—the laws of conservation of mass, energy, momentum, electric charge, etc.—are some of the most valuable tools of scientific analysis. These laws are not absolute prohibitions. Mass may be transformed into energy, for instance. For general application they must therefore be stated in terms that provide for transformations under special circumstances. However, they are applicable under a wide enough range of conditions to make them very useful. They are all local manifestations of what we may call the Universal Conservation Law, a far-reaching physical principle that prohibits getting something out of nothing.

For some reason this universal law has never been recognized, or at least never generally accepted, in economics. Indeed, the extent to which economic theory and practice follow policies based on hopes and expectations of getting something for nothing is simply astounding. Time and again in the pages that follow it will be necessary to point out that the result which is anticipated by the proponents of a particular economic action, or by the adherents of a theory that purports to explain the consequences of such an action, is nothing more or less than an expectation of getting something for nothing. Furthermore, it will be shown that some of the principal “defects” that present-day economists profess to see in the performance of the prevailing economic system are simply the automatic reactions of the mechanism to these “something for nothing” attempts.

Oddly enough, in view of the wide differences of opinion that divide the various schools of economic thought, this defiance, or disregard, of one of the most basic laws of the universe is one thing on which the great majority of economists are united. Some actually do profess to recognize the conservation law, and jocularly express it in the form, “There is no free lunch,” but even the wildest of the ideas and proposals for getting something for nothing have the support of economists of the front rank, while many of those whose true character is somewhat more obscure are part and parcel of the orthodox economic doctrine of the present era. A very substantial proportion of the vast stream of books and articles offering prescriptions for our economic ills that is now pouring forth from our publishing outlets could very appropriately be titled “How to Get Something for Nothing.”

This dream of something for nothing is one of the oldest and most persistent illusions of the human race. The physical fields have had their share of these fantasies. Perpetual motion machines were all the rage at one time, and even today there is no lack of schemes which purport to develop energy out of nothing. But where there is steady progress towards general agreement on basic principles, as there is in the physical sciences, the climate is unfavorable for ideas of this kind, and in our times they rarely get any support from professional scientists or engineers. As a scientific product, this present work must take a firm stand against all such proposals, and against all theoretical ideas that lend support to them, regardless of whether they emanate, as many of them do, from impractical visionaries who draw them out of thin air, or whether they come from some presumably legitimate source and are backed by economic authorities all the way from Adam Smith to J. M. Keynes.

Since purchasing power is something real that cannot be created out of nothing, it likewise cannot be dissolved back into nothing; that is, it is conserved. Like other conserved quantities it has a high degree of permanence. It cannot simply disappear: it must remain intact until it participates in a process whereby it is transformed into something else.

The scientist knows that energy, which is something, does not disappear in any ordinary physical process. The amount of energy coming out of such a process is exactly equal to that which entered. But it is by no means self-evident that this result is inescapable, and the fact that energy is conserved was not discovered until after modern scientific techniques had been perfected and applied to the problem. In the less advanced field of economics the fact that certain economic quantities analogous to energy are also conserved has not heretofore been recognized. But application of the powerful methods of physical science in the investigation whose results are being reported herein has demonstrated that purchasing power is the kind of a persistent economic entity to which we can apply the techniques of factual science. Once purchasing power has been produced, we can follow it from process to process, just as the scientist does with energy, knowing that what was originally produced will remain intact until its existence is terminated by consumption or the equivalent. Thus the clarification of this point is the first in a series of moves, which ultimately bring the economic mechanism out of the quagmire of assumption and speculation onto solid ground where we can subject it to exact logical and mathematical analysis.

It was emphasized in the course of the discussion in the preceding pages that application of factual scientific methods to the economic field would not simply rework the territory that has been covered by the economists, but would penetrate into new areas that the less effective methods of the “social sciences” have been unable to reach. The significance of this forecast can now be seen. The main line of development of theory from this point on will take the form of a study and analysis of the various aspects of that which the economists claim does not exist: a stable economic quantity—purchasing power—that is subject to a conservation law in essentially the same manner as energy in the physical field.

Before we can proceed further with our analysis, however, it will be necessary to give some consideration to the question of measurement. Some classes of goods can be measured physically, by counting, weighing, or some such process, but this does not give us an economic measurement. Since payment for goods must be made in other goods, the economic measurement of goods must also be made in terms of goods. We will call the quantity thus measured the value of the goods. The measurement standard may be either some one commodity or the weighted average of a number of goods.

Inasmuch as purchasing decisions are made by individuals, acting for themselves or on behalf of others, the economically significant assessments of the relative value of different goods are those that are made by these individuals. This means that value is subjective. It is value to a specific individual and at a specific time and place. It follows that values vary not only between individuals but also between different times and locations. Furthermore, goods have two values in each case: a value as purchasing power, which we will call seller’s value, and a value as consumption goods, which we will call buyer’s value.

 

From the very beginning of the systematic study of economics there has been a great deal of controversy over the question as to the meaning which should be assigned to the word “value,” and some of the most important differences between the various schools of economic thought can be traced back to the divergent concepts of value. Knut Wicksell even contended that the concept of value is the essence of an economic doctrine. He asserted that “It is well known that almost every new school of thought in political economy has laid down its own theory of value and from this, as it were, derived its entire character.”38

In fact, no definition has any more claim to validity than another. A definition is simply a description of the concept that is to be associated with the term defined, and as long as this association is rigidly maintained, the logic of the terminology is unassailable, regardless of any exception that may be taken on the grounds that the definition conflicts with prevailing usage, causes confusion, etc. Any relations that may be developed in the subsequent analysis are between concepts, not between words, and if the words clearly indicate the concepts to which they refer, they are performing their proper function. No definition can be wrong, as long as it is only a definition and nothing else. It may be ill-advised, even absurd if it is greatly out of step with accepted usage, but it cannot be wrong if it is self-consistent and consistently used.

Consistent use of a definition is, however, no easy task in a case where there is a pre-existing popular meaning associated with the term defined. In spite of good intentions on the part of those who set up other definitions, it is extremely difficult to avoid slipping into the use of both concepts in the same argument, thereby transferring relations that are valid for one concept over to another for which they may be totally invalid.

Precise definition of all quantities and concepts that are utilized is an essential feature of a sound scientific analysis. The non-scientist usually claims that he, too, defines his terms with as much precision as the subject matter will permit, but even within the non-scientific professional circles the lack of conceptual precision is recognized by careful observers. For instance, in a book entitled Economic Thought and Language, L. M. Fraser views the situation in economics in this light:

Economists have always suffered, as compared with natural scientists, from the inaccuracy of their linguistic equipment. Many of the disagreements which divide them are terminological, rather than genuinely economic in character.39

The first essential for a scientific treatment of the factual aspects of economics—the kind of a scientific treatment that we are describing in this volume—is to begin by identifying the concepts that we are going to use. The economic relations with which we will be dealing are relations between concepts. The names that we apply to them are merely labels by which we identify the concepts. Starting with the term “value” and trying to attach a meaning to it is putting the cart before the horse. What we are doing is setting up and defining our concepts; then looking for appropriate names to apply to them. One of the concepts that we will use in our analysis happens to coincide almost exactly with the layman’s idea of “value” as what the item in question is “worth,” so for this reason, together with the points previously mentioned, we will utilize this term in referring to it. Since the alternate definitions will not be used herein, there is no actual necessity to give them any further consideration here. However, it may be helpful to explain just how the value concept defined and discussed in these pages differs from each of the two most widely accepted alternatives.

Karl Marx’ theory, the basis of the so-called “Marxist” economic systems, defines the value of goods ,as equal to the amount of labor expended in their production. His special targets are the “capitalists,” who, in his opinion “exploit” the workers by means of their ownership of production facilities, and divert to themselves a substantial part of the proceeds that should accrue to the workers.

Here we have an illustration of the detrimental effects of mixing sociological concerns with economics. Capitalists are a social class, not an economic class. For efficient production it is necessary to have capital, and suppliers of capital are therefore essential to the economy. But, as noted earlier, these suppliers of capital, an economic class, are not necessarily capitalists. In some types of economic organization they are never capitalists, and it is not essential that they be capitalists in any economic system.

Since capitalists, as such, play no part in economic activity, the use of the terms “capitalist” or “capitalistic” in application to an economic organization, or to economic processes, is definitely out of order. A social organization may be capitalistic, in the sense that it provides for the existence of a class of individuals who obtain their income mainly from invested capital, but the existence of such a class is not dependent on any particular type of economic organization. Today even the most dedicated collectivist governments meet part of their capital requirements by selling bonds or by borrowing from foreign sources.

The inescapable fact is that the required capital must be obtained from individuals, either by borrowing from them, or by using governmental powers to take an additional slice out of their incomes. Obviously, borrowing is not possible unless the lenders are promised compensation. Thus Marx’ contention that the entire product belongs to the worker is true from the economic standpoint only if the worker is the supplier of capital. His argument is therefore social rather than economic. It is really an argument in favor of a social and political organization in which it is possible to compel the workers to supply the capital needed for production, so that they can reap the benefits of ownership. Whether or not this is desirable is outside the scope of economic science. If it has any connection with economics, that connection is with the sociological branch of the subject. The worker ownership that Marx wanted to achieve is not incompatible with any type of economic organization.

However, from the standpoint of economic science it should be noted that the theory of value that Marx developed to support his social and political objectives is subject to the same logical defect that we have previously mentioned as applying to all of the economists’ theories of value; that is, it changes definitions in the middle of the argument (without admitting this). In order to bolster his contention that the workers should receive the full value of the production in which they participate, he formulated a theory which characterizes the amount of labor applied to the production of economic goods as the value of those goods. , But value, as thus defined is a concept that plays no significant part in economic life, so Marx changes horses in midstream. To complete his argument, he shifts to the definition of value as that which goods are “worth,” thus arriving at the conclusion that what goods are worth is the amount of labor that has been expended in producing them.

Obviously, this is not true in the economic sense of “worth.” The purpose of economic goods is to satisfy human wants of an economic nature. These are necessarily the wants of individuals. Economic “worth” is therefore the worth to individual consumers. This worth has no definite relation to the amount of labor that has been expended in their production. Much labor is expended, particularly in those economies that operate on Marxist principles, on the production of goods that are not wanted by the consumers. On the other hand, it is not uncommon for the results of some production operation, such as the drilling of an oil well, or the invention of a labor-saving device, to be worth vastly more than the labor expended.

Sooner or later, in every economic transaction or discussion, it becomes necessary to make use of the concept of economic value as we have defined it, that which anything is worth, in the sense of that which an individual is willing and able to pay for it at a specific place and time. This does not mean that the concept must necessarily be called “value.” The economists are entitled to define their concepts as they see fit, and to call them by whatever names they consider appropriate. But we are justified in demanding that whatever definitions they formulate be adhered to throughout each of their arguments. This they cannot do if they define “value” in terms other than those used in the definition stated herein.

Everywhere in the economic field the concept of the “worth” of goods, the concept to which the layman applies the term “value,” continually arises, and no matter how pure their intentions may be at the outset, the economists eventually lay their own definitions aside and start treating “value” as “worth.” By this process of jumping across a wide conceptual gap and changing definitions in the middle of their arguments they arrive at totally unwarranted conclusions with respect to the special kind of “value” that they have set up. “The disentangling of the various concepts involved,” says Fraser, “is a painful and difficult business.”40

Value, as defined in the foregoing pages, is a difficult quantity to measure. It is not an inherent characteristic of the economic good, but a subjective quantity, an individual’s estimate of the worth to him (or to the group on whose behalf he is acting) at a particular time and place. Bird’s nest soup has a value to the Chinese but not to the American. Ice has a value in Palm Springs but not in Greenland. Today’s newspaper has a value today but not next month, and so on.

The extreme amount of variability in “value” as thus defined makes it hard to work with, which probably accounts for the modern economists’ practice of using another of the alternative definitions of value. The policy now prevailing is to equate “value” in general with “exchange value,” which is merely another name for market price. By means of this expedient the layman’s concept of “value” that is so difficult to handle is discarded, and replaced by a more tractable quantity. But the subjective concept of “worth” cannot be eliminated from economics. It plays a very important part in economic life, and the economists must use it. Consequently, they are doing just what Marx did; they are using the term “value” in both senses in the same arguments.

It would be quite understandable if the economist took the position that value, in the sense of “worth,” being difficult to measure, has only a limited usefulness in economics, and cannot be made the basis of any exact quantitative relations. We are very familiar with physical entities, which have this same status. Odors, for example, are extremely difficult to measure, and for this reason no mathematical science of odor comparable to those built around sound and light has ever been developed. But we would never consider for a moment any thought that we might pick out some other quantity that would be easier to measure, call this “odor,” and then substitute it for odor in the development of a theory. Even if measurement is impossible, the substitution of an irrelevant measurable quantity for a relevant immeasurable quantity is indefensible.

The real issue involved in the value controversy is whether or not the consumers should be allowed to make their own choices. The Marxists, and others who see the situation from the sociological viewpoint, take the stand that most consumers are not competent to judge what is “best” for them, and that the decisions should be made by individuals who are better qualified. Furthermore, it is the contention of the Marxists that there are aspects of the production decisions that are the concern of the state, rather than of the consumers, and that these decisions should therefore be made by government agencies. Whether or not these contentions have merit, they are social and political issues, not economic issues, and have no place in economic science.

Thus far we have been looking at value from a goods standpoint. We will now want to recognize that the value concept also applies to labor. The labor unions are vehement in their contention that “labor is not a commodity,” but this is a sociological point of view, not an economic judgment. From the economic standpoint, labor is the equivalent of a commodity, inasmuch as it is bought and sold in the same manner as commodities in general. We may therefore define the value of labor in the same manner as the value of goods.

The value of the labor of a particular individual to a specific individual or agency at a particular time and place is the maximum amount which that individual or agency is willing and able to pay for it.

This definition has to be modified in application to self-employed persons, but we can express essentially the same concept in self-employment terms as follows:

The value of the labor of a self-employed individual at a specific time and place is the value of the goods that can be produced by the most productive use of that labor.

Like goods, labor has both a buyer’s value and a seller’s value. The buyer’s value of labor is determined in the same manner as that of goods, but the seller’s value is subject to some other considerations. An important difference is that labor, as such, has no value to the worker other than that which he can realize from an immediate sale, whereas goods, as such, normally do have a continuing value to their current owner, at least for a time. If a proposed goods transaction fails to materialize, the owner holds the goods for some subsequent transaction with little or no loss in value. But if an expected labor transaction fails to develop, the potential labor, or a portion thereof, is lost, and whatever value it might have had simply disappears. Thus there is an element of urgency about the labor transaction that is usually absent in the case of the goods transactions, and this plays an important part in economic life.

To some extent the loss due to the failure to utilize potential labor may be offset by the leisure that is made available. Free time, which can be devoted to consumption, rest, recreation, or any other purposes which the individual has in mind, is a means of satisfying wants, and from an economic standpoint is the equivalent of goods. Leisure thus possesses economic utility. There are no different varieties of leisure, as there are of goods, but the utility of leisure, and the corresponding value, are extremely variable nevertheless. Arbitrary restrictions placed upon the activities of individuals decrease this utility. To the prisoner in solitary confinement free time is merely idleness: leisure of zero value. Restrictions imposed by economic factors have the same effect to a lesser degree. The person who is able to take a vacation at the seashore or go on an ocean trip is usually securing more utility from his leisure than the individual who must spend his vacation at home. In general, the availability of additional income (goods) increases the utility of leisure, while additional leisure facilitates the consumption of goods.

However, in spite of the parallelism between goods and leisure so far as utility is concerned, there is a significant difference in origin that has a major effect on value. Goods are produced by means of effort, whereas leisure, like the ability to exert effort, is a part of man’s original endowment. We cannot create more leisure in the way that we produce more goods. We have a certain amount of potential leisure to start with, representing all of our time except that required for the functional processes of living—eating, sleeping, etc.—but we sacrifice part of it in order to produce goods. The remainder is the amount available for enjoyment. Since we cannot increase the original allotment of time, the only way by which leisure can be increased is to decrease the amount of time devoted to production. Because productivity is essentially fixed in the short run situation, this means reducing the amount of production.

This is one of the fundamental economic problems facing all individuals and economies: how shall we balance more leisure against more production? Unless all available time is required for production of the bare necessities of life, there must be a choice. One cannot spend all of his time on production and also enjoy it as leisure. It has to be one or the other. If the individual himself makes the choice it is normally based on his appraisal of relative values. If someone else makes the choice for him, it may be purely arbitrary, without regard for the value relationships. In any event, the choice is always there; leisure cannot be increased without forfeiting production. An individual may, of course, obtain both the leisure and the goods if he can shift the productive burden to someone else by one device or another, but this possibility is not open to the community as a whole. All individuals cannot simultaneously transfer this burden to others.

Here we have an illustration of the desirability of studying the simple forms of economic life before passing on to those of a more complicated character. The facts pointed out in the preceding paragraphs are self-evident so far as the isolated individual is concerned, and once we get this picture firmly in mind it takes but little additional consideration to make it apparent that the same principle holds good no matter how large the economic unit may become or how complicated its organization. Additional leisure—shorter working hours, more holidays, longer vacations, etc.—cannot be obtained without cost; it can only be gained by sacrificing the goods which could be enjoyed if this time were devoted to production.

The utility of additional increments of goods decreases as the income of an individual rises, and since utility is one of the determinants of potential value, the potential value of these additional goods likewise decreases. On the other hand, a rising income usually increases the utility and the value of leisure, since it widens the range of pleasurable activities, which the individual is in a position to undertake. In general, therefore, the value equilibrium shifts in the direction of more leisure as the income rises.

The value equilibrium between work and leisure is also affected by the nature of the work. Some tasks are difficult; others are easy. Some are so distasteful that they will be undertaken only under the pressure of extreme need; others are agreeable enough to induce carrying them out for their own sake, irrespective of any income that may result therefrom. When we wish to strike a balance with respect to any particular item of production it is necessary to take this situation into account.

The difference between one type of labor and another due to variations of this character may be considered either as an element of cost or an element of value, depending on the point of view. If we take one of the more agreeable tasks as our reference level, the more arduous or more disagreeable work involves an additional cost If we move our reference level to the other extreme, the more pleasant work represents the addition of a certain amount of value over and above the value of the goods produced. Both methods of treatment are correct and they arrive at equivalent results. The difference between them is merely a matter of where we put the zero point. In this work we will, for convenience, take our zero at the level where the nature of the work has no effect on the values. Any additional effort or other element, which makes the work more distasteful we will call a cost. Any satisfactions arising out of the labor, other than its productivity, we will call values. This need to assign an arbitrary position to the zero level is one of the factors, which makes it desirable to define cost and value in commensurable terms. By so doing we arrive at the same answers irrespective of the location of the zero.

Where wants are few, the preference for additional leisure manifests itself quickly. Some of the early economists were puzzled by what appeared to be a failure of the usual laws of supply and demand in application to primitive economies. Simon Newcomb, for example, cites the case of an importer who was obtaining certain handicraft items from a South American Indian tribe. Finding a ready sale for the goods, the importer decided to pay a higher price so that he would stimulate production in accordance with the rule that an increase in the price increases the supply. Much to his dismay he found that the higher price actually resulted in reduced production, as the Indians simply quit working after earning enough for their most urgent needs, and at the higher price that point was reached earlier. “Here, then,” says Newcomb, “was a case in which a law of economics was completely reversed.”41

The advance of economic theory has cleared up this situation and it is now recognized that the early-day economists were in error in regarding it as a supply and demand problem. Instead it was a value problem, a question as to the comparative values of additional goods and additional leisure. These particular Indians had never cultivated any strong desire for additional goods, and they chose the leisure. The present-day labor unions who press for a shorter work week and longer vacations are making the same choice, although in this case the economic organization is so complex, and the factors involved are so imperfectly understood, that few of those who demand the additional leisure realize that either they, or some other workers, must pay for that leisure by forfeiting goods that they would otherwise receive.

An equally prevalent misapprehension is that work itself (or employment, which is the aspect of work that is the center of attention in the modern economy) has some inherent economic merit independent of the goods that are produced. Crusoe would never be deceived by any such specious doctrine. In his simple life, where economic relationships are clear and unequivocal, it is obvious that work, which does not produce any economic value simply sacrifices leisure to no purpose. But as economic organizations have grown in complexity this direct connection between gain in leisure and loss in production has been covered up by a confusion of detail, and we find that in the modern world much effort is devoted to work which cannot possibly produce sufficient values to justify the accompanying sacrifice of leisure. Even worse, so much confusion has been introduced into the picture that there is actually an influential school of economic thought, which contends that employment in itself creates economic gains even though no values at all are produced.

Under some circumstances non-economic benefits may perhaps be derived from work that produces no economic values, particularly if the alternative to employment is idleness rather than active leisure, but the contention of Keynes, Beveridge, Myrdal, et al., is that unproductive employment is economically beneficial, and it is this contention that must be categorically repudiated. All labor comes from individuals, whether or not they work in conjunction with others, and these individuals sacrifice leisure when they devote their time to work. If the sum total of the values placed on the potential leisure by these individuals is greater than the values produced, the employment has decreased economic well-being rather than increasing it. If no values at all are produced, the entire value of the potential leisure has been lost. No shifting of goods between individuals can alter these facts. As long as a loss in values is incurred by the unproductive employment, someone has to bear it. If arrangements are made whereby those engaged on the substandard work are compensated in money or goods for their labor, the loss is merely transferred to others.

05 Concepts and Definitions

CHAPTER 5

Concepts and Definitions

While we will be dealing largely with aspects of the subject matter generally included in economics that are different from those covered in the literature of the economic profession, the subject matter itself is the same. It will therefore be convenient to use the names and definitions that the economists apply to the various economic concepts, insofar as we will utilize these concepts without significant changes. The term “goods” has already been introduced. It is defined as follows:

Goods, are those things that satisfy economic wants, directly, or indirectly through participation in the production of other goods.

The economists’ definition of goods, which has been adopted for the purposes of this analysis, is considerably broader than the ordinary usage, which makes “goods” synonymous with “commodities.” Under this definition intangibles such as services are also goods, as is anything else, whatever its nature, that satisfies some kind of an economic want. The limiting adjective “economic” is a somewhat unconventional addition to the definition of “goods,” but this work will lay considerable stress on the point that items, which cannot be bought and sold, are outside the sphere of economics.

The word “goods” carries no implication of social desirability when used in its economic sense. It is rather unfortunate that the economic profession has adopted this particular term in preference to some one of the other words that would have been equally available, as the use of this terminology leaves the door open to confusion between the moral and sociological conception of good as socially desirable and the economic conception of a good as something that satisfies a want. It should be emphasized that from the economic standpoint all economic wants are alike. The opiates of the drug addict are goods to economics equally with the family bread and butter. The bombs and shells that destroy life and property are economic goods, even though their purpose is to do harm.

This does not mean that economic science approves of these things that are condemned by the ethicist. It neither approves or disapproves of anything, any more than physical science would contend that the diamond is too hard or that water boils at too low a temperature.

Utilities are those characteristics of goods which enable them to satisfy human wants, directly, or indirectly by participating in the production of other goods.

This concept of utility, or economic usefulness, as here defined, is an objective property; that is, one which has an actual existence independent of an individual’s mental processes. It exists whether he realizes it or not. Subjective concepts, those that exist only in the mind of the individual, are usually influenced by the objective—if they are independent of objective influence we usually suspect that there is something wrong with the mind—but they are not necessarily controlled by the objective.

Utility, as here defined, is not influenced by subjective opinion, except in certain special cases such as the administration of medicine, where the efficacy of the treatment depends to some extent on the patient’s mental attitude. The tomato had a utility as a food even in the days when it was considered poisonous. Anthracite coal had utility before anyone ever discovered that it would burn. Furthermore, goods often satisfy physical needs of which the individual is ignorant. It is only within comparatively recent years that the utility of certain foods in furnishing the vitamins necessary for health has been recognized. Citrus fruits and other natural sources of Vitamin C were performing their useful function of preventing scurvy and satisfying the want for health for thousands of years before their true utility was discovered.

The inherent utility of any good is, however, only a potential utility. In order to determine its actual utility we need to take into account not only the potential utility but also the relation of this potential utility to the wants of individuals. Bananas, ripening in Costa Rica, have potential utility to the inhabitants of Alaska, but no actual utility as long as they remain in Costa Rica. Ice has a potential utility for cooling purposes, but an inch thick coating on the river in midwinter has no actual utility of this kind. In general, the actual utility of an economic good depends not only on its inherent characteristics but also on the time and place at which it is available, and a very large part of man’s economic effort is expended in converting potential utility to actual utility by getting goods to the right place at the right time.

For convenience, it has become customary to speak of the inherent utility of goods at their original point of production as form utility, and to consider that additional time and place utilities are added as the goods are transported or stored. This is a useful concept, and the same practice will be followed in this work, but it should be realized that this is a purely artificial division for analytical purposes, and does not mean that a certain portion of the total utility is due to time, another to form, and so on. What we call the creation of place utility is in reality the transformation of already existing potential utility into actual utility by moving goods from one location to another where they are better able to satisfy wants. Many goods are produced at the time and place of use, and in such cases the actual utility cannot be broken down into form, time, and place components. But the same goods may be produced in an appropriate place and transported to the location where they are to be used, and then kept in storage until they are needed. In this case the actual utility is the same as in the first example, but for analytical purposes we say that time and place utility have been created in the processes of transportation and storage, and only the remainder of the utility can be characterized as the form utility produced in the original act of production. Time, place, and form utility are not different kinds of utility; they represent the same kind of final utility converted from the potential to the actual state by different processes.

Production is the creation of utilities.

This is another extremely broad definition. In ordinary usage the term “production” is restricted to primary processes such as manufacture or agriculture, but from the standpoint of economic life in general there is no difference between such activities and any other exertion of effort toward the satisfaction of wants. A gradual widening of the concept of production has been a notable feature of the history of economic thought. The first tendency was to consider only the activities directly connected with the creation of form utility as productive, and from the viewpoint of Karl Marx and other early economists a large part of the population was engaged on nonproductive work. Obviously, this put the theorists in a rather awkward dilemma. Most of these presumably non-productive operations were admittedly necessary, so the economist could neither advocate their abolition nor justify their existence. The development of the concepts of time and place utility was a big step toward resolving this difficulty, and it is now recognized that the railroad which transports the goods and the merchant who keeps them in stock until they are needed are producers in just as true a sense as the manufacturer who fabricates than originally.

The concept of services as goods has also been a gradual development. Many modern economists are still having difficulty with certain features of present-day economic life, particularly the activities connected with advertising and selling. Here, again, a broader understanding of the underlying situation is necessary in order to enable visualizing these activities in their true light.

The fact that income accrues to an individual from his activities does not necessarily indicate that there has been production. Theft, for example, involves effort, and it yields income to the thief, but this is not production. It does not create any utilities; it merely diverts them from one owner to another. Production, as herein defined, is measured in terms of the values created, not the amount of effort expended, or the individual income generated.

Consumption is the utilization of utilities for the satisfaction of wants, or for operations incidental thereto.

Consumption is the reciprocal of production. Production creates; consumption destroys. In production effort is expended. In consumption the results of effort are enjoyed. The definition, as given, excludes those uses of goods, which involve transformation rather than destruction of the utilities. This point will be elaborated later.

Utilities are often destroyed by agencies other than consumption during use. A warehouse may be destroyed by fire, or an earthquake may raze a whole city. Conversely, utilities may occasionally be created by purely fortuitous circumstances. So far as the operation of the economy is concerned, this unintentional creation and destruction of utilities has the same effect as if it were intentional, and since these incidental gains or losses are, at least to some degree, an unavoidable accompaniment of economic life, they will be treated for purposes of this analysis as an incidental part of the primary process. The definition of consumption has been phrased accordingly. If insects get into the flour in the consumer’s bin, so that it has to be discarded, the effect on the economic mechanism is exactly the same as if the flour had been consumed, and we will therefore treat this as consumption. If the insects made their inroads earlier, in the wheat before milling, or in the flour before it reached the consumer, the spoilage is simply another of the costs of production, and it will be so treated herein.

Labor is human effort devoted to production.

Here, again, it will be convenient to use the broad definition of the economist rather than the narrow popular usage which equates labor with manual work. Under this inclusive definition the efforts of managers, professional people, artists, entertainers, government officials, and all others who work in any productive activity constitute labor. From the standpoint of economic science one type of productive effort is the same as another. The familiar distinction between “blue collar” and “white collar” work is social and political, not economic.

Wages are the compensation received for labor.

In following the development of thought in the subsequent pages it will be essential to keep in mind that this definition of wages is coextensive with the definition of labor given in the preceding paragraph. All payments for productive effort are alike from the overall economic standpoint, and introducing distinctions based on social or technological criteria simply confuses the economic picture. There are significant differences in the basis of payment, to be sure, but in this work we will view the level of wages in terms of wage cost per unit of product, and on this basis it is immaterial whether the payments are made at hourly rates, as salaries, as fixed fees, as “fringe benefits,” or in any other manner.

Productivity, or productive efficiency, is the relation of the amount of values produced to the amount of labor, or its equivalent, that is expended.

To initiate an economic transaction the producer or owner of goods offers to sell them at what we may call a seller’s price, which he sets at or above the value to him as a seller. (This is the “asking price” of the organized exchanges.) An individual, or agent of a group of individuals, who is interested in the goods, either for consumption or for resale, then makes a counter offer, a buyer’s price, at or below the value to him as a buyer. (This is the “bid” price of the organized exchanges.) A process of bargaining then follows, terminating with an agreement on a sale price or, in the event of an impasse, without a sale. In some of the modern economies many of the seller’s prices, particularly in the retail stores, are fixed and not subject to bargaining, but in this case if the fixed price is above the buyer’s value the goods are not sold. The seller is then compelled to reduce his price to some lower level at which the consumers are willing to buy. This accomplishes the same result as bargaining, in a different manner. In the subsequent pages the term price, when used without qualification, will refer to sale price.

On the foregoing basis we have these definitions:

Price is a value placed on goods for purposes of economic transactions.

Seller’s value is the minimum price that the owner of goods is willing to accept for them at a specific time and place.

Buyer’s value .is the maximum price that an individual or agent is willing to pay for goods at a specific time and place.

The cost of goods is the price paid to obtain them, or if self-produced the values expended in production.

This brings us to the question, “What determines value?” On first consideration it might seem that utility is the primary criterion. Since the aim of all economic activity is satisfaction of wants, and utility (as herein defined) is that property of goods by which they are able to supply such satisfactions, it can hardly be denied that measurement of utility also measures the total results obtained from economic activity. But for present purposes we are not interested in the sum total of the material satisfactions that are realized; what we want to know is the size of that portion of the total that takes part in economic life, the portion of the utilities that, in the modern economies, can be bought and sold in the markets.

Although inherently subjective, value, as we have defined it, has a definite relation to utility, an objective property (as defined). In order that there may be value, the individual concerned must believe that there is utility to him, either directly or because of the possibility of exchange for other goods that he can utilize. It is not necessary that any actual utility exist, nor does the existence of utility automatically result in the existence of value. The essential requirement is a belief in the existence of utility. Many ineffective medicines have value because there are those who think that they are being helped by these concoctions, and are therefore willing to buy them. On the other hand, anthracite coal had no value until someone discovered that it would burn.

The perceived utility of economic goods is a factor in determining their value because it affects the individual’s willingness to make the expenditure that is necessary in order to obtain them. An equally important factor is his ability to pay the price. In Crusoe’s situation, the limiting factor is physical: his capacity for productive labor. If he finds it impossible to work more than an average of ten hours per day, then his average consumption of goods cannot exceed the equivalent of ten hours labor. When we examine some particular item such as the maintenance of comfortable temperatures in his house, we can see that both ability and willingness enter into the determination of the value of firewood. Part of Crusoe’s time must be spent in obtaining the necessities of life, and these items must be given precedence over the comforts. If half of his total labor is required for such purposes, the factor of ability limits him to five hours per day for obtaining firewood. But Crusoe is not willing to spend all of this time to obtain warmth, to the exclusion of all other non-essential objectives, and we will find that he sets a lower figure, perhaps something on the order of eight hours per week, as a maximum. If it requires more time than this to maintain a supply of firewood, he will accept the discomfort of a cold house, and apply his labor elsewhere.

We thus find that whereas cost may vary almost without bound, value has an upper limit. If the cost of production is above this limiting value, which we will call the potential value to emphasize the analogy with potential utility; these particular goods are not produced or bought. The difference between this concept of potential value and the value concept that the economists call “value in use” is in this limit imposed by a finite ability to pay. Like cost, “value in use” has no upper limit; it is this concept of value to which Joseph Schumpeter refers when he says that “total value will very often be infinitely large.”42 But this “value” has no economic significance, and bringing it into an economic discussion merely confuses the issues. Willingness to buy means nothing without ability to buy.

It should be noted that this limitation imposed by inability to pay any higher price is always effective, even in the case of the absolute necessities of life. The potential value of these necessities—food, for example—is relatively high, but it is still finite, not infinite as Schumpeter claims, because no matter how willing an individual may be to pay whatever price is necessary to sustain life, there is always a point at which he is no longer able to pay more. This is the potential value, and if the cost of food exceeds this level (by definition, a value to a particular individual and at a particular time) this individual and those dependent on him must starve, unless others come to their assistance, even though there is food somewhere which he could obtain if he were able to place a greater economic value upon it; that is, pay a higher price. We may deplore this situation, but it exists, and it is the function of economic science to analyze things as they are, not as we would like them to be, or as we think that they ought to be.

The potential value is the maximum amount, which an individual is willing and able to spend to obtain a particular economic product, if necessary. But ordinarily this great an expenditure is not required, and the actual value, the amount which he is willing to spend under the existing circumstances, is determined by those factors which make the maximum expenditure unnecessary. The first of these factors is the price at which similar goods are available. A certain article may have a potential value of ten dollars to the prospective purchaser, but if an equivalent article can be bought for one dollar elsewhere in the same general market, then the actual value of the article in question cannot exceed one dollar.

A second determinant of actual value is substitutability. On first consideration it may seem absurd to say that the value of oats is determined largely by the cost of wheat. One naturally expects value to be a characteristic of the commodity itself, on the order of density, viscosity, or some such physical property. Potential utility, as we have defined it, is such a property, an inherent characteristic of the goods, but value, potential or actual, is not. Except in the limiting situation where no acceptable substitute is available, value, in the sense in which the term is used in this work, is dependent to a very large degree on the cost of possible substitutes. Summarizing the foregoing, we find that potential value is determined by (a) utility, and (b) ability to buy (or produce). Actual value is determined by (a) seller’s offers (or minimum production costs), (b) availability and cost of substitutes, and (c) potential value (as a limiting factor). In an exchange economy the cost of production does not enter into the determination of values directly, but it does so indirectly through the seller’s offers; that is, sellers will not continue to offer products at less than the cost of production.

Whenever a deliberate economic choice is made, the decision as to what goods to buy or produce depends on the ratio of potential value to cost, how much value we get for our money, as the layman puts it. The most essential wants are satisfied first because the value-cost ratio is highest here; indeed nothing else has any value until after the necessities of life are provided for. This fact that less essential items may have little value, or perhaps no value at all, in spite of having considerable utility is one of the peculiarities of the value situation that is much easier to understand when we look at it in the context of the simple economy. Let us consider the case of an isolated person whose entire time is required for the production of the bare essentials of life, either because his environment is unfavorable, or because he is personally inefficient. To this individual, nothing outside of these essentials has any value, as herein defined, since, however willing he may be to produce it, he is not able to do so. Luxuries would still have utility, of course, and if there were any way of getting them without effort, he would be glad to have them, but he cannot devote any time to producing them, or to producing anything else that he can exchange for them, for if he does this he ceases to exist.

Now let us turn our attention to another individual whose productivity is fifty percent greater. In this case only two thirds of the total available labor time is required for producing the bare essentials, and the balance can be applied to improving the scale of living. Here comforts and conveniences begin to have a value. A third individual whose productivity is one hundred percent greater than the first would be able to assign a still greater value to these luxuries; that is, he would be not only willing, but also able to devote more of his labor to their production or acquisition. In general, we may say that the greater the productivity the higher the value that can be placed on non-necessities.

This is one of the places where scientific conclusions are distressing to some persons. Many economists and laymen wax highly indignant over the ability of persons with larger incomes to enjoy the good things of life that are denied to those not so fortunately situated, and they object to any kind of a terminology which might imply some justification for this state of affairs. They tell us that the wants of the poor are equally as strong as those of the rich, and that consequently, values are the same to all. But this is merely confusing value with utility. The utility of some goods may be the same to all, but in order to analyze economic processes we must have a concept that takes into account ability to pay the cost as well as desire to enjoy the goods. This does not imply either approval or disapproval of the existing situation, which requires the use of such a concept; it is simply a recognition of the facts. The value which most of us are able to place upon a yacht or an original Rembrandt has no economic significance, and nothing is gained by pretending that it does.

In this connection, it is interesting to note that the distinction between utility and value is recognized even by animals of presumably low intelligence, notwithstanding the fact that some of our savants manage to get them gloriously tangled up when they attempt to harmonize them with their own emotional judgments. The hungry cat will catch mice if there is no other source of food available, but he will not put forth the effort if a tenderhearted mistress is susceptible to some artful begging. The utility of mice as food is just as great in one case as in the other, but in feline economic life, as well as in human economic life, cost is compared with value, not with utility, and in accordance with the principles that have been set forth in the preceding discussion, the value of mice as food is decreased by the availability of acceptable substitutes at a lower cost.

As already noted, one of the principal determinants of buyer’s value. is the price at which the same goods can be obtained elsewhere in the same general market. Under some circumstances, sellers may offer limited quantities of particular items at abnormally low prices, especially if these goods are perishable. But they cannot continue to sell at a price below the cost of production. Under normal conditions the minimum price of any particular kind of goods is therefore the lowest cost at which any producer can produce them and transport them to the market area.

It follows that the amount of these goods available for sale at this price in this market, the supply, is limited to the optimum output of this one producer. If a somewhat higher price could be obtained, additional producers would be able to enter the market, and the original supplier might also be able to increase his output. It follows that the supply at this higher price would be greater. A still higher price would still further increase the supply. Thus the supply of a particular kind of goods in a market is not a specific quantity, but a series of quantities, a schedule, as it is usually called, corresponding to a similar series of prices.

The supply of an economic good in a specific market at a specific time is a schedule indicating the amount of that good which will be offered for sale at different prices.

As indicated in Chapter 4, the buyer’s value placed on goods by individuals must be above the seller’s price to enable a transaction to take place. At the minimum price (the seller’s value), the number of consumers whose value estimate is above this price is usually relatively large. The quantity that the consumers would buy at this price, the demand for these goods, is therefore also relatively large. At a higher price, some of the consumers find that the price now exceeds the value that they have placed on the goods as buyers. Consequently they do not buy them. A still higher price takes additional consumers out of the market. Thus the demand generally decreases as the price rises.

The demand for an economic good in a specific market at a specific time is a schedule indicating the amount of that good which will be bought at different prices.

In each case there is only one price at which supply and demand are equal. This is the only price that will “clear the market,” and it is therefore the price at which the transactions take place. Changes in either supply or demand result in corresponding changes in the market price.

The supply and demand relationships have been extensively investigated by the economists and are well covered in the economic literature. There is, however, a strong tendency to apply supply and demand reasoning to issues that are outside its range of applicability. “It is not too much to say,” contends one enthusiast, “that almost everything we know about the behavior of the economic system can be illuminated by way of reference to the fundamental cross of demand and supply.”43 But this is too much to say—far too much. The truth is that supply and demand theory does not illuminate all areas in economics. On the contrary, it has contributed greatly to the confusion that now exists in several important economic areas, particularly such subjects as the origin and magnitude of the total demand for goods, and the true significance of the money supply. The reasons for the inapplicability of the supply and demand principles to these issues will be discussed in connection with the examination of the individual issues in the subsequent pages.

 

06 The Money Economy

CHAPTER 6

The Money Economy

The third stage of economic development is reached when a medium of exchange is introduced. This is a far-reaching modification of the economic organization, and greatly increases the complexity of the economic process. Instead of one market transaction, exchange of goods (purchasing power) for goods (articles of consumption), we now have two separate transactions, exchange of goods (purchasing power) for money and exchange of money for goods (articles of consumption). It is clear, however, that the double transaction does not arrive at any different result; it merely reaches the same result by a more circuitous route.

This is typical of economic evolution in general. The fundamental objectives remain the same, but the process by which they are reached becomes more complex. As long as each person consumes that which he produces, economics is still in the amoeboid stage. But when specialization enters the scene it becomes necessary to introduce a process of exchange whereby the various kinds of goods desired for consumption can be obtained in return for the specialized goods that are produced. The simplest way of accomplishing this result is a direct exchange, but this process of barter is awkward and inconvenient, so for greater efficiency a system has been devised whereby the exchange is handled in two steps through the medium of money. When the two steps are complete, however, the final result is exactly the same as if the transactions had been carried out by means of barter. The goods have been exchanged, and nothing else of a significant nature has transpired. The money has not been altered in amount, and it is right back where it started from.

A useful analogy drawn from the physical world is the cooling of a gasoline engine. In this case the objective we wish to accomplish is to transfer heat from the engine cylinders to the surrounding air. We can do this in one step (analogous to barter) by direct contact, as in many aircraft engines and in some automobiles, but most automotive designers have found it convenient to use a transfer medium (analogous to money), which is usually water. The heat is first passed from the cylinders to the cooling water and then from the water to the air. The final result of this two-step process is exactly the same as when the cooling is accomplished by direct contact of air with the engine cylinders. The circulating medium has not been altered in any way, either in amount of in composition. Its only function has been to contribute to the efficiency and convenience of the primary process.

In both the engine cooling and the goods transaction a single operation has been carried out in two steps. The objective is not reached until both steps have been taken. Transfer of the engine heat to the cooling water is only half of the operation, and it accomplishes nothing by itself, as a motorist soon discovers if his radiator plugs up. The cooling system does not serve its purpose unless the second step is taken and the heat is transferred from the cooling water to the air. Similarly, exchange of goods for money is an incomplete transaction, only half of the total operation. The seller is not willing to stop here. He attaches no value to money per se; it has a value to him only as purchasing power by means of which he can buy goods. As in the case of the engine cooling, the transaction is not complete until the money proceeds of the original sale have been exchanged for other goods. The net effect of the transaction as a whole is therefore the same as that of direct barter. Goods (purchasing power) have been exchanged for goods (articles of consumption).

The general conclusions reached in this work by application of scientific methods and procedures are summed up in the form of a series of basic principles governing those aspects of production, exchange and consumption that are pertinent to the objectives of this work. These principles are the economic equivalent, in the area that they cover, of the laws of the physical sciences. They are independent of the particular forms of business and governmental institutions in vogue at the moment. They are as applicable to simple barter as to the most highly developed money and credit economy. They hold good under socialism, communism, fascism, or any other “ism” just as they do under the American individual enterprise system. The situations appropriate to some of these principles do not arise under the more primitive forms of economic organization, but whenever and wherever they do arise, these principles govern. It is not contended that the principles are usually valid or approximately correct, but that they are always valid and mathematically exact. The principles are simple, they are expressed in plain and unequivocal language, and their validity can easily be verified.

Furthermore, none of these principles is dependent in any way on the nature of human behavior. This assertion may be hard to accept after the way in which it has been drilled into us for decades that economics is a study of man’s actions and hence is essentially different in character from the physical sciences. But the truth is that applied science is also concerned primarily with human actions. Certainly the building of a bridge is the work of human beings. So is the design of an airplane, the synthesis of a new drug, the drilling of an oil well, or any other of the thousands of engineering and scientific tasks that might be mentioned. Science, pure and applied, deals with human actions, but not with the human aspect of those actions. The function of the physical sciences is to tell us what consequences will follow if specific actions are taken, or alternatively, what actions are necessary in order to achieve certain specific results. Economic science can do exactly the same thing. It cannot make our economic decisions for us any more than structural theory can decide whether we should build a new post office, or organic chemistry can decide whether we should make synthetic rubber. But it can tell us specifically and accurately, just as the physical sciences do in their respective spheres, what consequences will follow if we take certain actions, and it will thus enable us to adapt our economic actions to the results that we want to achieve.

The first of these principles that will be stated is the basic principle discussed in Chapter 3 that defines production as the only source of purchasing power.

PRINCIPLE I

Purchasing power is created solely by the production of transferable utilities, and it is not extinguished until those utilities are destroyed by consumption or otherwise.

 

The reason for specifying that the utilities must be transferable should be clear. Goods that have utility only to the producer or to their present owner have no status as purchasing power, regardless of the magnitude of that utility. A second hand watch possesses transferable utility and constitutes purchasing power, while a used dental plate does not, even though the latter may rank considerably higher in the esteem of the present owner.

In the barter stage of economic organization where goods are exchanged directly for other goods it is apparent that only goods can pay for goods. Now we see that the money economy does exactly the same thing, merely doing it indirectly rather than directly. Thus the same principle applies.

PRINCIPLE II

Only goods can pay for goods.

In earlier times, when this principle was emphasized in the economics textbooks, it was customary to add the qualification “in the long run.” Recognition of the incomplete status of the first step, the exchange of goods for money, makes this qualification unnecessary. Money is actually no more than a claim against the goods that have been produced, a claim that must ultimately be redeemed in goods of equal value. Of course, where money has an intrinsic value as goods, as in the case of the rare metals, that portion of the face value of the money that represents a value as goods is a partial payment.

Principles I and II are closely related. Since only goods can supply the ultimate purchasing power necessary to complete the two-step economic transaction, only the production of goods can create purchasing power. Whatever money purchasing power is obtained by any other means is only an additional claim against the same goods. It does not add to the total real purchasing power; it merely dilutes the value of the previously existing claims.

But even though the medium of exchange has no effect on the overall accomplishment of economic activity, it does play a very important part in the operation of the economic mechanism, and we will now want to give it some further consideration. The characteristics of money and money substitutes will be discussed at length later. The test of money is acceptance. If a commodity is accepted as a medium of exchange—that is, accepted not for its own utility, but as something that can be exchanged for other goods—then it is money; if not, it is not money. When we go a step farther and ask why certain commodities such as gold and silver are accepted as money whereas most goods are not, we find that there are a number of requirements, which a commodity must meet in order to be entirely suitable for use as a medium of exchange. The essential point is that variations in value must be minimized. This, in turn, means that the time and place utilities must be approximately constant. A circulating medium consisting of commodities of this nature, or credit instruments that have a similar acceptance as money, thus provides a means by which the full value of goods, including that of their highly perishable time and place utilities, can be transformed into a relatively permanent kind of value that can be used at the time and place most convenient for the possessor.

The only kinds of money accepted as such in the United States at present are the coins and currency issued by government agencies. The “money supply,” as defined by the economists, includes a number of other items, but unlike money, these items are not claims against goods, they are claims against certain specific quantities of money, and they have value only to the extent that such quantities of money actually exist, and are available. Bank deposits, for instance, the largest item in the so-called “money supply,” are claims against whatever money the bank may possess, the bank reserves, but these are much smaller than the total of the deposits. If the depositors write checks for a larger amount, the bank must arrange to obtain additional money from the Federal Reserve or some other outside source.

Gold and silver were once widely accepted as money, and gold still has this status to some extent. In the United States, however, the monetary metals must be sold, like other goods, to obtain money, and they do not add to the total money in use. The same is true of the various credit instruments classified as “near money.”

From the foregoing it can be seen that only the authorized government agencies can actually create money. It follows that the money in the economic system is conserved, and does not vary in total quantity except to the extent that it is created or retired by these agencies. (A small amount of destruction by fire, etc., occurs, but for analytical purposes we can consider the destructive forces as the equivalent of “authorized government agencies.”)

The difference between this view of the money situation and that found in the current literature of the economic profession is that present-day economic thinking does not distinguish clearly between that which has actual value and that which is merely a claim against values. Money is a claim against the goods that are produced. A quantity of the “bank money” or “near money” that the economists are including in their definition of the “money supply,” is only a claim against a claim. It does not add to the total of the claims against production, as a corresponding increase in the amount of money would do. Thus it has a much different effect on the streams of economic activity, as we will see later.

Because of the approximate constancy of value of the medium of exchange its introduction has done more than provide a common denominator to facilitate the exchange transaction. It has enabled storage of claims against goods independent of goods storage. This is a very significant point, but its major implications have been almost entirely overlooked by previous investigators because they have failed to appreciate the fundamental difference between drawing purchasing power from storage and creating it by production of goods. We will call the facilities for storage of money or goods reservoirs.

In the modern economies there are several different kinds of money reservoirs, but they all accomplish exactly the same result, a point that we will find very significant when we begin consideration of the methods that can be used for control of the reservoir transactions. The money storage may be done directly in a money reservoir, a bank, a pocketbook, or an old tin can, or government agencies may issue or retire money, or a nation’s currency may be acquired by foreign countries, which are then acting as reservoirs, so far as the domestic economy is concerned, or gold may be mined and used for money (not in the U. S. today). The activity in and out of these reservoirs is easily monitored, and the information required for control over the reservoir transactions is therefore readily available, if and when a decision is made to institute some kind of control.

Increases in the market prices of existing goods (particularly stocks, shares in the ownership of business enterprises) are often looked upon as sources of purchasing power. But these increases do not provide money purchasing power unless the goods are sold, and when the sale takes place it absorbs as much purchasing power from the buyer as it provides to the seller. Thus a transaction of this kind does not provide any more total purchasing power; it merely transfers purchasing power from one individual or group to another.

With the benefit of a realization that there are reservoirs in the circulating stream of money purchasing power that have a profound effect on the flow from production to the markets, it is now possible to return to the creation of purchasing power and to clear up another issue: the quantity that is created. Here, again, the facts are clear and unmistakable. Production of goods and creation of purchasing power are one and the same thing. That which we produce is purchasing power to us but goods (articles of consumption) to others. That which others produce is purchasing power to them but goods (articles of consumption) to us.

PRINCIPLE III

Purchasing power and goods are simply two aspects of the same thing, and they are produced at the same time, by the same act, and in the same quantity.

Production in excess of purchasing power is mathematically impossible. Nothing can exceed itself. It is immaterial whether the relative values of goods rise or fall; if the purchasing power of certain goods decreases because of a drop in relative value, the purchasing power required to buy those goods decreases by exactly the same amount.

This principle is not new. It was first stated by J. B. Say, one of the early French economists, and it is known as Say’s Law of Markets. To the economic profession it has been one of the great enigmas of their branch of knowledge. On the one hand, the “law” is so simple and logical that its validity is almost self-evident, but on the other hand, Say’s deduction from it, the seemingly obvious conclusion that the purchasing power available in the markets will always be sufficient to buy the full volume of production at the prevailing prices, is so completely at variance with actual market behavior that the law cannot command general acceptance either. The result is confusion.

An understanding of the role of the purchasing power reservoirs clears up the contradiction. We can now see that Say and his successors misjudged his finding. It is not a Law of Markets; it is a Law of Production. As such it stands solid and unshakable. Purchasing power is created in exactly the right quantity to buy the full volume of goods produced at the full production price. The availability of money purchasing power in the markets is an entirely different matter because of the presence of money reservoirs in the circulating stream.

The three fundamental principles that have been stated thus far make it clear that there is only one way in which the basic economic objective of increasing real purchasing power—ability to buy goods—can be attained. That is by increasing the production of goods, just as the only way by which we can increase the amount of heat transferred from the radiator of the automobile to the air (if we can think of any reason why we should want to do this) is by generating more heat in the cylinders. Real purchasing power (transfer of heat) cannot be increased by raising money wage rates (higher rates of water flow) or by cutting prices (lower rates of water flow) or by increasing the money supply (putting more water into the cooling system) or by shifting purchasing power from one group to another (stirring the cooling water) or by subsidizing some consumer group (which is just another way of accomplishing a transfer from one group to another) or by any of the other “something for nothing” schemes that are so plentiful in economics.

Further consideration will be given to each of these all too prevalent economic fallacies at appropriate points in the subsequent pages, but most of the obstacles that stand in the way of getting a clear view of the economic process can be avoided simply by keeping in mind that the whole object of any economic system—the sole reason for its existence—whether it is the simple barter economy of a savage tribe or the enormously complex mechanism that has been developed by the more advanced nations, is to provide a means whereby individuals may exchange the goods that they produce for the goods that they wish to consume, at the times that are convenient for them.

Another important result of the introduction of money into economic processes is that values are now customarily measured in terms of an arbitrary monetary unit whose relation to the true values (measured in terms of goods) is subject to continual variation. The true values, generally called “real” values, are widely used in economic discussions, but economic transactions in general are carried on in terms of monetary units—dollars, pounds, yen, etc. The ratio of real value to money value is the “value of money,” a quantity whose variations are responsible for many errors and misconceptions in economic thought, among economists as well as among laymen.

Most of the relations that will be developed in the subsequent discussion are just as valid in terms of money as in real terms, and the words “price” and “value” will normally be applied to both concepts without qualification. Where it becomes necessary to draw a distinction, such terms as “money value” and “real wages” will be used.

To illustrate what the word “value” means in their terminology, economists often make some such statement as this: “If one orange can be exchanged for two apples, then the value of one orange is two apples and the value of two apples is one orange.” Strictly on the basis of their definition of value as “exchange value,” this assertion is correct, but it gets us nowhere. It amounts to nothing more than a restatement of the definition in different words. However, the economist who makes this statement is doing something else with it; he is transferring conclusions reached on the basis of his own special definition of value to another totally different value concept. When he says that the value of one orange is two apples, he is not intending to convey the idea that this is true simply because he has set up his definition in this manner. He is implying that the orange is worth two apples; that is, he is using the word “value” in its ordinary everyday significance.

The difficulty here is that whereas the statement is true but meaningless as long as the economist stays with his own definition, the switch to a new definition in midstream has made it meaningful but untrue. Even a child in kindergarten knows that if he exchanges two apples for one orange, he cannot get the apples back unless he offers more than one orange. The exchange was made in the first place because the orange was worth more than the two apples to the original possessor of the apples, whereas it was worth less than the two apples to the original possessor of the orange. Both parties to the transaction thus experienced a gain in values as a result of the exchange, and if the transaction were reversed both would lose. Hence it cannot be reversed. Economic transactions are irreversible.

 

Here is the reason why it is essential to recognize the concept that we are calling “value” in this work, the amount that an individual is willing and able to pay for the goods in question. If we follow the example of the modern economist and attempt to carry out our analysis without the use of this concept, we not only have no explanation of this important fact that economic transactions are irreversible; we have nothing that explains why such transactions should take place at all. Present-day economic analyses take “demand” as their point of departure. “Let us start with demand,” says Samuelson, “Everyone has observed that how much people will buy at any one time depends on price.”44 But why should they buy this specific item at all? Why do they buy this at a high price rather than that at a low price? What are the limits on demand and price, and why do they exist? These are not trivial questions; they go to the heart of the economic process, and before we can accomplish our defined objectives we must put ourselves in a position to be able to answer them. As will be brought out in the pages that follow, lack of a clear understanding of the factors that determine the overall ability of the consumers to buy goods is responsible for some of the most serious errors in current economic thought and practice.

One of the important generalizations in the physical field is the Second Law of Thermodynamics. This law specifies that naturally occurring physical processes can move only in one direction: a direction that involves degradation of energy to a less available state. This degradation is measured quantitatively by an increase in a property known as entropy, and the Second Law can therefore be expressed concisely by the statement that naturally occurring processes always involve an increase in entropy. Value, as defined herein, plays the same kind of a role in economics that entropy does in physics. All voluntary economic transactions involve an increase in values. Hence goods can move only in one economic direction, gradually increasing in value as they approach the ultimate consumer, because of the continued additions of time and place utility.

If everyone had to go to the refinery to buy gasoline, the value of gasoline to the ordinary consumer would be low; it is only the omnipresence of the service station that makes gasoline powered transportation feasible on a large scale. So we have a whole series of values for gasoline, beginning relatively low at the refinery and increasing step by step until the ultimate consumer pays the retail price. But these values only hold good as long as the economic stream flows in the same direction, and no attempt is made to reverse any of the transactions that have taken place. If the automobile owner decides that he has bought too much gasoline and wants to convert some of it back into money, he finds that the value of gasoline has shrunk. He either has to accept a substantially lower price, or he has to spend time and effort in finding a retail buyer, which amounts to the same thing.

Gasoline therefore does not have a unique value that can be identified as “exchange value. ” At any specific time and place it has two values to anyone who appraises it: a downstream value in the direction of the consumer and an upstream value away from the consumer. A transaction, which involves movement of goods toward the consumer, increases the actual time and place utilities, whereas one in the opposite direction decreases the actual utility. Since this actual utility is one of the determinants of value, the change in utility also changes the value. The function of money, where it enters into the economic picture, is to provide a medium, which is independent of time and place, and therefore has equal value in both directions. This enables producers to convert the value of their products as objects of consumption, including the full value of the time and place utilities, into a form in which the value is invariable (ideally, at least).

The necessity for value differences to furnish the driving power for economic transactions, together with the irreversibility of these transactions because of the value differences, means that there is no such thing as a pure “exchange” in economic life, and expressions such as “exchange value,” or “stock exchange,” are to some extent misleading. A market transaction is an exchange, to be sure, but it is not merely an exchange; it is a dual process of sale and purchase. Aside from minor and incidental transactions, the original producer only sells, the ultimate consumer only purchases. Middlemen do both purchasing and selling, but they do not buy and sell at an “exchange price.” They buy at one price and sell at another. Even barter is not a pure exchange from an economic standpoint. What appears to be a simple exchange of wheat for fish, for example, is a dual economic process. The farmer is using excess wheat (purchasing power to him) to buy fish (goods to him), whereas the fisherman is using fish (purchasing power to him) to buy wheat (goods to him). The difference between this and a mere exchange quickly comes to light if one tries to reverse such a transaction. It then becomes apparent that the value of either commodity as purchasing power is considerably less than its value as goods.

It is quite possible that a decrease in value may take place at some point along the economic path where increasing value is the general rule, but such decreases do not take place by reason of economic transactions; they are the results of unilateral revaluation between transactions. A merchant may buy certain goods at a relatively high price and then find that he cannot sell them unless he reduces his selling price to a point below the original cost, so that he sustains a net loss, but this does not alter the fact that both of his transactions, purchase and sale, increased values at the time they occurred. The value of the goods to the merchant at the time of purchase exceeded the price that he had to pay; otherwise he would not have bought them. Their value to him at the time of sale was less than the selling price; otherwise he would not have sold them. Both transactions increased values, but between the time of purchase and the time of sale the merchant found that he had made a mistake, and he was forced to reduce his valuation of the goods.

The difference between the value to the buyer and the value to the seller can be compared to the physical concept that we call “force.” Where appropriate conditions exist in the physical field, an unbalanced force causes physical motion. Where appropriate conditions exist in the economic field, a difference in values causes economic motion; that is, an economic transaction.

Theoretically, any unbalanced physical force—a net excess in one direction or the other—will cause motion. In practice, however, this excess force must normally be great enough to overcome a certain amount of friction before movement is possible. Similarly, in the economic field there is economic friction to overcome, and transactions do not take place unless the difference in values is sufficient to overcome this friction. The market transaction is therefore a complex event involving a range of values whose significance cannot be accurately reflected by any single quantity such as the sales price, or “exchange value.”

07 Wealth and Capital

CHAPTER 7

Wealth and Capital

It was pointed out in the earlier discussion that the actual utility of goods at a specific time and place depends on the nature of the wants that can then and there be satisfied, as well as upon the inherent characteristics of the goods themselves. Food, for instance, has a high utility if it is available when and where it is needed. It does not follow, however, that an infinite amount of food at that time and place would have infinite utility. If Crusoe picks and eats a banana, the fruit contributes toward relieving his hunger, a very important want, and it also satisfies his desire for a tasty food, another want distinct from mere nutrition. A second banana is not quite the equal of the first, as the sharp edge has been taken off the hunger sensation, and the taste satisfaction probably lacks something of being the equal of that gained from the original unit. By the time he reaches the fifth or sixth banana, the ability of another one to satisfy either hunger or taste at this time has sunk to a low level, and if he keeps up the process he soon arrives at a point where bananas have no further utility to him at the moment.

This situation, we find, is not a peculiarity of bananas, but is characteristic of utilities in general. After the point of maximum utility (often the first unit) is passed, the utility of each successive additional unit becomes less and less until it finally reaches the vicinity of zero. This is called the principle of diminishing utility, and it is one manifestation of the general principle of diminishing returns, a mathematically based relation of very wide applicability.

For many economic processes the utility of the last unit of a kind, the marginal unit, has a particular significance. Of course, any one of the group could be the marginal unit. In the case of the bananas, no specific one can be singled out, prior to being selected for eating, as having more utility than another, but this is simply because we cannot tell in advance which will be selected first. We can, however, say definitely that the first banana picked will have the maximum utility, and the last one will have the least utility. As soon as the selection is made, the utility is determined. The utility of the last, or marginal, unit is the marginal utility of the total supply of bananas.

Like the supply and demand relations, the concept of diminishing returns and the marginal concept have been quite fully developed by the economists, and for present purposes the results of their work can be accepted substantially as given in the economics textbooks. These concepts will, however, play an important part in the discussion of the nature of interest and other aspects of the cost of the services of capital later in this chapter, and they will therefore be reviewed in somewhat more detail than would ordinarily be necessary for standard textbook material.

Value, like utility, is subject to the principle of diminishing returns. As the utility of successive units decreases, value likewise tends to decrease. However, the two quantities do not move in parallel courses. The actual value is generally well below the potential value because of the modifying effect of the availability of substitutes, etc., and since it is the potential value that is reduced by the diminishing utility, rather than the cost of substitutes and the other determinants of actual value. The value is maintained in the face of diminishing utility until the utility reaches a low enough point to have a direct effect. But when the value starts to drop, it decreases faster than utility because total utility is limited by wants, which are practically infinite, whereas value is limited by productive capacity (ability to buy), which is decidedly finite.

To illustrate how value controls productive activities, let us assume that wild pigs are plentiful on Crusoe’s island, so that an average of only four hours per animal is required for hunting, transportation, and preparation of the meat. Let us further assume that deer are to be found less frequently and farther away, so that it requires 12 hours on the average to obtain an equivalent quantity of venison. Obviously the bulk of the meat requirements will be met by hunting pigs, since the same values can be obtained at less cost. But as the diet of pork continues monotonously week after week, the marginal value of pork drops to some extent, whereas the desire for a change in diet causes an upward revaluation of venison. If Crusoe is living close to the limit of survival he may still be unable to raise the valuation of venison very much, perhaps not above 6 hours, and since it is not obtainable at that cost he will have to forego deer hunting. But if he has enough margin over the bare necessities, he may be able to place a value of 12 hours each on a limited number, say two or three animals per year, and an occasional expedition into the deer country then becomes feasible. Still more frequent hunting would not be possible under these circumstances, as venison would then cease to be a special treat, and its marginal value (now determined primarily by the cost of pork) would drop below the cost of production.

As long as we are dealing with goods such as the bananas and meat of the preceding discussion, rapid deterioration prevents any appreciable amount of storage under the conditions prevailing in the Crusoe economy. There are other goods, however, which can be stored for substantial periods of time, and this feasibility of storage introduces another important factor into the economic picture. We will apply the term “wealth” to any accumulation of goods, and we will define the term accordingly.

Wealth is an accumulation of goods.

A very important point that should be emphasized here is that money is not necessarily wealth. As will be brought out in the chapter on money and credit, money was originally some kind of goods that enjoyed wide acceptance as a trading item. This kind of money is an accumulation of goods and therefore does constitute wealth, although its value as wealth is not necessarily as great as its value as money. But modern money is almost entirely a credit creation, and it has no value in itself. It is only a claim against wealth. It has value to an individual only to the extent that some other individual can be induced to accept it in exchange for goods. The existence of money or other credit instruments thus adds nothing at all to the assets of the community as a whole. This is quite obvious when we consider the question in isolation, but like so many other economic truths, it is often lost to sight in the confusion of detail that surrounds specific economic problems, and we will find in the course of our inquiry that a great deal of unsound economic thinking is founded on the fallacious belief that money and credit instruments, particularly the latter, do constitute wealth.

The advantages of laying up a provision for the future in the form of a store of goods are so obvious that it does not take human intelligence to recognize them. Animals and even some plants make it a regular practice. The familiar example of the squirrel and his store of nuts is only one of many instances of this kind that can be found throughout the world of living things.

Consumption of the class of goods typified by the acorns that the squirrel stores away in some hollow tree is characterized by immediate use of all of the utility of the goods. When anyone eats an apple, all utility of the apple is eliminated. If we store such goods we merely postpone the enjoyment of their utilities to some future time. No utility is derived from the goods in the interim, aside from such satisfaction as may accrue from the feeling of security against future failures of the food supply. In fact, there is usually a certain amount of cost involved in providing storage space, maintaining proper storage conditions, and guarding against loss. In order to make such storage practical, therefore, it is necessary that the present value of the utility to be derived from the use of the stored goods at some future date be sufficiently in excess of the value of the goods for immediate consumption to justify these storage costs.

There is another class of goods that are consumed gradually rather than all at once, and yield utilities to the consumers over a period of time. When a certain amount of labor is expended in building a house, consumption of the product does not take place in one act, in the manner of consumption of food. The utility, which the dwelling is capable of furnishing, is developed over the entire useful life of the structure. For purposes of our analysis it is necessary to distinguish between these two classes of goods, and we will identify them by the terms transient goods and durable goods respectively.

It is convenient for many purposes to restrict the “durable” classification to goods that have a substantial lifetime. Many accounting procedures, for instance, allow tools to be capitalized only if they have an estimated life of more than one year. A similar criterion is applied to consumer goods in general by the economists, and on this basis such products as clothing are excluded from the durable category. From our analytical standpoint, however, the crucial issue is whether the consumption of the goods takes place immediately. If not, the length of the useful period is merely a limitation on total utility and value.

Time enters into the determination of the utility of transient goods only because the life of such goods is limited. The total utility of these goods is the summation of the utilities of the individual units that can be used during the limiting period of time. Values are based on the utilities thus derived, with certain modifications due to other factors, and have no time dimension; that is, the goods have a value at a specific time and place, and the same or some different value at another time and place prior to their consumption, but they do not have a value over a period of time. An orange may be worth ten cents at one time and place, or twenty cents at another time and place, but it has no value per unit of time. We cannot say that it is worth a certain amount per day or month.

The value of durable goods, on the other hand, does have a time dimension. The immediate utility of such goods is negligible. When time approaches zero, utility also approaches zero. The utility of a hat for an infinitesimal period of time is infinitely small. But durable goods have a rate of utility. A hat has a finite utility per week or per month. The total utility of the hat is then the integral of the utility over the useful life, or we may say that it is the product of the average utility per unit of time and the length of time the hat is in service.

Corresponding to the rate of utility, durable goods have a rate of value, a value per unit of time. These goods also have an immediate value, even though they have no immediate utility, as future utility is one of the elements entering into the determination of present value. In the modern economic organization we commonly recognize both immediate value and rate of value in connection with durable goods. We can buy a house for $100,000, or rent it for about $1500 per month. During the month we get essentially the same utility from the house whether we buy or rent. Indeed, we may not even know at the time whether we are buying or renting, as it is a common practice to execute rental contracts with an option to purchase that calls for a portion of the rent to be applied to the purchase price.

Immediate value is the present equivalent of all of the values, which are estimated to be realized over the useful life of durable goods. When the rate of value is the same for two articles, the immediate value of the one having the longer life is the greater. However, if we start with short-lived goods, and examine the immediate value of goods that have the same rate of value but successively longer life periods, we find that beyond the first few increments the immediate value increases more and more slowly, and finally approaches a limit. Thus an item with an extremely long life does not have an extremely high value. There is a limit to what an individual is willing and able to pay for it.

Let us assume, by way of example, that the climate of Crusoe’s island is such that he has a continuing need for a hat, and that the type of hat which he wears has a useful life of one month. Then, for convenience, let us establish our system of units on such a basis that the utility of a hat is one unit of utility per month, and the value realized from one month’s use of the hat is one unit of value, so that utility and value are commensurable. Now if an improved hat, similar in all respects except that it has a useful life of two months, is produced, the rates of utility and value remain the same, but the immediate value of this new hat is two units, since it is the equivalent of two of the less durable hats.

If the improvement process continues, and hats with a still longer life become available, the total utility realized from a hat increases in proportion to the extension of the useful life. The immediate value, however, soon begins to lag behind the utility because of the finite limit to Crusoe’s productive capacity. He is not able to devote more than a certain amount of time to the manufacture of hats, and he is not willing to spend even this much, as other wants take precedence. Hence he might not credit a hat with a useful life of ten months with more than perhaps eight units of value, he might give one with a useful life of a hundred months a value in the neighborhood of 50 units, and ultimately the valuation would reach a limit beyond which he would not increase it further even if the useful life became practically infinite. The magnitude of this limiting value depends on factors such as Crusoe’s productivity, the natural advantages of his environment, etc., but we know that the limit is finite, and we can deduce that it is not very high, since neither Crusoe nor anyone else in his right mind is going to set aside any very substantial portion of his income to provide himself with headgear for the far distant future. For purposes of this present illustration, we will estimate the limiting value at 200 units.

Now let us look at this same situation from a slightly different angle. The immediate value of the second hat is two units, and since the utility and value per month are each one unit, Crusoe is using up half of the total utility and realizing half of the immediate value during each of the two months. The consumption of the utility thus accounts for the entire realization of value, just as it does in the case of transient goods. When we come to the 10-month hat, however, we find that the one unit of utility chargeable to the first month represents 10 percent of the total utility, whereas the one unit of value realized in this first month is 12.5 percent of the total immediate value. In this case, then, the consumption of the utility no longer accounts for all of the values realized from the use of the hat; there is an additional increment of value over and above the value corresponding to the amount of utility consumed.

As the hat life increases, this value increment approaches a fixed limit, since one month’s consumption of utility in the use of a permanent article is zero, and all of the value realized by the use of such an article is due to the excess value factor. In the illustration given, this limiting increment is 0.5 percent of the immediate value. The following tabulation shows the entire situation:

Table 1: Value Realized by Article

Life (months) 1 2 10 100 Permanent
Value 1 2 5 50 200
Monthly value realized 1 1 1 1 1
Percent of total value 100 50 12.5 2 0
Monthly use of utility 1 1 1 1 1
Percent of total utility 100 50 10 1 0
Monthly excess value 0 0 2.5 1.0 0.5

We thus find that the rate of value of durable economic goods includes not only the value of the utilities that will be consumed during their useful life, but also an additional amount. This increment is a direct mathematical consequence of the fact that man’s productive capacity is limited, and it represents the value of the use of the unconsumed portion of the goods. In essence, the mathematical relation involved here is another manifestation of the principle of diminishing returns. Since the immediate value is always finite (that is, it is not possible to devote an infinite amount of labor to the production of any item) the extension of useful life results in continually decreasing increments of value until a point is reached at which the value increment due to consumption of the utility is zero. The rate of value under this limiting condition is the value of the services of wealth, a quantity that can most conveniently be expressed as a percentage of the immediate value. In the example cited, it is one half of one percent per month, or six percent per year.

The fact that the services of wealth do have a value is obvious. Anyone who questions this statement needs only to reflect how different life would be if it was not necessary to take into account the first cost of durable goods; if we could enjoy their utilities merely by meeting maintenance and depreciation costs (that is, replacing the utilities as they are consumed). Even the boldest utopia promises nothing like this. But the reason why this value exists is not so obvious, and there has been considerable difference of opinion on this score. The objective of the foregoing discussion has been to answer this question; to show why the value exists and how its magnitude is determined.

The value of the services of wealth is, of course, the basis for the existence of interest, and a consideration of the mathematical derivation of this value in the preceding paragraphs should be sufficient to dispose of most of the misconceptions as to the nature and origin of interest that are now prevalent. It is quite generally believed that interest is something that developed after the economic organization had reached a rather high degree of complexity, and it is true that the practice of charging interest on loans is of fairly recent origin—some of the churches considered this practice immoral up to a few centuries ago. But even Crusoe, who knew nothing of interest, or of borrowing money (or of money itself, for that matter), was faced with exactly the same situation. Because of the finite limits to his productive capacity, the use of existing wealth had a value to him over and above the value attributable to the utilities consumed, and he could not afford to put his available labor into the production of durable goods from which such values are not obtained.

Present-day theories of interest generally attribute it either to time preference, or to the productive capacity of wealth, or to something on the order of Keynes’ concept that it is “the reward for parting with liquidity for a specified period of time, ”45 but it should be evident from the foregoing analysis that none of these factors is basic. Any preference for present consumption over future consumption, or vice versa, or any preference for liquidity, will modify the rate of interest, but as long as human productive capacity is finite the services of wealth have a value, and hence an interest rate exists independently of any time or liquidity preference. Similarly, the productivity of wealth in certain forms may have an effect on determining the current rate of interest, but the services of wealth have a value even if that wealth is in such a form that it can neither be used in production nor converted to a productive form. The existence of interest is a purely mathematical consequence of a finite productive capacity.

Under the limiting condition of extremely long life, the value of the utilities consumed during a relatively short period—a year, for instance—is zero, and the entire value rate is attributable to the services. The limiting condition in the other direction is represented by transient goods which approach zero useful life, and therefore have no service value. Durable goods occupy the entire range between these two limits, varying from items which have a very short life and therefore have a value comparable to that of transient goods, to items which last almost indefinitely, and thus have a value approximating the value of the services alone.

In setting up a definition of the term “goods” in Chapter 5 it was necessary to take into account a class of items which do not have the ability to satisfy human wants directly, but which contribute in an indirect manner to such satisfactions by taking part in the production of goods suitable for direct consumption. Heretofore the discussion has been confined to direct consumption goods, but we have now reached the point where we are ready to begin considering this second major goods classification. To distinguish between the two we will use the terms consumer goods and producer goods.

Consumer goods were further subdivided into transient goods and durable goods. Corresponding to transient consumer goods is a class of transient producer goods consisting of materials and supplies and production services. Some of these transient goods fall into the category of producer goods by virtue of necessity, being inherently incapable of satisfying human wants. Limestone, for instance, ministers to no want directly, but it is an important factor in the production of many goods, which do satisfy wants. Other materials could be used either as producer goods or as consumer goods, and their classification must be based on the purpose for which they are actually used, or for which they presumably will be used.

In the primitive economies where each individual is a combination producer and consumer there is some uncertainty as to the classification until the time of use, but as the evolution of economic organizations has progressed, producers and consumers have been separated in most cases, and this makes the matter of classification much simpler. All goods in the possession or ownership of consumers, other than those to which they have title because of their ownership of the producing enterprises, can be classified as consumer goods. Goods held by producers for sale, directly or indirectly, to consumers are also consumer goods, but all other goods in the possession of producers are presumably intended for use in the production processes and hence are producer goods.

Transient producer goods differ from transient consumer goods in that their utilities are used but not consumed. In the process of consumption the utilities possessed by consumer goods are destroyed, but in the utilization of producer goods the utilities are passed on to other goods. Sugar consumed has lost all utility, but the utility of sugar used in making candy still exists as definitely as ever until the candy itself is consumed. The utility of the lubricating oil that overcomes friction in the bearings of the locomotive is transformed into place utility added to the products transported with the aid of the locomotive.

Producer goods can have no utility, as that term is defined in this work, other than the extent that they can be employed for the purposes of producing or increasing the utility of consumer goods. The measure of their utility is therefore the contribution, which they are able to make toward creating other utilities. This means that the actual utility of producer goods is dependent to a large degree on a factor, which does not enter into the utility of consumer goods: the efficiency of the productive process. The relation between potential and actual utility is therefore much less simple than in the case of consumer goods.

All of the general discussion of utility and value in the preceding pages applies to transient producer goods in the same manner as to transient consumer goods. The only observation that needs to be made in this connection is that the mental calculations leading to appraisal of the value of producer goods are somewhat more roundabout than the corresponding calculations for consumer goods. On the other hand, the subjective element is much less prominent, and the variations between appraisals made by different individuals is correspondingly minimized. In the final analysis, however, value is still a matter of individual judgment.

Corresponding to durable consumer goods are durable producer goods with similar characteristics. The term capital goods will be used to cover both durable producer goods and production materials; that is, all tangible producer goods.

In setting up this, the first of a series of definitions in the field of capital, we are entering another of the major areas of economic controversy. As Fraser expresses it, “Capital… is the most difficult term in the whole range of elementary analysis.”46 But here again, the controversy is wholly unnecessary, at least from the standpoint of a factual economic science. The debate is addressed to the issue as to how capital and associated terms should be defined. Once more, as in the case of value, the economists are putting the cart before the horse. They are first setting up a name, “capital,” and then trying to attach a definition to it. The logical procedure, the standard procedure of science, is to reverse this sequence, first formulating and defining the concepts that will be used in analyzing the phenomena in question, and then attaching appropriate names to them. The definition of capital goods set forth in the preceding paragraph is not being presented as the way in which this term ought to be defined, but as the description of a concept which will be used in the ensuing discussion, and to which the designation “capital goods” can appropriately be applied.

Since capital goods have been defined as tangible producer goods, and producer goods are those items which contribute in an indirect manner to the satisfaction of wants by taking part in the production of other goods, it follows that all of the items that the economist includes under the category of “land” are capital goods on the basis of this definition. At first glance this may seem to be completely heretical, since it is in direct conflict with the time-honored classification of the factors of production as land, labor, and capital. In reality, however, the economists themselves are growing weary of trying to maintain this distinction without a difference, and here and there in the economic literature we are beginning to find admissions of disillusionment such as this from Fraser: “For the moment we are left with the conclusion that it might have saved much time and trouble if the word “land” had never come to be used as the name of a factor of production in economic theory.”47

The trouble here stems from the fact that the original distinction between land and capital was not drawn on the basis of any economic analysis of the relation of these factors to economic processes, but rather on the basis of the particular social and technological situation existing in England and the neighboring European countries at the time when economic theory was in the formative stage. It is a social distinction, not an economic distinction. The British economy at that time was predominantly agricultural, and ownership of the agricultural land was primarily in the hands of a landowning class of society quite distinct from the tenants in one direction, and from the industrialists and factory workers in another. This combination of an economy based principally on a production process in which land plays a very important part, together with the existence of a social class deriving its income almost exclusively from the ownership of land naturally made a very strong impression on the early economists, and recognition of land as a separate factor of production followed somewhat as a matter of course.

As the development and clarification of economic ideas continued, however, it became more and more difficult to justify setting land off by itself as something distinct from any other economic item. To Ricardo and other early economists it seemed clear that land, as a product of nature, was inherently of a different character than goods produced by man, but it soon became evident that whatever could be claimed for land in this respect was equally true of the facilities utilized by the extractive industries—mines, quarries, etc.—and the economists’ definition of “land” was therefore enlarged to include all “free gifts of nature.”

Still further study revealed that this step taken to eliminate one difficulty simply plunged the theory into another. When “land” was redefined as a gift of nature to distinguish it from the products of human effort, the status of land itself as “land” in the economic sense became questionable. Productive land is not ordinarily a gift of nature. The raw material is supplied by nature, to be sure, but in order to fit it for a specific productive use an amount of effort is required which is not at all disproportionate to the amount of effort required to fashion mineral “land” into a productive machine. In the words of Fraser, “field and machine are alike in being the results of applying technical processes to a given material. From which it follows that fields are not “land” in the strict economic sense at all.”48 Now we have traveled the full circle. Land was originally designated as a separate factor of production because its special characteristics seemed to set it apart from ordinary capital goods. But when we analyze these characteristics and attempt to set up a definition that recognizes this presumably unique status, we find ourselves with a definition, which excludes land itself. Actually, land is a form of capital goods, and therefore cannot be distinguished from capital goods on any logical basis.

Inasmuch as we have defined cost and value in commensurable terms, we may simplify our value-cost comparisons by considering the values, which will be lost by diverting effort away from the production of consumer goods as the effective cost of producer goods. This effective cost can then be compared directly with the values produced. Such a procedure is particularly helpful when the time factor enters into the situation and we want to consider the rate of cost rather than the total cost. If we extend the previous consideration of the rate of value of durable consumer goods to capital goods as well, we arrive at a figure which represents both the rate of value of the services of productive wealth and the effective cost of using wealth for productive services, the cost of the services of capital, we may say.

The services of capital are the services of wealth used in production.

The cost of the services of capital to the supplier is the value of the services of the corresponding amount of wealth in the form of consumer goods.

It will be noted that we have defined the services of capital without previously defining capital itself. This may seem odd, but it is entirely logical. Whenever A is a function of B, it follows that B is likewise a function of A. We can therefore define B in terms of A just as logically as we can define A in terms of B. It is true that the simple term is usually defined before the compound term, but this is merely because the simple term is normally applied to the quantity that is most easily defined, regardless of its nature. In hydraulics, the integral quantity, the gallon, is defined before the differential quantity, the gallon per minute, but in electrical technology the opposite course is followed. Here the differential quantity, the watt, is first defined, and the integral quantity is expressed as a compound unit, the watt-hour. In the present instance we have found it simpler to follow the electrical example and define the services of capital first, and then proceed with the definition of capital.

Capital is the present equivalent of the future productive services of wealth.

An analogy with labor may be useful at this point. Labor is analogous to the services of capital, not to capital itself. Capital is analogous to the present equivalent of future labor, a concept to which no name has been attached. Here we note that labor, the continuing item, analogous to the differential quantity in physical relations, is the thing that has been defined, and to which a simple name has been applied. If we wish to speak of the present equivalent, analogous to the integral quantity in physical measurement, we then express this quantity in terms of labor. This is exactly the same thing that we have just done with capital.

The distinction between wealth and capital should be carefully noted. Wealth, as herein defined, yields satisfactions. Capital, as herein defined, yields goods. Capital meets the specifications of wealth indirectly, as goods yield satisfactions, but the converse is not true, as satisfactions do not yield goods. Wealth, which does not already exist in the form of capital goods, is capital only to the extent that it can be converted into capital goods. In the primitive types of economies such conversion is possible only in certain special cases, except to the extent that the consumption of stored goods may release labor for the production of capital goods. Wealth in the form of durable consumer goods must remain in this status until consumed. Later, when we consider more complex economic organizations we will find that means become available whereby the individual (but not the economic unit as a whole) can make the conversion from wealth to capital through transactions with other individuals. But even here we will find that it is not possible to make a complete conversion; that is, the value of goods as capital is normally less than the value of goods as wealth to be consumed.

It may not be immediately apparent why we have adopted a somewhat roundabout way of defining capital rather than merely saying, as the economists do (if they visualize capital in anything other than purely monetary terms), that it denotes goods devoted to production, or words to that effect. One reason is that there is a very important difference between wealth and capital that is ignored by such a definition. Since this difference will play a significant part in the subsequent analysis, it is necessary to take it into account from the start. Any tangible consumer goods that have a degree of permanence constitute wealth. In order to be classified as goods they must have utility, and that utility. However small it may be, has some value, and is preferable to no utility at all. Hence all such goods are assets to their owners and meet the definition of wealth. But not all capital goods constitute capital.

By definition, capital goods are goods used, or intended to be used, in the production of other goods. A tool, which Crusoe has made for use in his productive activities, meets this definition. But let us assume that after some experience with the use of the tool, Crusoe finds that the labor required to keep the tool sharp enough to serve its purpose exceeds the labor saved by the use of the tool. Immediately it ceases to be capital. The tool can still be used in production, and when it is so used it is the equivalent of a certain amount of labor, but it is not the equivalent of enough labor. We cannot say of capital goods, as we did of consumer goods, that a little utility is preferable to none at all. The zero point for the utility of capital is not at absolute zero, as in the case of consumer wealth, but a higher figure representing the cost of maintaining the capital. Any satisfactions that are derived from consumer wealth constitute a net gain, but unless the goods produced by the use of capital exceed a certain minimum, the net result is a loss.

The foregoing is not intended to imply that there is anything inherently incorrect in using the term “capital” synonymously with “capital goods”, or applying it to an accumulation of money, but such definitions preclude the use of this term in any accurate sense. Money, as such, serves no purpose in production, and consequently it is not capital, so far as the economy as whole is concerned. It is the equivalent of capital to the individual only because it enables him to secure capital from some other individual. Capital does exist in the form of capital goods, but the common usage of the term “capital” even in the textbooks that define it in another way, is clearly inconsistent with any other definition than that given herein. When we say that a person has lost his capital through unwise investments, we are not implying that the capital goods to which he acquired title have disappeared or changed in any way. We simply mean that these goods do not have the earning power that the owner anticipated. When we speak of capital gains and losses in our tax jargon, we are not talking about any change in physical goods. We are talking about revaluation of those assets based mainly on present views of their future earning power.

All capital, as herein defined, is subject to the cost of subsistence, regardless of the form in which it exists. This is easy to see in the case of tools, buildings, and other items, which visibly wear out or depreciate. It is no less true of capital in a presumably “indestructible” form. Even diamonds and bars of gold require protection and care, and the cost of that attention is a charge against capital. Land is often cited as an example of an indestructible form of capital, but to the rather limited extent to which land can legitimately be described as indestructible, it is as a capital good that the term is applicable, not as capital. Land is by no means free from maintenance costs. Furthermore, in order to constitute capital, land must be restricted as to ownership (nationally, if not individually), and ownership cannot be restricted without cost. Where the ownership is individual, the owner must either stand the cost of defending his title personally, as was the rule under primitive or feudal conditions, or he must rely upon organized society to defend it for him, in which case that society will tax him to defray the cost. Unless the land produces enough to support this cost, capital will erode away, even though the land itself remains intact.

Regardless of the stage of economic development or the nature of the existing economic institutions, a continuous replacement of capital is required in order to maintain the existing capital supply. Once the replacement ceases, or is diminished, the capital in service begins to decrease, for the process of capital deterioration never stops. Many a business fails because the owners are unable to appreciate the necessity of diverting part of the current income into a depreciation fund, which will enable replacing capital goods that wear out or become obsolete.

Much of the effort that is devoted to attempts to improve the economic status of workers at the expense of their employers likewise ends in futility because it conflicts with this same necessity of replacing capital. Because of factors which will be discussed in detail in the subsequent pages, the impact of most of these actions ultimately falls on the general public rather than on the employers at whom the actions are aimed, but if circumstances are such that an action of this kind does have the intended effect, this merely kills off the enterprise, as the owners of an unprofitable business are not inclined to increase their losses by making financial provision for depreciation, and without such provision the enterprise cannot long survive.

Now let us turn our attention to the question as to the value of capital. In order to be consistent with previous definitions it will be necessary to define the value of the services of capital is this manner:

The value of the services of capital is the amount that the producer is willing and able to pay (or, in the case of a self-employed individual, the amount of labor he is willing to expend) to obtain these services.

As in the case of consumer goods, the cost of substitutes is one of the determinants of the value of the services of capital. In many applications labor is a satisfactory substitute, and in general the cost of labor is the controlling factor in determining the extent to which capital is used. When the cost of labor is low, the value of the services of capital is likewise low, and since the cost of capital is relatively constant, the use of capital is minimized. Where the cost of labor is greater, the value of the services of capital rises accordingly, and the relation of this value to the cost of capital becomes more favorable, hence the use of capital increases.

Another of the determinants of the value of the services of capital is the contribution, which those services make toward production. If a workman using hand tools can make only two pairs of shoes per day, but by installation of power machinery can raise his daily production to twenty pairs, the difference of eighteen pairs, less the cost of operating and maintaining the equipment (including provision for depreciation) represents the gain made by the use of the machines. The value of the services of the capital invested in the equipment cannot exceed this amount, and it therefore constitutes a determinant. In accordance with the general principles governing multiple determinants, the factor that is controlling in any given situation depends on the particular conditions existing at the relevant time and place.

08 The Economic Mechanism

CHAPTER 8

The Economic Mechanism

All of the accessories that are added to the economic system as a result of the introduction of a medium of exchange exist only for the purpose of facilitating the exchange of goods (purchasing power) for goods (articles of consumption). The same is true of the new features that are added when the economy moves forward to a still more complex type of operation: the fourth stage of economic development.

Basic economic changes do not take place overnight. At the time they originate they are usually inconspicuous and seemingly of minor importance, and they develop so gradually and unobtrusively that they are often in full bloom before there is any general realization of what has happened. The transition from the third to the fourth stage of economic development has been no exception. Even today there is no general understanding as to when the change occurred, or as to the precise nature of the modification in fundamental economic processes that was involved. Economists have generally considered that the so-called “Industrial Revolution” caused by the introduction of power driven machinery into the manufacturing industries marked the beginning of the modern economic era. But the application of power to manufacturing was a technical, not an economic, change, and its economic effects were merely matters of degree, not basic modifications of the system. Similarly, the transition from small establishments to large establishments was an important step, and it made major problems out of items that were previously of little consequence, but from the economic standpoint it did not introduce anything new. It did not constitute a fundamental alteration of the mechanism.

Centuries of progress lie in between the village cobbler and the great shoe manufacturing corporations of the present day, but the significant economic step in the route from one to the other was not the application of power, nor the introduction of mass production techniques. The profound basic change in the economic system occurred when the cobbler first employed a helper. The step that ushered in the fourth stage of economic development was the introduction of a separate producing entity.

By this innovation, the original single step barter transaction, which was expanded to a two-step process through the use of a medium of exchange, has now become a four-step process. The cobbler, who is still in the third economic stage so far as his own personal productive efforts are concerned, exchanges the goods (purchasing power) that he produces for money and then completes the transaction by exchanging this money for goods (articles of consumption). The new helper participates in a cycle of an entirely different character. He never handles goods as purchasing power at any time. He exchanges his labor for money and then exchanges money for goods (articles of consumption). But this is only half of the full exchange cycle. The money the helper receives comes from the cobbler, not from the ultimate consumer. To complete the transaction it is necessary for the cobbler to step into a new role. Here he is no longer a combination producer and consumer, but merely a producer. As such, he first exchanges goods (purchasing power) for money and then completes the cycle by exchanging money for labor.

It should be noted that in his capacity as a producer the cobbler puts nothing into the economic process and takes nothing out. In his capacity as a supplier of labor he gets a portion of the proceeds that can be classified as wages, and in his capacity as a supplier of tools and equipment he gets another portion as compensation for the use of that capital.

In his capacity as a consumer he exchanges the purchasing power thus obtained for consumer goods, perhaps putting some of it back into the business, retaining the ownership thereof. When each of these actions is viewed in its economic significance, rather than in its social significance (as actions of a single individual), it can be seen that all of the proceeds of the business are paid out, actually or constructively, to the suppliers of labor and the suppliers of capital. All of the net production of goods goes to consumers.

Another important feature of the modern fourth stage economic mechanism is that its operation is a continuous process. In technical work, whenever we are dealing with a continuous process of any kind we find it very helpful to prepare a flow chart: a simplified diagrammatic representation of the process, which provides a convenient means of following the action through its various stages, and also enables us to visualize the relationships between the different parts of the process more readily than would be possible without such assistance. In line with the stated policy of this work that involves taking advantage of all of the effective methods of the engineering and scientific professions, the accompanying chart, Figure 1, has been prepared to picture the modern economic mechanism as it appears in the light of the findings detailed in this volume.

We may regard the economic system as an intricate mechanism into which we put labor and out of which we receive satisfaction of some of our economic wants. Accompanying our labor into the mechanism is a stream of economically worthless raw materials which act as carriers for the utilities that furnish our satisfactions. These materials pass through the machine and its various processes and are then ejected, again worthless: that is, without economic value.

For example, let us take the case of coal. Deposits of coal buried beneath the earth’s surface at some unknown location are worthless from an economic standpoint. If they remain unlocated, as some of them no doubt will, they will remain worthless to the end of time. However, by applying labor to discovery (a form of production) we bring the coal into the economic system. It takes on utility and simultaneously acquires a status and value as purchasing power as soon as it is discovered. From then on during mining, transportation, and storage, further utility and correspondingly greater value as purchasing power are created by the application of additional labor, together with tools and equipment produced within the economic system itself. Finally the coal is burned to provide human satisfaction in the form of heat or power. In this process utility and purchasing power are both extinguished (that is, they are transformed into the satisfactions), and the coal, now in the form of ashes, water vapor, and carbon dioxide,

Figure I: The Continuous Flow Process of the Modern Fourth-Stage Economy

and as worthless (from the economic standpoint) as the undiscovered coal beds, having served its purpose, is ejected from the system.

Nothing enters the system but labor and worthless materials; nothing leaves but satisfactions and worthless materials. Purchasing power and capital are created by the application of labor to production, and both exist only within the system. Purchasing power is destroyed by consumption. Capital returns to the productive process and is there utilized to facilitate production. Since materials do not participate in economic processes other than as carriers of utilities, it is possible to disregard them and simplify the presentation by considering the utilities of goods (their economic rather than their physical aspect) as the goods themselves. On this simplified basis, we put labor into the economic machine and get goods out.

Coal has been deliberately selected as an example because it illustrates a point that is essential to bear in mind whenever economic questions are under consideration. There will be a contention to the effect that undiscovered deposits of coal do have a value. It will be pointed out that the country, which has undiscovered resources, will ultimately find at least part of them, and therefore is better off than the country, which has no natural resources to discover. This argument is entirely valid, but the value of the undiscovered deposits is only one of many values, which are not economic values (as herein defined) even though they may, either now or in the future, contribute toward economic well being. So far as the operation of the economy is concerned, values can only exist to the extent that they can enter into transactions with other values. We cannot even buy so much as a loaf of bread by means of the value of an undiscovered mine. The country, whose inhabitants have a high level of education and are skilled in the arts and sciences, is far better off than those not so favorably situated in this respect. The climate of Florida or California is a definite asset to the inhabitants of those areas, and an adequate amount of rainfall is decidedly advantageous for agricultural purposes. Nevertheless, these items have no value in the sense of being able to participate in economic transactions, and when we are studying economic processes we must confine our analysis to those items, which actually take part in the activities that we are investigating.

It might be mentioned that the probability of discovering mineral wealth may have an economic value. Land in the vicinity of a proven oil field may sell for a high price simply because of the chance that the field may extend to this area. Such speculative values are however, created by the discovery of the original field, or by finding favorable geological conditions; they would not exist in the absence of some kind of discovery.

Returning to the flow chart, we see that the labor, which is put into the economic system, joins with the services of capital diverted from the stream of finished goods, and flows through the production market to the production process, where this combination of productive factors is converted into goods. The goods then pass on to the goods market and thence out of the system by way of consumption, except for that portion of the stream diverted back to production as capital. This is the main stream of economic activity. Through it the basic purpose of this activity is accomplished. All other features of the mechanism are purely accessories, the purpose of which is to facilitate the operations that take place along this main stream.

Economic activity is often portrayed, both in words and in flow charts similar to Figure 1, as a circular flow of two oppositely directed streams: a stream of goods and factors of production and a stream of money. Lloyd Reynolds explains his chart of the “circular flow” in this manner: “Money moves around the circuit in a counterclockwise direction. Physical quantities—factors of production and finished products—move in a clockwise direction. If we do our arithmetic correctly, the two flows must exactly balance each other.”49

But the main stream of the economy does not flow in a circular path. Individuals in their capacity as workers put their labor into the machine at one end, where it is converted into goods. The stream of goods, the main economic stream, then flows unidirectionally to individuals in their capacity as consumers, and passes out of the system. It does not return to the starting point and begin another cycle, in the manner of a circular flow. The main stream never turns back. It always flows in the same economic direction: from producer to consumer.

There is a reverse flow of the goods, which are diverted back into the system as capital; that is, these goods return to the production end of the mechanism, but they merely supply productive services. They do not reenter the primary goods stream, and do not participate in a circular flow. On the other hand, the flow of the auxiliary stream of money purchasing power is circular. After having made a complete circuit, this stream does reenter the production market and the same money begins a new cycle. There is an unfortunate tendency to regard such distinctions as the foregoing as mere hairsplitting. “This is only a rough diagram anyway,” someone will say. “What difference does it make whether the flow is circular or not?” The answer is that in order to understand how any system operates we must see that system as it actually is, not in some way that distorts the picture. The circular flow concept, and the diagrams that represent it, treat the goods flow and the circulating purchasing power flow as equivalent phenomena, and apply the same development of thought to both, whereas, in reality, the goods flow is an open unidirectional system while the purchasing power flow is a closed circular system. The difference is a critical one.

In the open system of goods flow in the economy (or the analogous heat flow in the engine) there is a definite rate of production, which is also the rate at which goods (heat) flow(s) away from the production process. There is no definite total quantity of goods (heat) involved, other than a total during some arbitrarily specified time interval. In the closed system of purchasing power (cooling water) flow, on the other hand, there is a definite total quantity of circulating purchasing power (water) in the system, but there is no fixed rate of flow, as this rate can be varied arbitrarily.

It should be obvious that any theories which equate these completely different flow phenomena, and apply the same considerations to both, cannot have any validity, yet this is just what much of current economic thought attempts to do. The “circular flow” diagram is more than a pedagogical aid; it is a representation of economic thought, and that thought is erroneous. For instance, the entire application of supply and demand reasoning to money is based on “open flow” premises—on the assumption that the relations which exist in the unidirectional goods flow also apply to the circular money flow—and as a consequence, the conclusions therefrom, including the widely accepted Quantity Theory of Money (to be discussed later) are inherently and unavoidably wrong.

One of the factors that has led to the practice of portraying the main stream of the economy as circular is a failure to recognize the true economic location of each of the participants in economic processes. Each worker is also a consumer, and the chart constructors therefore place workers and consumers at the same location (Samuelson, for instance, combines them under the designation “households”). But in the modern economic organization the workers who take part in the production of certain goods are not, except to a very minor extent, the consumers of these goods; they are consumers of other goods. Even from a physical standpoint, therefore, the worker and the consumer are not at the same location, and from an economic standpoint they are at opposite ends of the mechanism.

It was emphasized in Chapter 3 that in order to arrive at correct economic conclusions we must view economic facts in their economic setting, not in their social setting, or their political setting. It is equally important not to view them in their geographical setting. A recognition of economic location is essential for a proper understanding of many economic processes, and numerous issues which generate seemingly endless confusion and controversy become clear and simple when they are viewed in the context of their economic locations.

For example, transfers of goods or of purchasing power between individuals or agencies at the same economic location, the same point in one of the economic streams, have no effect on the stream flow. The total purchasing power in the hands of consumers is not affected in the least by taking purchasing power away from consumer A and giving it to consumer B, nor is the total amount of goods in the hands of consumers affected by a similar diversion. Sale of assets such as stocks, bonds, land, etc., by one consumer to another is nothing more than a simultaneous transfer of goods from consumer A to consumer B and transfer of purchasing power from consumer B to consumer A. Such sales therefore have no effect on the general price level or any other aspect of the economy as a whole. From the overall viewpoint all consumers are alike; they are all at the same economic location.

This matter of exchanges at the same economic location will come up frequently in the course of the subsequent discussion, and it will be helpful to express it as an additional basic principle.

PRINCIPLE IV

Exchanges between individuals or agencies at the same economic location (the same location with respect to the economic streams) have no effect on the general economic situation.

It is apparent from the flow chart that the efficiency of the production process is one of the major determinants of the results that are obtained from our economic activities. If the efficiency is zero—that is, if the labor and capital are applied to useless work—no goods will be produced and no contribution will be made toward the ultimate goal of economic effort. This is one of the simplest and most obvious economic facts, yet some of the most influential of the modern economic “authorities” actually contend that we can enrich ourselves by doing useless work. This fallacy is discussed at length in The Road to Full Employment.

It is also clear from the chart that so long as the prevailing rate of productivity can be maintained, the more labor we put into the machine the more goods we get out. Hence the more workers we employ and the more hours they work the greater our production becomes, up to the point where fatigue begins to have a material effect on the efficiency of labor. This point has some very important implications in the light of the many contentions that we can solve our problems by reducing the labor force or by cutting working hours. Those matters which have to do with individuals’ willingness to work are outside the scope of economic science, but all characteristics of the system that have a bearing on the ability of those desiring work to find employment are material to the inquiry and are explored in the two volumes of the present series.

The third determinant of the output of the economic machine is the amount of capital utilized in production. The flow chart emphasizes the point already brought out in the previous discussion that capital is not essential to economic activity; it is merely one of the expedients that have been devised to enable getting more results with the expenditure of less effort. As the chart indicates, capital comes out of the stream of goods that would otherwise go to consumption. It therefore represents a sacrifice of present enjoyment for the purpose of increasing future output of goods, and its justification is measured by the extent to which the contribution to production exceeds the sacrifice that it entails.

No economic action can have any influence on the ultimate results achieved by the machine except through the medium of one or more of these three determinants; that is, it must either cause a change in the amount of labor applied to production, a change in the volume of goods diverted to productive purposes as capital, or a change in the efficiency of the productive process other than that due to the additional capital. This point needs special emphasis because of the widespread acceptance of the idea that money circulation is the controlling factor in economic life. “Getting money into circulation” is the action that is popularly supposed to impart vigor to the economy, in some vague and unspecified way. But our analysis shows that the circulating stream is only an auxiliary. The impetus for economic activity has its source in production, not in the money circulation.

The circulating money purchasing power stream, like the cooling water in the gasoline engine, flows in a closed circuit. Except for the movement in and out of the reservoirs, and some minor and incidental fluctuations comparable to evaporation and leakage of the cooling water, nothing enters the circuit and nothing leaves. The only purpose of this money stream is to provide a medium to facilitate the exchanges that are the essence of the marketing process. As in the case of the cooling water, there is no energy in the medium itself; it will not move unless some outside force is applied. There must be a difference in values to generate the economic force that is required to initiate motion. As a worker, the individual must value the income that he receives from his labor more than his leisure; as a consumer he must value goods for present use more than the availability of purchasing power for future use. The circulation of money purchasing power is a result of the force applied to the auxiliary stream by these value differences.

The cooling system analogy provides a convenient means of visualizing the true functions of the circulating stream, and many of the pitfalls that beset the path of the student of economics can be avoided by referring to this analogy whenever questions involving the circulating medium are at issue. The functional correlation is very close, the principal difference being that the cooling system has only one pump, and the outward flow from the engine cylinders, where the heat is generated, is always equal to the flow entering the radiator, where it is dissipated. In the long run, the same equality must exist in the circulating money stream, but in modern practice we have the equivalent of a second pump ahead of the goods market, one that is connected to money reservoirs, so that, in the short run situation, the flow into the markets can be varied independently of the flow coming from the main pump at the production end of the system.

It is necessary to keep in mind, however, that the amount of real purchasing power (ability to buy goods) transferred by means of the circulating money stream is not altered by variations in the flow of the circulating medium any more than the amount of heat transferred by the cooling water would be changed by variations in the rate of water flow. This explains why “getting money into circulation” is meaningless from an economic standpoint. Real purchasing power, the entity that is transferred by the circulating medium, is analogous to the heat transferred by the cooling water, and its magnitude is determined by the quantity of goods produced, just as the amount of heat that is transferred is determined by the quantity of heat generated in the engine cylinders. In each case the quantity transferred is entirely independent of the quantity of the circulating medium in the system or its rate of flow. Changes in the circulating flow can only affect the rate of transfer per unit of the circulating medium: BTU per gallon, or volume of goods per dollar.

In the cooling system, the rate of heat production (BTU per minute) divided by the rate of flow of the circulating medium (gallons per minute) gives us the rate of transfer per unit (BTU per gallon)—the water temperature, we may say, since the BTU per gallon is a function of the temperature. Similarly, in the economic system, the rate of goods production divided by the rate of flow of the circulating medium gives us the value of money in terms of goods, and by inversion, the goods price level. Ordinarily, the flow of water in the cooling system is maintained constant and the temperature therefore varies with the changes in heat production. It would be entirely possible, however, to install a thermostatic control, which would hold the temperature constant by varying the flow in accordance with the changes in the amount of heat to be transferred.

At the production end, the economic mechanism has the equivalent of this latter kind of control. The economic “thermostat” governs the general price level and its inverse, the value of money, the economic quantity analogous to the temperature of the cooling water. The price “thermostat” can be set at any desired point within very wide limits by establishing an average wage rate. (In actual practice the wage rates are determined separately in each enterprise or industry, but this automatically establishes an average wage level for all labor.) The fact that goods and purchasing power are merely two aspects of the same thing (Principle II) then keeps the relation between production and flow of purchasing power constant. If the production of x units of goods generates y units of purchasing power, so that the average price is y/x, then an increase in production to ax units will increase the purchasing power generation to ay units, so that the average price remains y/x. The rate of flow of the circulating medium increases, but the average price and the value of money (analogous to the water temperature) remain constant.

The question as to where and how a control can be exercised over the price levels in the modern economy is an issue that is shrouded in a thick cloud of confusion in present-day economic thought. The mere fact that arbitrary “price control” can be seriously considered by economists, and even approved by some of them, is sufficient to demonstrate this point. But the question can easily be cleared up by an examination of the cooling system analogy. It is obvious that the control of the water temperature must be geared to the heat produced in the cylinders; that is, in order to hold the BTU per gallon—the temperature—at a constant level, the flow of water must be varied in accordance with the rate of heat production. It is also clear that the setting of the thermostat, which accomplishes the control of this flow, is arbitrary. There are certain practical limits of operation, but within this range the temperature can be set at any level. However, when this level has been selected, the temperature relations have been fixed for the entire circuit. The temperature decrement of the cooling water in the radiator must equal the temperature increment in the cylinders. No independent control can be applied at the radiator.

Now, if we put the same statements into terms of the economic flow system, we find first that the control must be geared to production; that is, in order to hold the dollars per unit of goods—the price level—constant, the flow of dollars must be varied in accordance with the rate of production. Here, again, the setting of the “thermostat” which accomplishes the control of the flow is arbitrary. As in the engine, there are certain practical limits of operation, but within this range the price can be set at any level by establishing a wage rate. However, once this price in the production market has been set, the price relations are fixed for the entire circuit. No independent control can be applied in the goods market.

As previously mentioned, the only difference between the two situations lies in the fact that the economic organization has the equivalent of a second pump which increases or decreases the flow of money into the markets by withdrawals from or inputs into the money reservoirs. But because of the finite limits of these reservoirs, the changes that can be produced by this means are no more than temporary fluctuations (although they may be important in the short run), and no actual control over the price level can be accomplished by manipulating the reservoirs. It is quite possible, however, to set up a control over the reservoir transactions, which will equalize input and output and thereby prevent any effect on the market price level.

All of these points brought out by means of the analogy are very important, and for emphasis they will be restated briefly as follows:

  1. The general price level in the production market is fixed by the establishment of money wage rate.
  2. In the absence of reservoir transactions, this is also the market price level.
  3. The money wage rate is set arbitrarily.
  4. The real wage rate (ability to buy goods) is independent of the money wage rate.
  5. No independent control of the market price level is possible.
  6. Temporary fluctuations in the market price level occur because of unbalanced reservoir transactions, but can be eliminated by controlling the money reservoirs.

Inasmuch as some of these conclusions are not only in direct conflict with current economic doctrine, but also bring out some of the hard facts of economic life that a great many individuals—both economists and laymen—do not want to believe and will therefore resist vigorously, this brief consideration will not be anywhere near sufficient, and the next several chapters will be devoted in large part to discussing each of these points in detail, developing them from the theoretical foundations, and bringing out the mass of factual evidence that establishes their validity. At this time, however, it is appropriate to call attention to the fact that they can all be derived from a consideration of the fundamental nature of the economic mechanism, as seen in the light of the gasoline engine analogy.

In order to simplify the presentation and avoid introducing unnecessary and confusing detail, the flow chart has been prepared on the basis of net flow; that is, the total forward flow less any transactions in the reverse direction. For like reasons, transactions involving the production of intrinsic money (primarily gold) or its reconversion to use as an ordinary article of consumption are considered as having two separate aspects, one affecting the goods stream and the other the money stream. From the first standpoint, gold mined and devoted to monetary purposes is simply produced and utilized (consumed) in the same manner as any other long lived goods. On the other side of the picture, this action constitutes a withdrawal from a money reservoir to swell the current purchasing power stream. The reservoir will be refilled when and if the gold is returned to industrial use, is lost (as in the sinking of a ship), or is demonetized.

The means that have been used to portray these transactions on the flow chart in the most convenient and understandable manner do not involve any unsubstantiated assumptions or any deviations from the truth. There is only one truth, but there are many alternative ways of depicting it. By the use of a similar convention it is possible to represent all stages of economic organization on this one flow chart. All that is necessary is to consider the more advanced elements of the modern mechanism as having been potentially present all the time (which is true) but inoperative in the more primitive stages.

On this basis, the first stage finds labor entering the system, joining with the services of capital, and flowing through the inoperative production market to the production process, where the conversion to goods takes place. These goods then go directly to consumption through the similarly inoperative goods market, with the diversion of a portion of the stream to capital taking place as in the modern system. The second stage activates the goods market, which now converts goods (purchasing power) into goods (articles of consumption). In both or these simple types of organization the auxiliary purchasing power circuit is dormant.

The third stage introduces money, a medium of exchange. This activates the circulating purchasing power circuit and also results in a separation between producer and consumer in the goods market. The producer exchanges goods (purchasing power) for money, which passes through the inoperative production market into the hands of the same individual in his capacity as a consumer. He then completes the cycle by exchanging the money for goods (articles of consumption) in the consumer section of the goods market. The fourth stage activates the production market and thereby effects a complete separation of producer and consumer.

This accurate representation of all stages of economic organization on one simple chart is possible only because of the fact that the primary objective of economic activity and the basic processes through which this objective is reached never change. Economic development is evolution, not revolution. This is no accident; it is true because the natural laws that govern economic processes are fixed and immutable. The same principles that determine the course of events in the most highly developed economy are equally valid, to the extent that they are applicable, to the simplest types of economic organization. Man may change the form of his economic institutions, but he cannot alter the basic principles that govern his struggle to make a living. The relations indicated by the economic flow chart are broad generalities entirely independent of the type of economic system in vogue or the nature of the medium of exchange, if any. They are equally correct whether trade is carried on by means of barter, by Federal Reserve notes, or by pieces of eight.

09 The Markets

CHAPTER 9

The Markets

In the earlier stages of economic development there was only one kind of market: a place where goods (purchasing power) were exchanged for money or goods (articles of consumption). Such a market also plays a major role in the fundamental economic transaction in the modern world. It is in this goods market that the present-day consumer exchanges money for goods and the producer exchanges goods for money. But the remainder of the exchange cycle portrayed in Figure 1 is carried out in an entirely different market, one in which goods do not participate at all. Here the worker and the supplier of capital exchange labor and the services of capital for money and the producer exchanges money for labor and the services of capital.

Since the entire flow of circulating purchasing power passes through both markets, it is apparent that this second market is fully coordinate with the goods market in the operation of the system. Functionally, however, it occupies a position in the economic mechanism that is the inverse of the position of the goods market. The “real” wage rate, the price of labor in terms of goods, is the reciprocal of the “real” market price level, the price of goods in terms of labor.

It takes no more than these few brief comments to emphasize the importance of the new market that has emerged as a component part of the fourth stage economic system, but it is only comparatively recently that the true relation between the two markets has begun to be understood. Some of the early constructors of price indexes, for instance, recognized that the price of labor must be taken into account in some manner, and they tried to include it in their indexes, but the way in which they went about this indicates that they had no more than a hazy view of the true situation. Carl Snyder, one of the price index pioneers, adopted a 15 percent weighting for labor and 5 percent for rents, leaving 80 percent for items handled through the goods market.50 These figures give us an insight into his evaluation of the relative importance of the two markets, as well as indicating his opinion that the labor price enters into the determination of the general price level in the same manner as the goods price.

In reality, however, there are two price levels, not the single one that Snyder and his fellow index-makers were trying to measure, and the relation between the price level in the goods market and the price level in the production market is one of the vital factors in the operation of the economic machine. Even without the benefit of any detailed consideration it is apparent from the reciprocal relation between the two markets that it is the relative price level that is most significant, not the absolute level in either market. From the consumers’ viewpoint, a rise in prices in one market is equivalent to a fall in the other, and any change, which affects both equally, is no change at all.

In any case such as this where one quantity is, in effect, the reciprocal of the other, it is possible to express all variability in both quantities in terms of either one or the other; that is, we can compute one index and let it do the work of two. The present practice is to set up an index of goods prices—a cost of living index, a construction cost index, or something of the kind—and then to use this index not only as an indication of the goods price level, but also, by relating wages to a constant goods price level, as an indication of the level of real wages, the wage level in terms of goods. The opposite procedure is equally possible; that is, we can compute what we may call real prices, the market prices in terms of labor. But such figures have less practical utility, and are seldom used except in comparisons between different national economies, where a statement as to the number of hours it is necessary to work in each country to earn the price of a particular commodity is more impressive than any comparison expressed in purely monetary terms.

The present-day computations of the price levels are mathematically sound (aside from what seems to be an unavoidable degree of inaccuracy), and are undeniably useful for many purposes. However, the concentration of attention on the goods market has had the effect of obscuring the very significant role that the production market plays in the economy. This is all the more unfortunate because the markets are affected by different influences and do not respond to changing conditions in the same way. The most striking differences are due to the fact that the production market and the production process are located at the head end of the main economic stream, and it is here, and only here, that the streams of economic activity are subject to deliberate control. The volume of production can here be adjusted to whatever level seems appropriate, and once this decision (in practice, the sum of many individual decisions) is made, the volume of goods flowing to the markets is fixed, except for the minor effect of goods storage. As brought out in the discussion of the cooling system analogy in Chapter 8, the production price, in monetary terms, is also subject to arbitrary control, and once this price is established it determines the normal flow of money purchasing power in the entire auxiliary circuit.

The economic location of the markets also has an important bearing on the way in which each market responds to any variation in the flow of money purchasing power. The production market transaction takes place before the act of production, whereas the goods market transaction takes place after production. This means that the response to a change in the flow of money entering the production market can be either a price change or a volume change, as long as the necessary labor is available, since the volume of production has not yet been determined, whereas a similar change in the amount of money entering the goods market can only affect the price, except to the minor extent that storage of goods is feasible.

In this connection it should be noted that the role of goods storage in the operation of the system is almost negligible in comparison with the total volume of production. Services cannot be stored at all, some goods are perishable, others are too bulky, others can only be produced as ordered, and so on. Furthermore, storage is costly. The net variation in business inventories from year to year, aside from the effect of changes in the price level, is seldom more than about one percent of the total national product. In the subsequent discussion the effect of goods storage will be noted at the appropriate points, but for most practical purposes this factor is not significant, and can be disregarded.

Before proceeding farther it may be helpful to elaborate to some extent on the differentiation between the goods market and the production market. We are accustomed to classifying goods into various categories, such as those previously mentioned, durable or transient, consumer goods or producer goods, and so on, and we speak of the goods market, the investment market, etc. For some purposes we even go still farther and distinguish between the potato market and the prune market. But such distinctions are not fundamental. From the broad general viewpoint these markets are all part of the same thing. The money available for the purchase of potatoes can just as well be used to buy prunes, or durable consumer goods, or the capital goods that we classify as investments. But money already in the hands of consumers cannot be used in the production market to buy labor of the services of capital. Before this can happen, the money must get into the hands of producers. Likewise, money in the treasury of the General Motors Corporation is not available for buying Chevrolet cars, or any other consumer goods, until after General Motors has paid it out, directly or indirectly, through the production market in exchange for labor or the services of capital. The distinction between the goods market and the production market is fundamental, and purchasing power available for use in one market stands in an entirely different relation to the economic mechanism than that which is available for use in the other market.

As noted earlier, one of the far-reaching consequences of the addition of the production market to the exchange mechanism has been the transformation of economic activity from an intermittent process to a continuous process. In the earlier stages of economic development the market transactions were mostly intermittent. The small farmer, whose operations are typical of the third stage cycle, carries on his activities over a long period of time. He prepares the soil, plants his crops, cares for them during the growing season, and finally harvests them. After this long period in which no marketing has taken place, he sells his products and then starts production again. Since the marketing transaction is the source of the farmer’s income in his capacity as a worker, there are long intervals during which he is receiving no payment for his labor, and that payment, when received, is usually directly related to the amount of production that has been accomplished.

On the other hand, in the modern fourth stage cycle, where labor is marketed directly in a separate market, there is a steady flow of purchasing power to the worker. Even the person whose salary is nominally on an annual basis receives a pay check once or twice a month. This means that there is a never-ending drain on the producer’s funds, and as a practical matter of self-defense the producers have so organized their operations that they have a continuous flow of income with which to meet this continuous outlay. But they are now faced with a never-ending task—that of maintaining this flow of income at a high enough level to sustain the current rate of expenditures. This is their primary concern in the operation of their respective enterprises.

The producer of the modern type is not particularly interested in the relation between the actual cost of production of a specific item and its selling price. Usually he will not even know that cost if any substantial time has been involved in the production process. His concern is with the current cost, a composite figure, which he reaches by summing up the present cost of each of the separate operations involved in production of the item. If a product can be sold at a price of $1.00 per unit, and the current cost is under this figure, the producer will not shut down his plant simply because the stock on hand actually cost $1.50 each. Likewise, his calculations for the future are not based on a comparison of present production costs against present selling prices, but on his forecasts of future costs against future selling prices.

The usual economic analysis proceeds on the assumption that the producer starts from zero, that he makes a certain advance outlay for labor, capital, and materials, and that he endeavors to sell his finished products for a price which will reimburse him for his actual expenditures and in addition will give him a satisfactory rate of return on the capital that has been invested. This is a reasonably accurate picture of the situation in the third stage economy, where the producer sells the products of his own labor, but the modern fourth stage organization, which sets the pattern for our present-day economic life, is a going concern, a continuous operation that has no zero point. It is true that when an enterprise is first launched a certain amount of expenditure must be made to build an inventory of raw materials and goods in process, and also a working stock of finished goods, before income from sales begins to flow in, but the producer does not expect repayment of this expense from sales as long as the business stays alive. He sets this amount up on his books as working capital, and from his standpoint it is the equivalent of a like amount of the fixed capital that is invested in plant and equipment.

What the modern producer expects the income of his enterprise to do is not to reimburse it for past expenses, but to meet current expenses, including satisfactory earnings on the invested capital. If the operating income for the current month or the current year is sufficient to take care of operating expenses and fixed capital charges, including depreciation, and to leave a reasonable amount for the owners of the equity capital, the operations have been satisfactory, and the business can continue on the existing basis. If current income is more than adequate for these purposes, consideration can be given to reducing prices or increasing wages. If it is less than adequate, attention must be given to means of increasing income or reducing expenses.

These facts are commonplace. Everyone who has had anything to do with organized business affairs is thoroughly familiar with them. To be sure, there is still a substantial volume of production being carried on by individual farmers, shopkeepers, professional people, and others who operate under third stage conditions, but it is the business enterprise that employs labor that dominates present-day production, and it is this fourth stage mechanism that we must analyze in order to get an accurate picture of the modern economy. Even though the basic principles remain unchanged, we must nevertheless study the details of the processes that are in actual use today; we cannot solve today’s problems by studying the processes that were in vogue in the days of the feudal barons.

In the modern economic world, the leading role is played by the corporation, a device, which has enabled a definite physical separation between producers and consumers. All corporations are producers pure and simple; their only function is to produce and they take no part in consumption. It is true that they use certain goods in the course of their activities, but this is part of the productive process. It is an element in the production of other goods, and does not constitute consumption as the latter term has been defined for the purposes of this analysis. The essential difference from an analytical standpoint is that utilities are not destroyed when goods are used in production, as they are when the goods are consumed. They are transformed into utilities of a different kind. The volume of production that can be attributed to any producer is the net amount after subtracting the value of the goods used or wasted in the production process: the “value added” by production, as the statisticians call it.

Individual producer-consumers, in their capacity as producers, are subject to the same considerations. Producers, corporate or otherwise, are merely intermediaries by means of which the labor and capital furnished by the workers and suppliers of the services of capital are converted into goods for the benefit of those individuals. in their capacity as consumers. All goods produced by the economic machine must go to consumers, either directly of in an indirect manner by contributing to the production of other goods. All of the instrumentalities of production come to the producer from individuals in their capacities as suppliers of labor and capital; all of the proceeds go back to them. The net result to the producer is zero.

This kind of an equilibrium relation, the knowledge that certain quantities always add up to zero, is one of the most powerful tools of mathematical analysis, and in view of the importance of the point just brought out it is desirable to express it as another of the fundamental principles of economic science.

PRINCIPLE V

The income to the producer from goods produced is exactly equal to the expenditures for labor and the services of capital. The net result to the producer is zero.

In order to get a clear picture of the basic relations and the application of Principle V it is necessary to differentiate clearly between the producer (corporate or otherwise) and the supplier of capital. These are two separate and distinct economic entities, even though they may often be combined in a single individual. There are many persons who furnish capital for a productive enterprise and also direct the productive activities, but in so doing they are performing two separate economic functions, just as the farmer is both a producer and a consumer. All that has been said with respect to corporations also applies to these individuals in their capacity as producers. As suppliers of capital, however, they stand in the same relation to the economic system in general as the suppliers of labor.

Here is another significant truth that has been covered up by the confusion and complexities of modern economic life. All income received by producers of any category, over and above the cost of goods purchased from other producers, is paid out to, or credited to the account of, the suppliers of labor and the services of capital. All payments are made in the same kind of money, all go to persons whose intention is to use them sooner or later for buying goods in the markets (this is equally true whether earnings on capital are paid out in dividends or “plowed back” into the business), and there is no way by which we can differentiate between wage dollars and interest or profit dollars once they are in the hands, or the accounts, of the recipients.

There is one school of thought which insists that it is wrong to permit any payment to individuals for the services of capital (except perhaps interest, which for some strange reason does not seem to be quite as reprehensible as rent or profits), but questions of right and wrong, in the moral sense, are beyond the scope of economic science, and of this work. As long as payments of this nature are being made, we cannot get a true picture of economic conditions if we ignore them, or allow sentiment or prejudice to cloud our vision so that we fail to see them in their proper setting. The objective of the present inquiry is to determine the facts, the true relation of these payments to the primary economic processes. From this standpoint the answer is clear. A dollar paid for the services of capital has exactly the same economic status as a dollar paid for labor. So far as the general operation of the economic system is concerned, labor and the services of capital are equivalent items.

One point worthy of special attention is that the owner of capital retains ownership and does not surrender it to the producer. He merely sells the services of this capital just as he sells labor, his personal services. Ultimate ownership of capital always rests with individuals. From the standpoint of the corporation, the entire net worth of the business, including undivided profits, is a liability, an amount, which the corporation owes to its stockholders, and the books of the corporation so indicate. Hence investment is purely a consumer function. The cost of capital improvements always comes out of funds belonging to individuals. It is immaterial, from this standpoint, whether the money is actually paid out to the stockholders and reinvested by them, or whether the producer uses it directly for the increase of capital (plows it back into the business, as commonly expressed) or builds up reserves of marketable assets to help bridge over difficult times. In the investment of surplus corporate funds the officers of the corporation are performing the functions of a trustee, acting on behalf of the actual owners of the funds.

Many economists are inclined to regard corporate reserves as quite distinct from consumers’ assets, apparently because the individual stockholder, in most cases, has little voice in the determination of policies with respect to the accumulation and utilization of such reserves. This present analysis, however, is concerned with the facts, not with mental reactions, and from a purely factual standpoint there is no difference between capital deliberately invested in a business and capital involuntarily invested when a corporation builds reserves of one kind or another. The effect of an action is determined by the nature of the action that is taken, not by the nature of the influences that caused it to be taken.

It is true that corporate reserves are more readily available for meeting operating requirements, as distinguished from needs for additional capital, than funds which have already been paid out to the stockholders as dividends, and to that extent these reserves have the status of producer money reservoirs. However, the stockholders own the funds in these reservoirs just as they do all other assets of the corporation, so these funds have the same economic status as any other capital assets.

After the current expenses of an enterprise, the amounts owed to other producers for materials and services, the cost of labor, the cost of capital employed on a time basis, taxes, and various miscellaneous items have been paid, and reserves have been set aside to cover depreciation and other deferred liabilities, any amount remaining out of current income is added to the earned surplus of the corporation, one of those corporate assets which, as has been pointed out, are owned by the individual stockholders of the corporation. This addition to the earned surplus, the net profit for the current period, is the compensation for the services of capital supplied by the stockholders, irrespective of whether or not it is currently paid out in the form of dividends.

Here is one of the many places where the injection of sociological viewpoints and prejudices into economic thought has had a serious effect in confusing the issues. The economic theorists exhibit a curious reluctance to classify profits in accordance with their true economic function as a “wage” of capital, a payment for useful services rendered by capital goods, and a strange assortment of doctrines has been advanced, ranging all the way from the absurd contention that profits (at least the so-called “pure” profit, any excess above the normal interest rate) are an unearned and unjustified charge against the general economy to weird theories which are based on the assumption that profits are abstracted from the circulating money stream and are not available for consumer buying.

The truth is that profits are the price of junior capital (risk capital) in exactly the same way in which interest is the price of senior capital (debt capital). Those who accept interest and condemn profits and the “profit motive” are allowing their sociological prejudices to lead them into a flagrant inconsistency. Neither capital nor any other form of wealth is essential to life, but wealth does enable us to live a more pleasant and comfortable life, and all forms of wealth therefore have economic value. Thus the cost of using capital cannot be escaped any more than the cost of labor can be avoided. This is just as true under socialism, or any other collective economic system, as it is in the United States today. Turning to a collective economy eliminates the name “profits” but nothing more. Those who favor collectivism because they are opposed to profits are closing their eyes to the economic facts, as the cost of the services of capital still has to be met under some other name. We cannot evade that inconvenient ban on “something for nothing” that stands in the way of so many ingenious schemes.

Under many circumstances there is no actual payment for the capital or other wealth that is utilized, and in such cases the existence of the cost factor is often overlooked. The man who has paid $100,000 for his house may be inclined to feel that he can now enjoy its use without cost, since no further payments have to be made, but this individual is simply deceiving himself. If his $100,000 were not tied up in the house he could invest it in something that would give him an income of at least $6.000 per year, and forfeiting this income is just as real a cost as the amount that he would have to pay in rent if he did not own his home. A state-owned industry that has built a million dollar plant is in exactly the same position. The million dollars invested in the plant would have earned $60,000 or so annually if the money had been put to use elsewhere. The cost of having this much capital fixed in the new plant is therefore about $60,000 per year, regardless of the fact that the collectivist system of bookkeeping requires no actual payment or recording of the amount. As long as the productive capacity of the human race is finite, the services of wealth have an economic value, and there will be an equivalent cost attached to the use of wealth as capital.

The use of money as a measure of value does not affect the situation one way or another. Those economists such as Schumpeter, who contends that “in a communistic or non-exchange society in general there would be no interest as an independent value phenomenon” (“The agent for which interest is paid simply would not exist in a communistic economy,”51 he says) are being confused by the money aspect of interest payments to the point where they are mistaking the bookkeeping for the essence of the phenomenon itself. Schumpeter’s assertion that “interest attaches to money and not to goods”52 is totally wrong. Interest, rent, and profits are payments for the services of wealth, and whether they are paid in money, or in goods, or in the loss of services that would have been enjoyed if the wealth were otherwise utilized, is merely a detail. As Frank Knight pointed out, “A moment’s reflection on the Crusoe situation should make it clear that a purely monetary theory of interest is simply nonsense.”53 Neither the communists nor the Crusoes can have the services of wealth free of charge.

Here, again, those who have centered their attention on the social forms rather than on the economic functions have been misled by what they see. If we look at activities involving the use of capital from a purely economic standpoint, and avoid differentiating between actions that are economically equivalent, we get a totally different picture. Let us consider a typical example of a capital investment. An engineering firm designs an improved type of oil refinery, and offers a “package” deal whereby it handles the entire construction and delivers the complete unit at a fixed price. Each prospective purchaser then faces only the problem of how to raise the necessary capital, and each proceeds in its own way to do so. Company A issues bonds for the purpose and thus borrows the money from the individual purchasers of the bonds. Company B elects to use a method of financing that is currently popular. It arranges with an insurance company to build and own the plant, and it then leases the plant on a long-term basis. Company C finds that it has sufficient reserves to enable paying for the plant out of its own treasury. Across the international border in socialistic state D the government taxes its citizens to raise the necessary capital.

Now let us look at these transactions from a purely economic standpoint. First, we find that is all cases the capital comes from individual suppliers. In case A it comes from the individuals who are now bondholders. In case B it comes from funds belonging to the individual policyholders of the insurance company (assuming that it is a mutual company). In case C it comes from the individual stockholders of the company, who own all of the assets of the company, including the cash reserves. In case D it comes from the individual taxpayers. In all cases the cost to the individual suppliers of capital is the same; they must forego whatever gains or satisfactions they would otherwise have obtained from the use of the money elsewhere.

Next we note that in all cases the individual suppliers retain ownership of the capital. The bondholders in case A merely lend their money. The insurance company policyholders in case B own the plant after it is built, and so do the stockholders in case C. In the state of D, the ownership is theoretically vested in the citizens of the state, but since we can, in general, equate citizens with taxpayers, particularly in a collectivist economy, where a large part of the taxation is concealed and broadly based, the taxpayers own the plant for which they have supplied the capital.

Finally, we can see that in all cases the individual suppliers of capital expect to be compensated by the production agency for the use of their capital. In case A the bondholders receive interest. In case B the policyholders (owners) of the insurance company receive rent. In case C the stockholders of the company receive profits. In case D the citizen taxpayers also receive the residue after other production expenses have been met—what we call profits in the individual enterprise economy—but they do not recognize them under that name, because the payment is indirect and not clearly identified as to it origin. The profits in this case are either returned to the general funds of the state, in which case the individual citizens benefit by being assessed less taxes than would otherwise be necessary, or they are used for other capital requirements, or they are distributed to the citizens in the form of lower prices.

It is then evident that we can describe the general economic process involved in all four cases in exactly the same words:

The production agency obtains labor and the services of capital from individual suppliers, utilizes them to produce goods, and with the proceeds thereof compensates the suppliers of labor and the services of capital for the services utilized.

From the economic standpoint, the general process is the same in all of these cases; whatever differences may exist are in the details. The important conclusion to be drawn from this identity, so far as the point now at issue is concerned, is that the payments made by the production agency—the producer—to the individual suppliers of capital have identically the same function in all cases. They are nothing other than compensation for the services of capital, regardless of whether we call them interest, rent, or profits, or bury them under some vague classification of socialistic benefits. The economic purpose of the payment is the same in all cases; the only difference is in the basis on which the payment is made. Interest is related to the amount of capital that is supplied, rent is related to the specific capital goods that are furnished, and profits are related to the output of the production process.

Essentially the same situation exists with respect to the labor payments. All such payments are made for the same economic purpose—as compensation for services—but there are differences in the basis on which payment is made. Some payments are made on a time basis—daily or hourly wages, monthly or annual salaries, etc.—while others are made on an output basis; that is, at a certain rate per output unit. In industrial production this is called a “piecework” rate. Elsewhere such terms as “royalty,” “fee.” or “commission” are used. Work such as that performed by authors or inventors is mainly handled on the value output basis, since the commercial value of the product has little or no relation to the amount of time spent in producing it. There are even cases where the price to be paid is established on a contingent basis, so that no payment at all is made unless certain specified results are achieved.

Just why the economists have been unable to see that profits are the piecework or royalty rate of payment for the services of capital is a mystery of the first order. They all recognize that labor is paid either on a time basis or on an output basis, and they recognize that interest and rent are payments for the services of capital on a time basis. The existence of payments for the services of capital on an output basis would seem to follow almost automatically, and it should not take any great perspicacity to see that profits are payments of this kind.

Furthermore, it is generally conceded that the average percentage return on invested capital is approximately the same whether it is received in the form of interest, rent, or profits. Schumpeter, for instance, refers to “the phenomenon observed by theory from time immemorial, that all returns in the economic system, seen from a certain aspect, tend to equality.”54 It seems almost incredible that such an obvious clue to the true nature of profits should have been ignored, but the economists’ own admissions show that they have looked the situation straight in the eye and have still been unable to see profits in their true perspective. Fraser, for one, simply does not see the analogy between piecework rates and profits. “In practice,” he says, “the distinctions between time rates and piece rates are only important in the case of incomes from labour. Property incomes are regularly calculated in relation to time, not to services rendered.”55

Once again, the sociological fixation to which the economist is subject prevents him from seeing the economic facts. He cannot see profits in their economic setting because, under the conditions now prevailing, a substantial part of the total paid out as profits accrues to the benefit of a social class with which he is not in sympathy. As a result of this social viewpoint, or more accurately, these social viewpoints, since the sociological picture of the constant economic reality necessarily changes every time social practices and institutions are modified, the socio-economist is unable to recognize the economic fact that profits are simply one of the alternative methods of paying for the services of capital, a method in which, with all due respect to Fraser’s statement to the contrary, the amount of payment is “calculated in relation to services rendered.”

Where there is no emotional factor involved, the present-day economist is able to get a clear picture of the payment situation, and he is able to recognize that piecework rates for labor are payments for services rendered, and that they differ from daily or monthly rates only in the basis of calculation. No one even so much as suggests that the difference between the piecework rate and the time rate has any theoretical significance, and no one contests the assertion that any excess of the piece rate above the hourly rate is just as much a payment for labor as the hourly rate itself. When he turns to a consideration of the analogous payments for the services of capital, however, the same economist sees the situation through the haze generated by his sociological prejudices. Since he has a strong emotional antipathy to large profits, he does his best to set up a theoretical classification in which any excess of profit above the current interest rate, “pure profit,” as he calls it, becomes some kind of an unjustified charge against the economy, rather than a legitimate payment for services performed.

“The economic system in its most perfect condition should operate without profit.” says Schumpeter, “profit is a symbol of imperfection.”56 This statement refers, of course, to the economists’ “pure profit,” and what Schumpeter is saying, in effect, is that under the optimum conditions there can be no reward for assuming the risks involved in operating a business enterprise. But the very essence of the prevailing economic system, the factor that is mainly responsible for its unparalleled record of achievement, is that it rewards the efficient and penalizes the inefficient. Inequality of earnings is not a “symbol of imperfection,” it provides the incentive that assures productive efficiency. The whole concept of “pure profit” should be dropped from economics. In application to genuine economic issues it leads to nothing but such unrealistic conclusions as the one of Schumpeter’s just cited. The only real purpose that it serves is to create an opening for the introduction of sociological viewpoints into economic reasoning.

It is recognized by many of the economic theorists that the unrealistic theories of profits, which the profession has developed, are not satisfactory, even though they continue to cling to them. Fraser tells us that “the theory of profit is by common consent the most recalcitrant element in the whole structure of value and distribution analysis.”57 His use of the word “recalcitrant” in this connection is highly significant. Of course, he really means that the established facts are recalcitrant; they stubbornly refuse to fit the theory. A continuing conflict of this kind exists wherever theory constructors try to force the facts to conform with some preconceived ideas of their own, and the “recalcitrance” of the economists’ theory of profits is simply a result of their insistence in having a theory which portrays profits in an unfavorable light. This antagonism is not based on economic grounds; it is sociological. And, as Lloyd Reynolds comments, the form in which the attack on profits often takes “arouses a suspicion that the critic has not thought through his position.”58

10 Price Levels

CHAPTER 10

Price Levels

The subdivision of physical science, known as mechanics, is customarily separated into two parts. First the student of the subject is introduced to statics, which is devoted primarily to the effects of the application of forces to bodies at rest. Then he goes on to dynamics, in which he studies the effects of forces on bodies in motion. In general, he finds that the conclusions drawn from the static principles are not applicable to the dynamic situation. A static balance, for example, does not necessarily indicate a dynamic balance. In order to arrive at the right answers with respect to the dynamic system he must study it as a system in motion, not as a system at rest, and he must apply dynamic principles rather than static principles.

An important point that is emphasized by the scientific analysis of the factual aspects of economic life whose results are reported in this volume is that the modern economic system is a dynamic mechanism, a continuous flow process, while the analytical methods that have usually been applied to the study of economic problems have treated each individual item on a static basis, without adequate consideration of the relation of this item to the flow pattern of the system as a whole. The application of supply and demand theory to a determination of the general price level, for example, is a case of applying static methods to a dynamic problem. As previously mentioned, it gives completely erroneous answers to some of the most significant questions that arise in connection with the price situation. A distinction between static and dynamic processes is frequently made in economic literature, but this is something of a different nature. In the economists’ terminology, the expression “dynamic” is employed with reference to conditions in which the controlling elements of the static process are variable. As explained by Simon Kuznets:

Static economics deals with relations and processes on the assumption of uniformity and persistence of either the absolute or relative economic quantities involved. In contrast, dynamic economics deals with relations and processes on the assumption of change in either the absolute or the relative economic quantities.59

Another author puts the case in this way:

“Dynamics” now denotes analysis that takes explicit account of temporal leads and lags in economic relationships… as against “statics” in which all the variables refer to the same point of time.60

In this present study it has become apparent that fourth stage economic activity is characteristically a thing in motion. Some of its elements are not directly affected by time, but on the whole, fourth stage economic life is a continuous flow: a ceaseless progression down the corridors of time, not a stationary entity that can be analyzed on a static basis, irrespective of whether or not the analysis is modified to allow for “leads and lags.” Most of the basic components of modern economic activity that are customarily visualized and treated independently of time are in reality dynamic entities that can be properly understood and appreciated only if they are studied as moving, working parts of an operating mechanism. In this work the motion—the continuous flow—is recognized as the essence of present-day economic life, and the term “dynamics” is used in the sense in which it is defined in the physics textbooks: “Dynamics is the study of motion in terms of the forces that produce it.”

To the economist who believes that he is already using dynamic methods, and to many laymen who are not familiar with mechanics, the distinction that has been drawn between the economists’ concept of dynamic processes and the scientific sense in which the term is employed in this present work may not seem very significant. However, the inadequacy of the economists’ “dynamics” has been stressed by many observers, even within the economic profession itself. Frank H. Knight, for instance, pointed out years ago that “what it (the economic profession) calls dynamics should be called evolutionary or historical economics.”61 He emphasized the need for a real dynamics. “The crying need of economic theory,” he insisted, “is for a study of the “laws of motion,” the kinetics of economic changes.”62

The difference between the two concepts—the economists’ dynamics and the scientists’ dynamics—can be illustrated by consideration of the forces acting on, and in, a pipeline filled with water. If the line is closed at both ends and left undisturbed, we have a static situation, one in which the various forces acting upon the water and upon the pipe are constant in magnitude, and can be identified and measured independently of time effects. Then, if we connect one end of the pipeline to a reservoir in which the water level varies from time to time, we have the equivalent of the economists’ “dynamic” situation. At any specific moment of time the pipeline and its contents are subject to the same kind of forces and stresses as in the constant static situation, and while a few minor and incidental phenomena—shock waves, for instance—may be introduced, the only major difference is that the physical magnitudes involved are altered whenever the fluctuations in the reservoir change the pressure head acting on the pipeline.

If we now open the other end of the pipeline and allow the water to flow through the pipe, the result is something of a totally different nature. The phenomena that are now of greatest concern to us are such items as pressure gradients, rates of flow, friction factors, etc., which were totally absent from the static picture. Here is a true dynamic situation, one that is not in any sense a static situation modified by the introduction of variable magnitudes and by corrections for “leads and lags,” but a totally different set of phenomena. Our analysis indicates that modern economic life is analogous to this latter situation, and the primary concern of this work is with what Knight called the “laws of motion” or the “kinetics” of the economy.

The foregoing reference to a “continuous” flow in the streams of the economic system does not by any means imply a steady flow. On the contrary, most of our attention will necessarily have to be devoted to the variations in the rates of flow, since it is these variations that introduce problems into economic life. But it is important to realize that the phenomena with which we will be dealing are actually fluctuations and irregularities in a continuous flow process, not independent entities that we can examine and manipulate in isolation.

In this present chapter we will apply this dynamic concept of the nature of the economic mechanism to the determination of price levels and some related economic quantities. It is evident to begin with that man’s economic endowment—his potential labor and his leisure—come to him as a continuous flow, not as an aggregate or a series of aggregates. The arrival of today presents each individual with the potential of a day’s work, which he may put into the economic system in exchange for the benefits that may be derived from such labor. But if he does not choose, or is not allowed, to convert this potential labor into actual labor today, he cannot do so tomorrow. Unless today’s potential is realized today, it is gone forever.

Similarly, the benefits of economic activity must come to him essentially in a continuous stream. So far as the basic needs of life are concerned, there is little more leeway than in the utilization of labor. Food must be supplied continuously. Otherwise, the individual ceases to exist. Clothing and shelter must likewise be available every day if they are to serve their purpose. There is no value in having warm and comfortable facilities available tomorrow if we freeze to death today. After the necessities are provided for, it is in theory possible to take delivery of the additional goods in larger aggregates rather than as a continuous day to day flow, but in actual practice a certain standard of living is established by each individual or family, and this standard of living takes the place of the bare necessities as the level beyond which diversion of some of the flow of goods from immediate use becomes possible. Since there is strong pressure for the standard of living to approximate income, within the range of income of most persons, only a small percentage of the population is able to get very far away from the immediate use of all income, even in the wealthiest countries. Thus the consumption of goods is essentially the same kind of a continuous process as that which provides the potential supply of labor for the production of those goods.

As brought out in Chapter 9, the evolution of the economic organization has taken place in the direction of accommodating the mechanism to this need for a continuous output of goods, and the modern fourth stage economy is definitely a continuous flow process, a true dynamic operation. The basic elements of the process, as shown on the economic flow chart, Figure 1, are the stream of goods flowing from production to consumption, and the auxiliary stream of purchasing power flowing in a closed circuit. Goods and purchasing power are both conserved, as is money, although the ratio of money to purchasing power may vary. We are therefore able to treat both streams by the same specific and precise techniques that are applied to the flow of physical substances in scientific and engineering practice.

Availability of these accurate methods of procedure is particularly helpful when we undertake to analyze price relations. The present-day theoretical approach to price problems is almost entirely from the direction of supply and demand. But to anyone accustomed to dealing with quantities that “stay put,” demand is a highly unsatisfactory subject for analysis. The fact that it is not conserved makes accurate results impossible. Furthermore, the real demand, the quantity of goods that consumers are able to buy at a given price cannot be increased in any other way than by increasing production. (Principle I). The measures that are taken to “stimulate demand” are thus nothing more than devices to produce inflation of the price level. They will be examined in more detail later.

Purchasing power is usually treated rather cavalierly in modern economic analysis. When it is introduced at all it is regarded merely as an antecedent of demand, and the analysis proceeds on the basis of the latter. But it is evident from the points brought out in the discussion in the preceding chapters, and from an examination of the economic flow chart, that the flow of purchasing power is not only a vital element in the modern fourth stage economic organization, but is also susceptible to accurate analysis because it is conserved.

As noted earlier, the conservation laws, which tell us that certain quantities pass through the various processes to which they are subjected without change in magnitude, regardless of how much they may change in form, are some of the most useful tools for analyzing complex phenomena that the scientist has in his repertory. The law of conservation of energy, for instance, asserts that the energy leaving a process is exactly equal to that which enters, plus or minus the energy released from storage or stored during the process. By means of this law we can follow energy from one process to another, balancing our figures as we go, and verifying the accuracy of our calculations at every step. If we find a discrepancy, as we occasionally do, we do not waste time devising some ingenious theory as to why this process differs from all others. We start looking for our mistake, and we always find that there was such a mistake.

Purchasing power is an economic factor, which, as indicated by Principle I, has a similar persistence. Hence we may extend the analogy and set forth a corollary to Principle I, which will serve the same purposes as the law of conservation of energy. Since the circulating purchasing power is conserved, the flow through successive points along the stream cannot vary except in the way that the flow of energy can very; that is, to the extent that reservoir transactions take place along the route. We therefore have

PRINCIPLE VI

The circulating purchasing power arriving at any point in the stream is equal to that leaving the last previous processing point, plus or minus net reservoir transactions.

This principle is valid in terms of real purchasing power as well as in terms of money purchasing power, but storage of real purchasing power can take place only by storage of goods, and consumer storage of goods takes place only to a very limited extent.

The average price in the goods market, by definition, is the quotient of the money purchasing power actually used in the market, the active purchasing power, we may call it, divided by the quantity of goods actually sold. This, the market equation, is a direct mathematical relation that holds good under any and all circumstances, with no ifs and buts to qualify it. By Principle VI, the stream of money purchasing power reaching the goods market is the stream that was created by production, with only such modifications as may have been caused by diversions from the stream to fill money reservoirs, or by withdrawals from those reservoirs, to swell the stream. Thus the active purchasing power is equal to production, in terms of its money value, plus net consumer money reservoir transactions.

In the discussion of reservoir transactions we will treat a withdrawal from the stream (an input into a reservoir) in the algebraic manner, as a negative addition to the stream, avoiding the use of the expression “plus or minus.”

The quantity of goods actually marketed is equal to production plus withdrawals from the goods reservoirs (producers’ stocks). Substituting the foregoing expressions into the market equation that was formulated above, we find that the average goods market price (the price level) is equal to production, in terms of its money value, plus net consumer money reservoir transactions, divided by production, in terms of volume, plus net goods reservoir transactions.

In accordance with the definitions previously stated, the word “production” is used in the general sense as the creation of utilities, and includes the activities involved in the distribution of goods and the rendering of services as well as the production of physical goods. The average price is the average number of units of money per unit of goods volume, regardless of the system of units that is used, and it covers all goods and services marketed, without distinction between capital goods and consumer goods. As should be clear from the context, however, it does not include the items that are handled in the production market: labor and the services of capital supplied to producers. It should also be noted that all of the foregoing discussion of the flow of goods and money refers to the total flow. The extent to which individual products and producers participate in this total is subject to some further influences.

Let us now examine some of the consequences of the relation expressed by the market equation. It can be seen that if there were no reservoirs, either of goods or of money, no change in the general price level could originate in the goods market. On first consideration, this observation may not appear to have any significance in application to real life, since there are reservoirs, both of goods and of money, and they play such an important part in modern economic life that their elimination is practically inconceivable. But even though we cannot eliminate the money reservoirs, it is definitely possible, and indeed relatively simple, to eliminate their effects, so far as the price level is concerned, by introducing oppositely directed reservoir transactions of just the right magnitude to counterbalance the net excess of input into, or output from, the uncontrolled reservoirs.

Thus, at this very early stage of our inquiry, we have already identified the means whereby the fluctuations in the general price level that originate at the market end of the economic mechanism can be eliminated. Various practical methods of accomplishing this result with a minimum of interference with normal economic relationships will be examined later.

Under present conditions, where no such control exists, there will necessarily be occasions when purchasing power is being withdrawn from some money reservoir to swell the stream flowing to the markets. The first reaction to this will be a withdrawal from the goods reservoirs. This has the same effect on the markets as an increase in production, so it maintains the equilibrium between money and goods at the existing price level. But since the goods reservoirs are very small compared to the large money reservoirs, they are soon effectively empty, and the goods stream reverts to the volume of production. Then, unless the withdrawal from this money reservoir is counterbalanced by an input into another reservoir, the price level must go up. No other result is mathematically possible. Similarly, if the net reservoir transactions are in the other direction, prices must drop.

Before going farther, let us stop for a moment and consider the significance of the points that have been developed thus far in the discussion. We have set out to determine just why the market price is unstable. Previous investigators have given us an assortment of theories, but freely admit that none of them provides a satisfactory answer, and have not been able to arrive at any consensus. Now we have gone ahead with a factual analysis by scientific methods, and we hardly get started before we encounter some basic principles that clarify the entire situation.

We produce goods, and the exact amount of purchasing power required to buy those goods, simultaneously in a single operation. Production of goods and creation of purchasing power are one and the same thing. But we have translated the purchasing power into terms of money, and we have set up a series of reservoirs in the money stream between the production market and the goods market. By the use of these reservoirs we vary the money flowing to the goods market so that it is sometimes more than enough to buy all of the goods that are produced, at the full production price, sometimes less. But the flow of goods continues without change, except as modified by the relatively small goods reservoirs. So when excess money enters the markets, the ratio of money to goods (the market price level) increases. When some of the money in the circulating stream is being withdrawn to refill the reservoirs, the general price level drops.

Many readers will no doubt find it difficult to believe that the answer to an important problem of such long standing can be so simple, but it does not take any complicated or intricate reasoning. The logic is plain enough for anyone to follow, and the conclusions meet the ultimate and exacting test of science: they are consistent with all of the known facts. Accomplishment of these results in an area where theory has hitherto been confused and uncertain has been possible because the concept of reservoirs in the circulating money stream, like the concept of energy in physical science, enables us to recognize the equivalence, from certain standpoints, of apparently dissimilar phenomena, and to define their effects in that respect with precision, independently of any other aspects that they may possess.

The fidelity with which the reservoir theory conforms to all of the established facts concerning business fluctuations will be clearly demonstrated in Chapter 14, where the mechanism of the business cycle will be explained in detail. For the present it will suffice to point out that it is quite evident from the mass of business and monetary statistics now available that the booms and recessions that we have actually experienced have displayed exactly the same characteristics as the fluctuations which we can see must inevitably result from the presence of uncontrolled reservoirs in the circulating money stream.

A few more points in connection with the price mechanism should have some attention. The market equation demonstrates that, so far as the goods markets are concerned, prices are not affected by the volume of production. Any change in the volume of goods produced is accompanied by an equal change in the amount of purchasing power (both money and real) that is created. (Principle III) Since money purchasing power and volume rise and fall together, the quotient is not altered (except to the extent that the relative magnitude of the reservoir transactions may be modified). It should be noted that this does not mean that the volume of production is unaffected by price changes. That is another matter altogether, but it is outside the scope of the present discussion of the goods market price level, and it will be taken up separately.

Inasmuch as the modern fourth stage economic system operates on a dynamic basis, the significant economic quantities are the differential quantities, the rates. The magnitudes of the integral quantities, the accumulations at the various locations, are for most purposes irrelevant. The amount of money stored in the various reservoirs, for instance, has no effect on the price level, as a given rate of withdrawal from a full reservoir has exactly the same effect as an equivalent rate of withdrawal from one that is nearly empty. In the latter case, the state of the reservoir has a bearing on how long that rate of withdrawal can continue, but as long as it does continue, the condition of the reservoir is immaterial.

This means, of course, that the quantity of money in the circulating system is completely irrelevant, except insofar as the rate of flow may be changed by some process that involves an input into, or a withdrawal from, this stream. This conclusion will no doubt be distasteful to those who look upon the “money supply” as the governing force in economic activity, but the rate of flow of money is the significant item, and this flow rate is not a function of the total quantity in the system, any more than the rate of flow of the water in the automotive cooling system is a function of the amount of water in the radiator. These facts are practically self-evident as soon as the characteristics of the money purchasing power flow are given a close examination, but in view of the large amount of attention that has been given to this question as to the effect of the quantity of money on the price level, this subject will be examined in detail in Chapter 15 in connection with a discussion of other aspects of money and credit.

Purchases of goods by producers for production purposes do not affect the general price level. Such purchases are simply exchanges at the same economic location, the same point in the mechanism. The total amount of goods in the hands of producers is exactly the same as before the transaction, and the same is true of money purchasing power. So far as the general situation is concerned, transactions between two or more individual producers have the same standing as transactions between departments of one large producer.

This is another fact that may be difficult for some of those accustomed to current economic thinking to accept. The statistical economist pays little attention to retail trade, other than in total, focusing his vision on wholesale transactions, and particularly on the organized commodity exchanges, where economic data are more readily available. This has fostered the impression that these wholesale transactions are the most important part of marketing. But it can easily be seen that the prices, which are arbitrarily assigned for accounting purposes to goods transferred between departments in a single productive enterprise, have no important economic significance, and it is equally clear that from the general economic standpoint transactions between producers have the same status as these intra-company transactions. A railroad, which mines and transfers coal from its mines to its railway, is carrying out the same economic transaction as the railroad, which buys coal from an independent producer. Here we again meet Principle IV. All producers are at the same economic location. Hence transactions between producers, or between departments, have no effect on the flow of the economic streams, regardless of the volumes of goods involved, or the prices at which sales take place.

At a given level of production, the basic factor which determines the general price level is not the price which one producer charges another, or the price which the producer of the finished product attempts to get from the consumer. The determining factor is the amount, which the producers pay out through the production market for the labor and services of capital that they utilize. The total of these payments is the total money purchasing power generated at the production end of the economic mechanism, and, aside from the effect of the reservoir transactions, which balance out in the long run, it is the total purchasing power utilized in the markets. The quotient of the active money purchasing power divided by the volume of production is the general market price level to which the average of all individual prices must conform. If the prices that the producers try to establish exceed this level on the average, the producers that are in the weakest market position simply have to bring their prices down.

Here we can see the difference between the determination of the general price level and the determination of individual market prices. The general price level is determined in the production market, as the production price level is also the normal goods market price level, the level that exists in the absence of unbalanced reservoir transactions. The relative values of the various products are then determined in the goods market by supply and demand considerations; that is, the function of the price system in the goods market is to divide up the total incoming money among the various goods according to the consumers’ preferences. It is commonly taken for granted that the prices of individual goods are determined by the interaction of supply and demand in the market, and that the general price level is the average of these individual prices. But this is not the way that the system operates. The general price level is a result of a set of factors totally independent of the goods market.

The distinction between purchase of producer goods and purchase of capital goods should be noted. Producer goods, including materials purchased for use in maintenance and repair of capital equipment, are bought with funds that would otherwise be available for buying labor and the services of capital in the production market. The purchase of such goods is, in fact, merely an indirect purchase of labor and the services of capital, and the cost of these goods will be reflected in the selling price of the producer’s products. But goods purchased as additions to capital assets are not bought with funds available for buying labor and capital services in the production market. They are bought with funds that have already been used for this purpose, and have been paid out, actually or constructively, to workers or owners of capital.

The accounting procedures that are prescribed for regulated enterprises such as the public utilities show this distinction very clearly. Producer goods—materials and supplies for use in operation and maintenance of facilities, raw materials for use in manufacture, etc., are charged against the operating accounts of the enterprise, and the business is ultimately reimbursed for these costs in the sale of its products. But the regulatory authorities will not permit the enterprise to charge its customers a price that will recover any of the cost of capital additions, or will enable it to lay aside funds, other than reserves to cover depreciation and other deferred expenses, for future construction. If the enterprise wishes to expand it must obtain the necessary funds through investment channels, either by borrowing, by selling additional stock, or by persuading its existing stockholders to “plow back” some of the money that would otherwise be paid out in dividends.

Private sales between consumers (exchange of goods for money) or trades (exchange of goods for goods) are exchanges at the same economic location, and therefore have no effect on the streams of goods and money purchasing power, and no effect on the general price level. Examination of this situation on the basis of supply and demand is likely to lead us astray, but when it is analyzed by means of the purchasing power relations the answer is clear and unmistakable.

Use of goods from consumers’ storage likewise has no effect on the general price level, under normal conditions. This is another of the places where the supply and demand approach to economic problems is likely to be misleading. It is generally assumed that the consumption of goods withdrawn from consumers’ supplies would reduce the demand for currently produced goods, and thereby lower prices. This could conceivably happen in the case of individual items. Consumers might, for example, decide to wear out the clothes, which they already own rather than buying new clothing in the usual quantities, with a consequent detrimental effect on the clothing market. The purchasing power analysis shows, however, that this would not change the total amount of money purchasing power flowing to the market, and the decreased buying of clothing would be offset by increased purchases of other goods. The general price level would not be affected.

It is possible, of course, that money made available through sale or use of stored goods may itself be stored or utilized for debt retirement, in which case the final effect on the markets might be different. But this does not necessarily follow, and in any event the consumer’s decision has no bearing on the result. If he decides to save the money rather than spend it, he deposits it in a bank, and the bank then lends it to someone else, who spends it. No input into the money reservoirs occurs unless some other factor causes the bank to add the money to its reserves instead of lending it to a customer. Such other factors are independent of the goods transaction and they will be analyzed separately. It should be noted in this connection that no assumption is being made as to what the ultimate result of the goods transaction will be. The point that is now being brought out is that use of supplies on hand does not in itself cause any change in the flow of purchasing power. Input into the purchasing power reservoirs, if it follows, does alter the stream flow, but the two matters have no essential connection with each other, and they are therefore being treated separately in accordance with the scientific practice which has been followed throughout the entire study.

Another example of a transaction between individuals at the same economic location is a shift of purchasing power from one group of consumers to another. There is one school of thought, which holds that the root of some of our present difficulty in maintaining a consistent high level of production, is a misdistribution of purchasing power among the various economic and social groups. The present analysis indicates, however, that no economic benefit can be obtained by a redistribution of purchasing power. The general price level is determined by the total flow of money purchasing power into the markets, without distinction as to the source or as to the kind of goods purchased. Whatever instability of the price structure may exist is due entirely to reservoir transactions.

The usual argument in favor of these redistribution proposals is that the spending pattern of the higher income groups is less stable because they save more of their income, and the amount of their saving is likely to vary, thus creating fluctuations in the general level of consumption. The flaw in the argument is that variations in the amount of saving do not normally affect the market mechanism. The more affluent groups do not hoard their savings; they invest them, which means that this purchasing power is spent for capital goods, and such spending has exactly the same effect on the purchasing power stream and on the markets as an equivalent amount of spending for any other type of goods.

These proposals for redistribution of income have a great deal of support because they provide an apparent justification for taking from the “haves” for the benefit of the “have nots,” but from the standpoint of the economic purpose which they are ostensibly designed to accomplish they are of no value. Our policies with respect to taxation and other factors, which influence the distribution of income, are far from perfect, and some modifications and improvements from time to time are undoubtedly in order. But these should be considered on their own merits, and not on the basis of their purely mythical contribution to economic stability.

The three important generalizations developed in the foregoing discussion may be summarized in the following principles:

PRINCIPLE VII

Except as modified by reservoir transactions, the purchasing power (money or real) available in the goods market is equal to the purchasing power expended in the production market.

PRINCIPLE VIII

Any net change in the levels of the consumer purchasing power reservoirs results in a corresponding change in the money price level in the goods market, except insofar as it may be counterbalanced by a net change in the levels of the goods reservoirs.

PRINCIPLE IX

The market price levels are independent of the volume of production.

The principles that have been stated thus far, and those that will follow, are not all on the same logical level. For instance, Principle I is a statement of the basic fact of the conservation of purchasing power. Principle VI expresses the effect of this conservation on the flow in the circulating stream, Principle VII, is a restatement of Principle VI in the form in which it is specifically applicable to the determination of the price level in the goods market. Thus there is considerable overlapping and duplication in the list, but this appears to be necessary in order to accomplish the double purpose of defining the basic economic relations in the way in which they will be applied to specific situations, and at the same time indicating how these relations are derived from the broad general principles that govern economic life as a whole.

For the benefit of those who prefer to analyze the situation mathematically, the essence of this chapter can be set forth in a few equations. This economy of time and effort in the development of thought is characteristic of mathematical treatment in general, and to take advantage of the additional clarity of presentation that is made possible by this means, the appropriate mathematical expressions will be formulated in connection with the explanatory discussion from this point on. For this purpose the following symbols will be used:

V = Volume of goods
B = money purchasing (Buying) power
P = Price

To indicate changes due to voluntary actions affecting the operation of the economic mechanism, a series of factors denoted by lower case letters will be employed.

  1. change in the volume of production
  2. consumer money reservoir transaction
  3. producer money reservoir transaction.
  4. goods reservoir transaction
  5. change in production price

This list may seem very short for a classification, which purports to represent all of the things that man can do to influence the general operation of the exchange mechanism, but it is complete. The explanation of the brevity is, of course, that the term “reservoir transaction” covers a great diversity of actions, all of which we are able to classify under no more than three headings, since all actions in each of these categories have exactly the same effect on the general operation of the economic mechanism. This recognition of the equivalence of apparently unrelated phenomena is extremely useful, and it has been one of the major tools of this analysis.

It will be noted that a symbol has been provided for a voluntary change in production price, but none for a similar change in market price. The reason is that the market price level cannot be changed by direct action. As explained in the preceding pages, this price level is a resultant, the quotient of the active money purchasing power divided by the volume of goods entering the market. It can therefore be altered only by an action which modifies the flow in one or another of these two ways; that is, a change in production price (symbol f) or a reservoir transaction (symbols c and e). It cannot be changed arbitrarily, nor is it affected by an increase or decrease in the volume of goods produced, since any such change is accompanied by an equivalent change in the money purchasing power stream (Principle IX).

The impossibility of any direct manipulation of the market price level, a point which has not been generally recognized heretofore, but was brought out clearly by the cooling system analogy in Chapter 8, is very significant, as it stands squarely in the way of the success of price control and similar economic actions, and it imposes an overall limitation on the ability of individual producers to set prices for their products. These matters will have more detailed consideration at appropriate points in the subsequent chapters.

The proportionate effect of any change in the quantities that affect the price level will depend not only on the magnitude of the change itself, but also on the magnitude of the original quantity that is being modified. In order to take this into account, these changes will be expressed as percentages of the base quantities rather than as additives. In the case of a change in the volume of production, for instance, if we denote the actual additional volume as V’, the factor a will be equal to (V+V’)/V.

The market equation, which we will find applies to the production market as well as to the goods market, and will therefore be designated as the GENERAL ECONOMIC EQUATION, can be expressed as

B/V = P

Using the notation that has just been specified, we can now state Principles VIII and IX in this manner:

PRINCIPLE VIII

cB / V = cP

PRINCIPLE IX

aB / aV = P

These relations are mathematically exact, not speculative or empirical. They hold good whether the transactions take place through the medium of money or by some credit arrangement, whether the goods are durable or transient, capital goods or consumer goods. Prices rise when purchasing power is being swelled by reservoir withdrawals; they fall when the stream of purchasing power shrinks because of diversions to replenish the reservoirs. The fact that many economic activities are still being carried on by combination producer-consumers who do not utilize all of the advanced fourth stage economic processes does not alter this situation. The flow of purchasing power follows the same economic channels as in the newer type of organization. There is merely one less point along the line where the flow can be modified.

Page Index

The Road to Permanent Prosperity Page Index

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Note: Missing even page numbers are blank pages between chapters, since chapters usually start on an odd page.