08 Employment by Inflation

CHAPTER VIII

Employment by Inflation

Inasmuch as the shortcomings of public employment as a source of additional jobs, as discussed in the preceding chapter, are generally understood, and it is recognized that the use of this expedient is “to some extent a desperation measure”,47 the current employment program relies mainly on the stimulation of the private economy by means of an inflationary tax cut, the only other tool that is now regarded as being available for the purpose. The deliberate use of inflation as a means of increasing business activity and employment is based on J. M. Keynes’ economic theories, and to see just how our present findings apply to this situation, it will first be desirable to have a clear idea as to just what Keynes’ contentions with respect to employment actually are. His theory was developed as an alternate to the so-called “classical” theory of employment, the previously orthodox economic doctrine in this field, and his explanations are expressed mainly in terms of contrast with the earlier views.

“The classical theory of employment”, he says, “has been based… on two fundamental postulates… namely:

  1. The wage is equal to the marginal product of labor.
  2. The utility of the wage when a given volume of labor is employed is equal to the marginal disutility of that amount of employment.”

Translating the second postulate from the professional jargon of the economist to the vernacular, he arrives at this alternative, and more understandable, statement: “That is to say, the real wage of an employed person is that which is just sufficient (in the estimation of the employed persons themselves) to induce the volume of labor actually employed to be forthcoming”.48

Keynes accepts the first of these two postulates but denies the second. The most fundamental objection to this proposition, he says, is that it involves “the assumption that the general level of real wages is directly determined by the character of the wage bargain”.35 In an extended analysis he shows that this assumption is erroneous, and he arrives at the same conclusion reached in the present analysis; that is, the general level of real wages is fixed by factors which operate independently of the bargaining process, and it is not altered by any manipulation of money wages.

According to Keynes, the “classical” economists’ basic mistake in their analysis of the employment situation is a result of their explicit or tacit acceptance of Say’s Law of Markets, a principle formulated by J. B. Say, one of the early French economists, which asserts that inasmuch as the price paid by the buyer is income for the seller, the act of production creates all of the purchasing power required to buy the product. Keynes termed this principle “an optical illusion, which makes two essentially different activities appear to be the same”.49 By virtue of its acceptance of this law, “The classical theory assumes… that the aggregate demand price (or proceeds) always accommodates itself to the aggregate supply price…That is to say, effective demand, instead of having a unique equilibrium value is an infinite range of values all equally admissible; and the amount of employment is indeterminate except in so far as the marginal disutility of labor sets an upper limit. If this were true, competition between entrepreneurs would always lead to an expansion of employment up to the point at which the supply of output as a whole ceases to be elastic”. Thus Say’s Law, Keynes contends, “is equivalent to the proposition that there is no obstacle to full employment”.50

Since there obviously is some obstacle to full employment, and since the ability to manipulate the real wage level assumed by the classical theory does not actually exist, Keynes rejected that theory and formulated a new concept in which for a given “propensity to consume” and a given rate of new investment. “There will be only one level of employment consistent with equilibrium”. He summarized his new concept in these words:

The outline of our theory can be expressed as follows. When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income… Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level.51

Here, then, we have Keynes’ employment theory, as presented by its author, together with his explanation of the principal points of conflict between his ideas and the theoretical outlook shared by most of his predecessors: the “classical” theory. This classical theory is a wage theory; that is, it is based on supply and demand reasoning applied to the price of labor. Since a lower price, according to the classical ideas, will increase the demand that is, the number of jobs—there would appear to be no obstacle to full employment if the workers are willing to accept the appropriate wage. But the adherents of this viewpoint are victims of that unquestioning confidence in the universal applicability of the supply and demand principles that so often leads economists to apply these principles to issues which are not supply and demand problems at all. Considerations of supply and demand are not applicable to any situation unless the price is variable, and as Keynes has emphasized, the real wage rate, the true price of labor, is fixed by external factors (the factors that determine the rate of productivity) and cannot be arbitrarily changed. Money wage rates can, of course, be manipulated, but this does not alter the workers’ actual compensation in terms of buying power, and such wage changes therefore have no supply and demand implications.

The significant quantity in the labor market is not the money wage, which is merely a label, but the real wage, the wage in terms of buying power, and it is not possible for the average real wage to be raised too high. Indeed, the average real wage is not subject to any arbitrary change. As Keynes pointed out, “there has been a fundamental misunderstanding of how in this respect the economy in which we live actually works”. The real wage level, he asserted, is determined by “certain other forces” and cannot be altered “by making revised money bargains with the entrepreneurs”.35The markets automatically convert the money wage rate, whatever it may be, to the real wage rate determined primarily by productivity.

To replace the classical “wage” type of theory, no longer tenable after the factors which determine the level of real wages are clearly understood, Keynes proposed that we may call a market type of theory: one which is based on the changing situation in the goods markets. Inasmuch as Say’s Law, in its original form, established a direct connection between the wage level and the market price level (in Keynes’ words, this law implies that “the aggregate demand price always accommodates itself to the aggregate supply price”) he found it necessary to break the connection by repudiating Say’s Law and giving the total demand for goods an autonomous status.

The effect of an excess of saving over investment, according to Keynes, is to withdraw purchasing power from the active stream, thereby decreasing “aggregate demand”. This reduction of demand cuts the income of the producers and forces curtailment of productive operations, thus creating unemployment. By way of example, he cites “sinking funds, depreciation allowances” and other such financial provisions made to compensate for the depreciation or obsolescence of physical assets. “Take a house which continues to be habitable until it is demolished or abandoned”, he explains, “If a certain sum is written off its value out of the annual rent paid by the tenants, which the landlord neither spends on upkeep nor regards as net income available for consumption, this provision… constitutes a drag on employment all through the life of the house, suddenly made good in a lump sum when the house has to be rebuilt”.52 As Keynes saw it, this “financial prudence” is disastrous. “In so far as our social and business organization separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the latter with them, financial prudence will be liable to diminish aggregate demand and thus impair well-being, as there are many examples to testify”.53

This is the so-called “paradox of thrift” that has aroused so much antagonism against Keynes’ ideas among those who hold to what Samuelson calls the “old-fashioned doctrine” that thrift is always a virtue. According to his explanation of the Keynesian thesis, “under some circumstances, private prudence may be social folly”, and “attempts to save… really lead only to decreases in income”. Whether or not thrift is appropriate, he tells us, depends on the stage of the business cycle; that is, on “whether or not national income is at a depressed level”.54 If so, the answer of the “new economics” is increased government spending to bring “aggregate demand” up to the desired levels.

From the foregoing description it can be seen that Keynes’ theory is not a “general theory of employment”, as he called it, but a theory of the business cycle, and his conclusions with respect to unemployment, insofar as they are valid, apply only to the cyclical addition to total unemployment. Instead of the direct relation between inflation and employment which the followers of Keynes think that they see in their Phillips curves and other empirical data, what actually exists is a relation between inflation and business activity, together with a relation between business activity and cyclical unemployment.

Furthermore, Keynes’ theory is an incomplete explanation of the business cycle. Our analysis shows that he was correct in asserting that the basic cause of business recessions is the withdrawal of purchasing power from the active stream. But he failed to recognize that a deficiency in the rate of investment is only one of a number of ways in which purchasing power can be diverted into some form of storage, and later released from that storage in the rising phase of the business cycle. Instead of being the key factor about which all else revolves, as the Keynesians see it, the relation of saving to investment is only one element of a large and complex purchasing power movement.

Our analysis also indicates that in repudiating Say’s Law and replacing it with the concept of an autonomous demand, Keynes made a serious error. As mentioned earlier, the argument against this law which he considered conclusive is that, on the basis of Say’s Law, “there is no obstacle to full employment”, whereas experience shows that in reality there is such an obstacle. This argument has now been invalidated by our finding that the existence of unemployment is not a purchasing power phenomenon, but the result of an excessively high survival limit. The real difficulty here, we find, is not that Say’s Law is incorrect, but that it is incorrectly applied. It is not actually a “Law of Markets”, but a Law of Production. Goods and purchasing power are produced at the same time, by the same act, and in the same quantity. Keynes was correct in asserting that this does not assure availability of the purchasing power in the markets at the right time and in the right quantity, but separating “aggregate demand” from total purchasing power production and giving it an autonomous status introduces a “something for nothing” aspect into the economic process that confuses the issues, and is responsible for much of the trouble in which the economy is now entangled.

These errors and inadequacies in Keynes’ business cycle theory are of sufficient importance to justify extended consideration in any general treatment of the cycle, but from the standpoint of the employment question that we are now discussing, they have relatively little significance. Keynes’ conclusion, in essence, was that the cycle results from fluctuations in the flow of purchasing power into the goods markets, and our analysis confirms this finding as a general proposition, even though it arrives at different conclusions with respect to the details. It follows that the results of this analysis agree with Keynes’ recommendation with respect to the use of countercyclical fiscal and monetary policies as an effective means of eliminating, or at least dampening, the cyclical swings. Since these policies are subject to deliberate control, it is possible to create inflation by government actions to offset deflationary tendencies in the private economy, and vice versa. This is the theory on which the present efforts to increase employment by cutting taxes are based.

For a full understanding of the possibilities and the limitations of this kind of a program it is necessary to recognize just what it does to the survival limit. This limit is related to the cost of production, or, as we have called it, to emphasize the relationship to the market price, the production price. (Keynes called it the “supply price”.) The distinctive feature of the inflationary stage of the business cycle is that the volume of purchasing power flowing into the markets, and then back to the producers, is greater than that currently generated by production. The difference goes into the variable production costs, principally profits, and the ratio of fixed costs to income, the survival limit, therefore decreases, with a corresponding increase in the volume of business and employment.

In the downswing of the cycle, these conditions are reversed. Now the purchasing power entering the markets is less than that generated by production (that is, some is being held out of the stream) and the returns to the producers decrease. This decrease in producer income increases the survival limit, the ratio of fixed costs to income. Many businesses cannot raise their productive efficiency enough to meet this higher limit, and are forced to cease operation. The less favorable prospects for earnings likewise reduce the formation of new business enterprises. Employment therefore decreases.

A Keynesian “addition to aggregate demand”, such as that resulting from a tax cut financed by inflationary borrowing is effective in counteracting the loss of employment during a recession because the inflation that it causes brings the survival limit back down toward the normal level. But there are strict limitations on the amount of reduction that can be accomplished.

The first point to be recognized in this connection is that if the countercyclical principle is followed, and the inflationary stimulus is limited to overcoming the effects of deflation in the private sector of the economy, the most that can be accomplished by this means is to offset the abnormal increase in the survival limit resulting from the deflation, and thereby to reduce the unemployment rate to the level that prevails under stable economic conditions, a level which is currently somewhere in the neighborhood of five percent. This is probably as much as the authorities are hoping to accomplish at present, and the conclusion reached by the present analysis therefore is that the inflationary program now under way is capable of accomplishing its objective if it is applied on a sufficiently massive scale, and not nullified by coincident deflationary measures. It should be clearly understood that it is the inflation caused by the deficit financing required by reason of the tax cut that improves the employment situation, not the tax cut itself, and there is no way by which the results of inflation can be obtained without having the inflation.

The experience of the last few decades, which has demonstrated that Keynes’ prescription of inflationary governmental actions to counteract the loss of employment in the deflationary stage of the business cycle has a substantial degree of effectiveness, has led to a rather widespread belief that there is a direct connection between inflation and employment, and that we are consequently confronted with a dilemma. As expressed by Reynolds: “When we say we are aiming at full employment, we mean really that we want a desirable level of employment. And this is related to how much inflation we are willing to tolerate”.55 Inflation is generally regarded as the lesser of the two evils, and recent economic policy in the United States has therefore been aimed at using inflationary measures not only to offset the effect of deflation on employment, but to reduce unemployment to still lower levels. But the actual result of the application of this policy is that we now have both inflation and unemployment.

Those who have put their trust in a “trade-off” between inflation and unemployment are greatly disconcerted by what is taking place, and are complaining that the economy is no longer “following the rules”. Of course, the truth is that they have misunderstood the rules. Inflation does not, of itself, increase employment. Under certain circumstances it increases the profitability of business operations, and thereby decreases the survival limit, which, in turn, results in more employment. Thus, as long as the inflation is working against a deflationary situation—that is, profitability is being brought back up from a sub—normal level it is effective from the employment standpoint. But when profitability rises above the normal level, no more than a transient effect can be expected, as competition from new enterprises attracted by the favorable earning prospects now drives the average profitability back down toward normal, regardless of the inflationary additions to purchasing power. Inflation then becomes part of the existing business climate, business enterprises accommodate themselves to it, just as they do to taxation, and the inflationary effect on profits terminates. The improvement of employment dies with it.

The vigorous promotion of inflationary measures by the so-called “liberal” elements of society is typical of the impatient, emotional approach to economic questions that is so prevalent in the world of today. These liberal groups have little sympathy for business, particularly big business, and are, ostensibly at least, strongly committed to the improvement of the economic position of the individual consumer. But the inflation that they are promoting so assiduously is very kind to business, as most of the inflationary unbalance goes into added profits, while the consumer suffers a double blow, first paying the full cost of the inflation in the form of higher prices for everything that he buys, and then bearing the brunt of the economic dislocations during the deflationary period that ultimately follows.

In this case, as in so many others, the policies adopted on the basis of emotional reactions and good intentions, without adequate consideration of their ultimate effects, are producing results that are just the opposite of those which the advocates of these policies claim that they favor. This lack of correlation between the emotional aims of economic actions and the direction that the results of these actions actually take is one of the greatest obstacles standing in the way of solutions for our most serious economic problems. When those who advocate inflation and other policies that work to the detriment of the individual citizens claim to be their best friends, and are widely accepted as such, whereas those who try to keep the economy on the sound basis that is most beneficial to both worker and consumer are charged with a lack of sympathy for the “common man” because they oppose well-intentioned but unsound measures, it can hardly be expected that wise economic decisions will follow.

This emphasizes the desirability of replacing the emotional approach to economic questions with the kind of cold-blooded scientific analysis and reasoning that are being used in this work. Good intentions are seldom sufficient in themselves to produce good results in any field—indeed, their futility is proverbial—but in economics, where the good intentions usually take the form of trying to circumvent the basic economic law that prohibits something for nothing, they are not only futile but definitely destructive.

Summarizing the contents of this chapter, we may say that the Keynesian remedy for unemployment—inflation—has a legitimate place in a comprehensive employment program, but its usefulness is severely limited. It is not actually an employment measure; it is a business stabilization measure, whose contribution to employment is merely to prevent creation of an abnormal addition to unemployment through cyclical fluctuations in business activity. We cannot reach the goal of full employment by the inflation route.