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.