by George Reisman, 1996.
MONEY AND SPENDING
3. The Quantity of Money and the Demand for Money
[…] The demand for money is determined by a variety of factors. One of the most important, and, indeed, the most fundamental, is the security, or lack of security, of property. Where property is insecure — where it is subject to arbitrary confiscation by the government or to plunder by private gangs — saving and provision for the future will be low, because people will not be in a position to count on benefitting from it. But such saving and provision for the future as does occur will largely take the form of holding precious metals and gems — items easily concealable and easily transportable. A gold money in such circumstances has a very low velocity of circulation. 23
23. For the sake of brevity, in what follows I generally refer to gold and gold money, but, of course, my discussion applies equally to silver and silver money.
By the same token, under conditions in which property is secure from confiscation and plunder, the demand for gold for holding will be less, and thus the velocity of circulation of a gold money will be greater. The same result is aided by the development of financial markets and financial institutions, which make it easier and more profitable for people to invest their savings rather than hold them in the form of precious metals or precious stones.
Interestingly, the effect of lack of security of property is very different on a paper money than on a gold money. In conditions in which a government loses the power to stop private plunder or itself becomes a looter, people switch their savings from assets denominated in the government’s paper to precious metals and precious stones. They lose the desire to hold such paper, because it becomes more and more likely that the government will sharply reduce its value by rapidly increasing its supply. Thus, the velocity of a paper money tends to rise in such circumstances.
The velocity of money can also be increased by such developments as improvements in transportation, which reduce the time money is in transit and correspondingly increase the speed with which it is available for respending. The development of clearing houses reduces the amount of money that is required to perform a given volume of transactions: instead of all of the transactions needing to be effected by means of the transfer of money, only the settlement of the net amounts owed or owing, after the canceling of offsetting debts by the clearing process, needs to be effected by means of the actual transfer of money. The money set free by the clearing process is thereby made available for spending for other things. Thus, the total spending that the same quantity of money can effect is increased.
What is especially worthy of note is the fact that in the context of an economic system with developed financial institutions and financial markets, saving operates to raise the velocity of circulation of money. (This may be the cause of some surprise, in view of the popular fallacy that confuses saving with hoarding.) There are two reasons for this. First, under such conditions funds that are saved are likely to be made available for spending sooner than funds that are held for consumption. For example, the part of his paycheck that an individual deposits in his savings account is available for lending by the bank almost immediately. However, the part of his paycheck that he retains in his possession in the form of cash that he plans to spend on consumers’ goods in the coming days or weeks prior to his receipt of his next paycheck will enter into the hands of others only over the length of this considerably longer period. Second, to the extent that the availability of additional savings contributes to credit being readily available, it becomes possible for individuals and business firms to substitute to some extent the prospect of obtaining such credit for the holding of money as the means of providing for their future need for funds. To this extent, they reduce their cash holdings and thus bring about a rise in the velocity of circulation of money. 24
It should be realized that in the conditions in which the velocity of circulation of a gold money rises, there is unlikely to be any fall in the purchasing power of gold as a result. This is the case because the rise in velocity here is the accompaniment of a process that sharply increases the physical ability to produce — above all, the growth of saving and the channelling of those savings into productive investment. In addition, a further factor that must be mentioned, which is especially relevant in appraising the effects of the development of clearing procedures, is that the productive process also tends to become more complex at the same time that the demand for gold holdings falls. Because of the intensification of the division of labor, which is inextricably bound up both with the growth of saving and investment and the increase in production, a tendency exists toward an increase in the number of payments needed in the production and distribution of ultimate consumers’ goods. For example, instead of a farmer selling his food to a consumer, he sells it to a food processor, who sells to a wholesaler, who in turn sells to a retailer. Possibly several processors and wholesalers are involved. The intensification of such specialization and its requirement for additional acts of exchange more or less keeps pace with the decline in the desire to own balances of gold. Consequently, while the total of spending of all types combined rises relative to the quantity of gold, it does not follow that spending specifically for consumers’ goods rises relative to the quantity of gold. In other words, the velocity that actually rises is the so-called transactions velocity, but not necessarily income velocity, or certainly not to the same degree. (Furthermore, it should not be assumed that either the fall in demand for gold holdings or the growth in complexity of the productive process necessarily goes on indefinitely.)
PRODUCTIONISM, SAY’S LAW, AND UNEMPLOYMENT
SAY’S (JAMES MILL’S) LAW
5. Falling Prices Caused by Increased Production Are Not Deflation
[…] The fact that the falling prices resulting from increasing production are not accompanied by a decline in the general or average rate of profit represents an enormous departure from the conditions of a genuine deflation. In a genuine deflation, business profits are almost universally depressed, if not eliminated altogether. But we have seen that the aggregate profit of the economic system can be represented by the difference between the spending of consumers to buy products and the wages paid by business to produce them, and that so long as those magnitudes, and thus the difference between them, remain the same, the aggregate profitability of business is totally unaffected by the physical volume of goods and services produced and sold. Thus, when production increases, prices fall. That is perfectly true. But the general rate of profit does not.
By the same token, when prices fall because of an increase in production, there is nothing present that would cause any general increase in the difficulty of repaying debts, which is the most prominent symptom of a genuine deflation. A fall in prices resulting from more production in the face of constant sales revenues does not mean that there is any greater difficulty of earning any given sum of money. If, over a period of years, an increase in production, let us say a doubling, is achieved by virtue of business firms becoming more efficient, then the conditions of the case imply that the mathematically average business firm produces twice the output just as easily as it previously produced its original output. True enough, a unit of output sells for only half the price. But, by the conditions of the case, the average business firm has twice the units to sell. Its sales revenues in money are, therefore, just as great as they were before, and no more difficult to earn. Whatever money it is obliged to repay, does not come to it with greater difficulty than was originally the case.
It is certainly true that individual firms and whole industries could find it more difficult to repay their debts as prices fell. These would be the firms that did not improve their efficiency while their competitors did, and the industries that were relatively overexpanded. These firms and industries would suffer a decline in sales revenues and profits, and probably incur outright losses. But for every firm and industry in this position, there are other firms and industries that enjoy correspondingly increased sales revenues and profits and a correspondingly enhanced ability to repay their debts. Namely, the firms that introduce improvements ahead of their competitors, and the industries that are relatively underexpanded. There is no overall pressure on debtors here — nothing present that operates against debtors as a class.
Thus, it is simply incorrect to think of falling prices per se as “deflation.” The falling prices caused by more production share only one symptom of deflation — namely, the fall in prices itself. They do not share two further, essential symptoms of deflation — namely, the sudden reduction or total elimination of business profitability and the increased difficulty of repaying debts.
What accounts for the combination of these three symptoms of deflation together is not any increase in production or supply, but a decline in monetary demand — a contraction of spending — which occurs as the result of a drop in the quantity of money or at least a slowing down of its rate of increase. A drop in total spending reduces prices. That is one of its effects. In addition, and totally unlike an increase in production and supply, it also reduces total business sales revenues. This reduces the availability of funds with which to repay debts. It makes it more difficult for the average seller to earn any given sum of money, because there is simply less money to go around. In addition, and again totally unlike an increase in production and supply, a drop in total spending reduces the general rate of profit, because while sales revenues fall immediately as a consequence of a decline in spending in the economic system, total costs of production in the economic system fall only with a time lag. For example, depreciation cost continues to reflect the larger volume of spending on account of plant and equipment that existed in the past. […]
The Anticipation of Falling Prices
[…] The first thing that must be pointed out is that even if the prospect of falling prices caused by increases in production did increase the demand for money, which it does not, the increase would be of an essentially one-time nature. Once the increase in the demand for money took place, further increases in production and the falling prices they caused would take place with no further increase in the demand for money.
For example, let us suppose that there is a given, fixed quantity of money in the economic system and that initially the aggregate demand for consumers’ goods is 500 monetary units and the aggregate demand for labor is 400 monetary units … We can assume that initially production and prices are both constant from year to year. And now we assume that production begins to rise and prices to fall from year to year and, for the sake of argument, in response to the fall in prices and the prospect of the fall continuing, the demand for money rises. If it occurred, the rise in the demand for money would have the effect of reducing the monetary demand for consumers’ goods and labor. For the sake of illustration, let us assume that the effect would be to reduce the demand for consumers’ goods and labor by 10 percent, namely, from 500 and 400 respectively to 450 and 360 respectively. From this point on, it is clear, production would increase and prices would fall with no further increase in the demand for money and no further fall in the monetary demands for consumers’ goods and labor.
[…] The only reasonable basis for a further rise in the demand for money based on the anticipation of falling prices caused by increases in production would be if the rate of increase in production and fall in prices accelerated. In that case, it might plausibly be argued that there would be a one-time further increase in the demand for money and a one-time further fall in the aggregate demands for consumers’ goods and labor.
Thus, even if the argument alleging deflationary effects were correct, which it is not, it would still be essentially false. For at most, it would apply only to a transition phase. Thereafter, once the additional demand for money was satisfied and the volume of spending in the economic system stabilized at a lower level, production could go on increasing and prices go on falling at any given rate with no further increase in the demand for money, exactly as I have described.
[…] Insofar as the increasing production and falling prices are the result of improvements in the productivity of labor, the falling prices do not lead to a postponement of consumption and thus do not increase saving at the expense of consumption. This is because they are the accompaniment of the average person having a higher real income and thus being better off in the future than in the present, which prospect gives him as much motivation to consume more as the prospective increase in the buying power of money gives him to postpone consumption and save more. 52 Inasmuch as the two incentives are thus mutually offsetting, there is no overall tendency for consumption spending to fall, or saving to increase, as the result of falling prices caused by increases in production — not insofar as the increases in production and fall in prices are the result of a higher productivity of labor.
When increases in saving do occur, the demand for money does not increase, but, if anything, decreases. This is because … the average rate of profit and interest in the economic system is always both positive and sufficiently high — in the absence of monetary contraction — to make it worthwhile to invest savings that are available for any significant period of time rather than hoard them. In such an environment, as we saw in the last chapter, the effect of an increase in saving is actually to reduce the demand for money, both because funds that are saved are normally available for spending sooner than funds that are held for consumption and because savings are the source of credit, the prospective availability of which reduces the need to hold money. 53 […]
Economic Progress and the Prospective Advantage of Future Investments Over Present Investments
[…] Thus, to the extent that there is economic progress, the machines of the future will be more efficient than those of the present and therefore today’s machines will be at a competitive disadvantage in comparison with them. The question that arises is whether this circumstance might operate to depress current investment by creating the prospect of losses or, at any rate, lower profits than could be obtained by delaying investment, and whether it might thus operate to cause an increase in the demand for money as well as to inflict losses on the producers of plant and equipment, who would have to cut their prices in the present in order to be competitive with the plant and equipment of the future.
The answer is that if economic progress took place only once, or were just about to take place for the first time, then it would be true simply that the machines of the present would be at a competitive disadvantage with the machines of the future, with the result that a rise in the demand for money might ensue and the new machines of the present might have to be sold at a loss if their competitive disadvantage were major. Observe, however, that the increase in the demand for money would exist only until the expected more advanced machines arrived on the market, and the loss would be borne only by the machines which did not embody the progress. The arrival of the more advanced machines would put an end to any increase in the demand for money. They would be in demand and would not sell at a loss. More importantly, it should be realized that if improvements in machinery are a repeated occurrence and are expected, there is no increase in the demand for money and no problem of the owners or producers of machinery incurring losses because of the prospective introduction of more efficient machines in the future.
This is because in such conditions, while the machines of next year may be expected to be more efficient and at a competitive advantage over the machines of this year, the machines of this year are, for their part, more efficient and at a competitive advantage over the machines of last year and previous years. Because of their greater efficiency and higher productivity, the machines of this year account for a disproportionately large share of total production, when compared to the machines of last year and previous years.
[…] Similar observations apply to the case of inventory and the fear that business would always have to sell its inventories at a loss, because of continuously falling costs and prices. The fact is that to the same extent that older inventories must be sold at a loss, newer inventories can be sold at a correspondingly enhanced profit. This proposition can be demonstrated for the case of any given rate of increase in production and any given ratio of inventories to sales. If, for example, production were to double from period to period, and half of current production were always to remain in and constitute inventory, then in any given period sales would represent half of the production of the current period plus half of the production of the previous period, which was half as great. Thus, two-thirds of current revenues would be attributable to half of the production of the current period and one-third of current revenues would be attributable to half of the production of the previous period. To the same extent that the half of the production of the previous period brought in deficient revenues, the half of the production of the present period that is currently sold would bring in additional revenues. Thus, the general rate of profit would not be affected. What is present here is nothing fundamentally different from the fact that businesses are profitable despite the fact that they run clearance sales on which, considered in isolation, they incur a loss; the losses on the clearance sales are compensated for by the profits on regular operations.
I have said that if economic progress took place only once, or were just about to take place for the first time, then it would be true simply that the machines of the present would be at a competitive disadvantage with the machines of the future, with the result that a rise in the demand for money might ensue and the new machines of the present might have to be sold at a loss. This is actually an overstatement of matters, because unless such a situation were pervasive, that is, applied to the greater part of the economic system at the same time, the decline in expenditure to buy the machines even of a fairly substantial number of industries would almost certainly not represent a decline in expenditure in the economy as a whole. The funds not expended for the machines in question would be made available for other purposes and be expended elsewhere. The only way that spending in the economic system as a whole would be reduced is if economic progress throughout the economic system, or at least in the greater part of the economic system, were about to take place for the first time or, what would be very similar, were about to undergo some significant acceleration. Only in such unusual cases, would spending in the economic system as a whole temporarily fall, awaiting the appearance of the improved machines. […]
THE NET-CONSUMPTION/NET-INVESTMENT THEORY OF PROFIT AND INTEREST
Net Investment Versus Negative Net Consumption
Because of net investment, it would be possible for an aggregate profit to exist in the economic system even in the complete absence of net consumption — indeed, even in the face of negative net consumption.
Net consumption falls below the consumption of businessmen and capitalists to the degree that wage payments fail to be accompanied by equivalent consumption expenditures. At the crudest level of analysis, one might imagine a portion of wage payments simply being hoarded by the wage earners. To this extent, receipts from the sale of consumers’ goods to wage earners would be less than wage payments, and the excess of total receipts from the sale of consumers’ goods over wage payments would be correspondingly diminished. The excess of total sales revenues over total productive expenditure would, of course, also be equivalently reduced, inasmuch as it reflects merely the addition of the demand for capital goods both to the demand for consumers’ goods and to the demand for labor. The addition of equals to both sides of a diminished inequality does not alter the diminution of the inequality.
More realistically than being hoarded, a portion of wage payments might be used to finance additional productive expenditures. One can imagine, for example, employee stock-purchase plans, under which a portion of wages is turned back to business firms and used by the firms for the purchase of additional capital goods (or even for the payment of wages to additional workers). The same results would follow to the extent that the savings of wage earners that were deposited in banks were used in making loans to business firms, which then expended the proceeds of the loans in these ways. If — for lack of a better description — such secondary productive expenditures should exceed the financing of wage earners’ consumption by means of loans extended by business firms, then, to that extent, consumption on the part of wage earners as a group would be less than the payment of wages.
The implication of a fall in net consumption here can also be seen in the fact that each dollar of wage income paid by business that is used to make productive expenditures represents two dollars of productive expenditure for every one dollar of sales revenues. This is because there is first a dollar of productive expenditure in the payment of the wages, and then, to the extent that the wages themselves are used to finance productive expenditure, a second dollar of productive expenditure in the expenditure of the wages. There is only one dollar of sales revenue, however, which occurs when the wages are expended in the purchase of capital goods, or when the wage earners whose wages are paid by means of secondary productive expenditure, purchase consumers’ goods.
In these cases, total sales revenues in the economic system would still be the same, but productive expenditure would be larger and net consumption, therefore, as the difference between sales revenues and productive expenditure, would be equivalently reduced. Looked at in more detail, to the extent that the wage earners’ savings were used to buy capital goods, receipts from the sale of capital goods would replace receipts from the sale of consumers goods to wage earners. This fall in receipts from the sale of consumers’ goods, in the face of the same wage payments, would represent diminished net consumption. To the extent that the wage earners’ savings were used to employ additional producers’ labor, whose wages, it may be assumed, were themselves fully consumed, the result would be that while receipts from the sale of consumers’ goods stayed the same, the total wages paid by business would rise. Either way, net consumption would be reduced.
It could also be the case, of course, that the savings of wage earners that were turned back to business would make possible merely the continuation of the same amount of productive expenditure in the next period instead of a larger amount of productive expenditure in the current period. In this case, the situation would resemble the case of hoarding on the part of the wage earners, in that sales revenues in the current period would be reduced by the amount of such saving, and thus the difference between sales revenues and productive expenditure — i.e., net consumption — would again be equivalently reduced. Unlike the case of hoarding, however, business would receive back the cash it had expended, though in the form of loans or receipts from the sale of securities rather than in the form of sales revenues.
If businessmen and capitalists themselves consumed little or nothing, say, 5 or 10 monetary units instead of 100 or 200 monetary units, and at the same time there were a significant excess of secondary productive expenditure over the granting of new and additional consumer loans by business to wage earners — that is, if the net amount of secondary productive expenditure were significant — the excess of wage payments over the consumption of wage earners would mean the existence of negative net consumption. But even in such an unlikely case, a significant aggregate profit and average rate of profit could still exist in the economic system on the strength of net investment alone. This is illustrated in Tables 16–8 and 16–9.
Table 16–8 assumes that the consumption of businessmen and capitalists is zero and thus that productive expenditure is the only source of sales revenues. It further assumes that a portion of wage payments is simply hoarded. It shows that despite this, an aggregate profit can exist on the basis of net investment. Specifically, the table assumes that the demand for capital goods is 500, and that while the demand for labor is 300, the wage earners consume only 200, because they have chosen to hoard 100 of their wages. Thus, sales revenues in the economic system turn out to be only 700 (500 + 200), while productive expenditure is 800 (500 + 300). The underlying basis of this shortfall of sales revenues in comparison with productive expenditure, namely, that wage earners consume only 200, while their wages are 300, represents negative net consumption in the amount of 100 — viz., 200 of consumption minus 300 of wages. Nevertheless, even with sales revenues less than productive expenditure, an aggregate profit exists in Table 16–8 by virtue of the costs deducted from sales revenues being further below productive expenditure than are sales revenues. With aggregate costs of 600, as the table assumes, there is an aggregate profit of 100 on the 700 of sales revenues. At the same time, the subtraction of these aggregate costs from 800 of productive expenditure results in net investment of 200. Thus 200 of net investment offsets 100 of negative net consumption and results in an aggregate profit of 100.
The excess of productive expenditure over sales revenues described in Table 16–8 could continue virtually indefinitely if, instead of the current saving of the wage earners being hoarded, which is a case so unlikely that it actually deserves hardly any consideration, they were used in financing loans to business or in purchasing securities from business. In this way, business could repeat its current level of productive expenditure in the next period.
Table 16–9 arrives at an essentially similar result to that of Table 16–8 under the assumption that a portion of wages is used to finance secondary productive expenditure in the same accounting period. It shows the wage earners’ saving of 100 of their incomes resulting in a secondary productive expenditure of 100, which is added to the original, primary productive expenditure of 800, thereby bringing total productive expenditure to 900. For the sake of simplicity, the secondary productive expenditure is assumed to be entirely in the form of an additional demand for capital goods. Thus, Table 16–9 shows a demand for capital goods of 500 + 100 and identical receipts from the sale of capital goods of 500 + 100. By the same token, while it shows 300 of demand for labor, it shows only 200 of receipts from the sale of consumers’ goods to wage earners. Thus, while productive expenditure is 900 (500 + 100 + 300), sales revenues are only 800 (500 + 100 + 200). The reason for the disparity, it must be recalled, is that the use of wages to buy capital goods adds to productive expenditure, but does not add to sales revenues; the expenditure for the capital goods merely takes the place of expenditure for consumers’ goods. Because wages themselves are part of productive expenditure, the use of wages to make further productive expenditures has the ability in an extreme case such as the present, to raise productive expenditure above sales revenues.
Thus, in this case, there is again a shortfall of sales revenues relative to productive expenditure in the amount of 100, which represents negative net consumption in the amount of 100 (viz., only 200 of consumption accompanying 300 of wages). But once again, an aggregate profit exists on the strength of net investment — viz., on the strength of costs being below productive expenditure to an extent sufficient to enable them to be below the sales revenues that are below productive expenditure. In Table 16–9, net investment in the amount of 300 is accompanied by profit in the amount of 200. The net investment reflects the fact that while productive expenditure is 900, costs are only 600. Profit is 200, because even though sales revenues are 100 less than productive expenditure, costs are 300 less, which means that costs are 200 less than sales revenues. Thus, in this case, 300 of net investment offsets 100 of negative net consumption and results in an aggregate profit of 200. 51
51. Net investment and profits are 100 larger in Table 16–9 than in Table 16–8 — i.e., 300 and 200 respectively versus 200 and 100 respectively — because the 100 of wage-earner saving is spent for capital goods rather than being hoarded or turned back to business in the form of loans or securities purchases to finance productive expenditure in the following period. In being spent in this way, it adds 100 both to productive expenditure and to sales revenues. In enlarging both productive expenditure and sales revenues by 100 in the face of the same aggregate costs of 600, it adds 100 to both net investment and profits.
It must be stressed that the possibility of negative net consumption is extremely remote to begin with, since most savings of wage earners are used to finance consumption expenditures, such as the purchase of homes or personal automobiles, and to the extent that they are not, are largely or entirely offset by loans to wage earners from business for such purposes. Thus, as a practical matter, as I have already said, it is reasonable to assume that virtually 100 percent of wages has a counterpart in consumption expenditure. Moreover, to the extent that savings are used to finance loans for consumption expenditures, the payment of interest on such loans represents a source of return on savings over and above ordinary net consumption — a source that may be termed secondary net consumption.
This is the case because the use of wages to pay interest on consumer loans not only constitutes consumption expenditure from the perspective of those who pay the interest, and, at the same time, interest income from the perspective of those who receive the interest, but also does not diminish the demand for the products of business. This last is because the recipients of the interest are able to spend the proceeds in buying goods or services from business. Thus the demand for the products of business remains the same, while the total of consumption expenditure and the total of interest income in the economic system are increased.
For example, total wage payments in the economic system could be 300 monetary units, of which the wage earners consume 270 monetary units in buying consumers’ goods from business and pay 30 monetary units in interest on consumers’ loans. The recipients of the 30 in consumers’ interest — who could well be wage earners themselves, insofar as they had saved, and their savings had been lent to consumers — could then expend that 30 in buying consumers’ goods of their own from business. As a result, everything would be the same except that 30 more in consumers’ interest had been paid. The situation would be analogous to the case of the wage earners using part of their wages to employ consumers’ labor — or paying taxes to the government, which uses the proceeds to employ consumers’ labor.
In those cases, the effect is to increase the overall demand for labor while leaving all other spending magnitudes the same. 52 Here, the interest on consumer loans is not at the expense of the profits and interest earned on the capital invested in ordinary business firms, but stands as a further source of net consumption and thus of aggregate profit and interest in the economic system. In fact, insofar as it is equivalent to net income, the payment of such interest constitutes a direct addition to the amount of net consumption in the economic system. This is because it is both consumption and, not being wages, an addition to the amount of consumption in excess of wage payments. 53 (Of course, the rate of interest on consumer loans, like the rate of interest on loans to business firms, is governed by the rate of profit on capital invested in business. This is because investing in business or lending to business is typically an alternative for whoever lends to consumers. At the same time, if additional funds are required for loans to consumers, the sources will most likely be parties presently engaged in these activities.)
However, what is decisive is that even if negative net consumption were to exist, however unlikely that might be, its existence would necessarily be strictly temporary and would be followed by the resumption of a significantly positive rate of net consumption. As the analysis of the next subsection will show, this is because net investment can be indefinitely prolonged. As net investment occurs, the amount of capital invested in the economic system increases. So too, of course, does the volume of accumulated savings, which is comprised both of capital, which is by far its main constituent in any modern economic system, and savings invested in the financing of loans to consumers. In the context of an economic system with an invariable money [i.e., money of invariable value, see pp. 536-540], in which the sales revenues of business have a fixed limit and all other spending magnitudes are also constrained by the fixity of the quantity of money, the increase in accumulated capital and savings is not only an absolute increase, but also an increase relative to consumption expenditure and incomes. In other words, it constitutes an increase in the degree both of capital intensiveness in the economic system and in provision for the future relative to provision for the present. As a result, its effect is to provide the basis for greater and greater consumption expenditure relative to income, which puts an end to all possibility of negative net consumption. 54
The Process of Capital Intensification
A related approach for understanding the process whereby net investment ultimately must disappear under an invariable money [see pp. 536-540], is to observe just how the economic system becomes more capital intensive as the result of a process of saving. At the same time, this will provide further understanding of the fact that any possible negative net consumption that might temporarily exist as the result of saving on the part of wage earners, must also disappear.
This approach requires tracing out the process of capital intensification step by step. This is done in Table 16–10. In this table, the economic system is assumed to begin with an annual aggregate expenditure for consumers’ goods of 500 units of money. The total value of the capital employed in this economic system at all stages of production combined is assumed initially to be 1,000 units of money. This sum is the value of all the land, buildings, fixtures, plant, and equipment of business firms, less accumulated depreciation reserves, plus the value of all the inventories and work in progress that business firms possess. It also includes the quantity of money held by business firms. 66 Please note that what is referred to here is the value of the capital stock of the economic system, not the annual expenditure for capital goods.
The ratio of accumulated capital to consumption, or, more precisely, to the sum of consumption plus net investment, is typically called the capital-output ratio. More correctly, of course, it should be called the capital-net-output ratio, inasmuch as consumption plus net investment represents the net product of the economic system, not the actual total output. 67 Because of the equality between net product and national income, the ratio can also be expressed as the ratio of capital to national income. 68 Its closeness to the ratio of capital to consumption makes it obvious that the so-called capital-output ratio can be taken as a measure of the degree of capital intensiveness in the economic system, alongside the ratios we have mainly used up to now, namely, the ratio of capital to consumption, wages, and sales revenues respectively. 69
What is necessary at this point is to trace out how saving brings about a rise in the capital-net-output ratio from its initial level to a higher level. For the sake of simplicity, the example describes how the ratio is raised from an initial level of 1,000⁄500 to 1,500⁄500, or from 2:1 to 3:1. It should go without saying, that the principles contained in this example are applicable to the process of capital intensification in general, that is, to a rise in the capital-net-output ratio from any given starting level to any other given level, and for any absolute values of consumption expenditure (or consumption expenditure plus net investment) and the capital stock.
The table assumes that the process of capital intensification is brought about by a reduction in consumption expenditure from 500 to 450 for a period of 10 years. It assumes that in each of these 10 years 50 of savings out of net income are invested and added to the preexisting value of the accumulated capital stock, which means that 50 of net investment occurs in each year. It further assumes that once the value of the capital stock has been increased by a cumulative total of 500, so that the ratio of accumulated capital (savings) to income stands at 3:1, people are content with their degree of provision for the future and thus restore their consumption expenditure to 500.
The first column of the table is simply a series of years. The second column, K, presents the amount of accumulated capital year by year; the third, C, the amount of consumer spending year by year; and the fourth, I, the amount of net investment year by year. For the sake of simplicity, I follow my usual practice of assuming that all financial transactions take place on the first day of the year. … Thus, for example, the accumulated capital of 1,050 shown for Year 3 both incorporates the 50 of net investment made in Year 3 and serves in the production of the net output that becomes available at the start of Year 4.
For each year, the fifth column of the table, K/(C+I), presents the ratio of accumulated capital to the so-called net national product (NNP), which, of course, is equal to the sum of consumption plus net investment and to national income. Initially, NNP is equal to 500 of consumption expenditure alone, and will be once again, at the conclusion of the process. But in the interval, as the process of capital intensification takes place, NNP is equal to the sum of 450 of consumption plus 50 of net investment. Because the net product of the economic system comes to be divided into these two portions, 450 of consumption and 50 of net investment, the total accumulated capital stock of the economic system comes to be divided into two corresponding portions: the one portion serving in producing the part of the net product purchased by the consumers, the other portion serving in producing the part of the net product that constitutes net investment.
The division of the capital stock in this way is shown in the last two columns of the table, headed K1/C1 and K2/I1. It should be observed that C1 is the demand for consumers’ goods of the following year, and, accordingly, K1 is the portion of existing accumulated capital employed in the production of consumers’ goods to be sold in the following year. By the same token, I1 is the volume of net investment of the following year, and K2 is the portion of existing accumulated capital employed in the production of the portion of next year’s NNP that is represented by net investment. (This aspect of the table is similar to Figures 16–1 and 16–2, in which the disposition of the factors of production within each year is assumed to conform to the pattern of the relative demands for consumers’ goods and capital goods in the following year. The difference is that now the disposition of the net output in the following year between consumption and net investment is taken in place of the relative demands for consumers’ goods and capital goods, which categories of goods, of course, are the components of gross output. 70)
In Table 16–10, Year 1 represents an initial equilibrium. It shows how the economic system has been operating up to this point. The value of the capital stock is 1,000, the demand for consumers’ goods is 500, and the capital-net-output ratio is 2:1. 71 In Year 2, consumption spending continues to be 500 and saving and net investment continue to be zero. But in this year, the allocation of capital undergoes an important change, in anticipation of the drop in consumption of 50 and emergence of 50 of net investment that is to occur in Year 3, and which will be maintained for a total of 10 years, viz., through Year 12. Accordingly, in Year 2, 100 of capital is transferred from the production of consumers’ goods for Year 3 to the production of the part of the net output of Year 3 that will be represented by net investment. Hence, in Year 2, K1/C1 is 900⁄450 and K2/I1 is 100⁄50. To describe matters in terms of concretes, what will happen in Year 3 is that there will be 50 less of spending for such goods as residential housing and personal automobiles, and 50 more of spending for such goods as factory buildings, trucks, and freighters. Accordingly, in Year 2, 100 of capital is shifted from the production of such goods as residential housing and personal automobiles to the production of such goods as factory buildings, trucks, and freighters.
In Year 3, 50 of saving and net investment occur and result in a rise in the accumulated capital of the economic system from 1,000 to 1,050. This additional 50 of capital is divided between the production of consumers’ goods for Year 4 and the production of the portion of the net output of Year 4 which is represented by net investment; that is, it is divided in the ratio of Year 4’s demand for consumers’ goods to Year 4’s net investment, i.e., in the ratio of 450:50, or 9:1. Thus, 45 of the additional capital is devoted to the production of consumers’ goods of Year 4, and 5 of the additional capital is devoted to the production of the part of the net output of Year 4 that is represented by net investment. Observe that from this point on the employment of capital in the production of consumers’ goods begins rising. Both the production of consumers’ goods and the production of the goods represented by net investment become progressively more capital intensive.
The process of increasing capital intensiveness in the production both of consumers’ goods and the portion of net output represented by net investment continues from Year 3 to Year 11. By Year 11, total capital has risen from 1,000 to 1,450, of which 1,305 are employed in the production of consumers’ goods for Year 12, and 145 in the production of the part of the net output of Year 12 that will constitute net investment. In Year 12, however, the final 50 of additional capital is accumulated, and, at the same time, the allocation of capital is shifted back from the industries producing for net investment and the increase in capital intensiveness to the industries producing consumers’ goods. This is because having achieved the desired higher ratio of accumulated savings to current income by Year 12, people once again consume the whole of their nominal incomes starting in Year 13.
Of course, both the beginning and the end of the process need not be as abrupt as I have described it. There could be a gradual increase in saving and net investment accompanied by a gradual shift in the allocation of capital to the production of goods representing net investment. And the later, reverse movement could be equally gradual. Nor is it necessary that the changes in the consumption/saving pattern be anticipated with the precision I have presented. Any lack of anticipation of the initial shift will result in comparatively higher profits for the capital goods industries and comparatively lower profits for the consumers’ goods industries, because to this extent there will be a greater demand relative to supply in the case of capital goods and a smaller demand relative to supply in the case of consumers’ goods. By the same token, lack of anticipation of the later, reverse shift will result in comparatively higher profits for the consumers’ goods industries and comparatively lower profits for the capital goods industries, because now the opposite imbalance would ensue.
Under all conditions, however, at the end of the process, the net effect is that people end up with greater provision for the future (both absolutely and relatively), production is more capital intensive, the supply of goods is more abundant and can go on increasing more rapidly (thanks to the increased ability to implement technological advances that more capital intensiveness makes possible), and people restore their consumption expenditure in a condition in which they are better able to afford to do so. It thus works out to be the same as for an individual, who first saves and, as a result, later on puts himself in the position of being able to afford to step up his consumption.
And in just this way, any saving on the part of wage earners which did have the effect of bringing about negative net consumption would prove temporary. It would go on only until wage earners had accumulated savings sufficient to enable them to consume the whole of their wages, at which point, everyone in the economic system would be better off than he had been before. (To be sure, the wage earners would not only consume the whole of their wages but the whole of any profits or interest currently earned on the capital they had accumulated.)
It should be realized, although it is not stated explicitly, that the accumulation of capital and savings in the present analysis leads to a reduction in productive expenditure along with the restoration of consumption expenditure, just as in the previous analysis. This fact is present implicitly in the restoration of consumption expenditure and disappearance of net investment.
7. The Inherent Springs to Profitability
This chapter has shown how the productive process generates its own profitability through net consumption and net investment. It has shown how net investment in the context of an economy with an invariable money, in raising the degree of capital intensiveness, lays the foundation for capital accumulation and rising production and thereby an increasing quantity of commodity money. It has shown how this last, in raising the level of spending from year to year, both perpetuates net investment and adds a corresponding positive component to the rate of profit.
What must be realized now is that these sources of profit are virtual springs to profitability, which operate to restore profitability whenever it might temporarily be lacking for any reason (notably, because of a financial contraction and ensuing depression). Insofar as net consumption exists — and it must exist, whenever savings have been accumulated in a sufficient ratio to income and consumption — the only thing which can prevent the existence of an aggregate profit is negative net investment, which certainly cannot be more than a temporary phenomenon. An increasing quantity of money and rising volume of spending, the by-product of capital accumulation and increasing production, also cannot fail to reestablish profitability.
The potential for net investment, which always exists, constitutes an even more powerful spring to profitability, one whose power increases as the prevailing rate of profit decreases. Whenever aggregate profitability is lacking, not only is net investment sufficient to restore it, but, in addition, as I will show, net investment is more and more encouraged by the fact that the lower is the rate of return on capital, the higher is the degree of capital intensiveness that pays, and thus the more powerful is the stimulus to the existence of net investment, as the means of achieving a higher degree of capital intensiveness. Thus, the economic system is so constituted that if the rate of profit should ever become unduly low, or disappear, that very fact encourages a move toward further capital intensiveness and thereby the calling into being of net investment, which restores the rate of profit. Once I have demonstrated these propositions concerning net investment, it will be possible not only better to understand what causes and perpetuates depressions and unemployment, but also to appreciate just how alien such phenomena are to the actual nature of a capitalist economy.
In order to understand the principle of potential additional net investment serving as a spring to profitability, the context of discussion must be carefully defined. The context is the general rate of profit in the economic system as a whole. More than that, it is the general rate of profit in the economic system as a whole as determined apart from changes in the quantity of money and the overall volume of spending. In other words, it is the rate of profit insofar as it is determined by the rate of net consumption and by the rate of net investment apart from changes on the side of money.
The naming of the first proviso, that it is the general rate of profit in the economy as a whole that is under consideration, should make it possible to avoid committing the fallacy of composition and making an invalid generalization from the consequences of a low rate of profit in an individual industry to the consequences of a low rate of profit in the economic system as a whole. In the case of an individual industry, a low rate of profit means a low rate of profit relative to rates of profit in other industries. The effect of this, of course, is to discourage investment in that industry, indeed, to encourage the withdrawal of capital previously invested. But the context under discussion here is … that of a low rate of profit prevailing throughout the economic system. If this is kept in mind, then it will not be difficult to see how in these conditions, a low rate of profit actually works to encourage more capital investment rather than less.
[…] Let us consider, first, the case of a railroad company which is contemplating whether it should construct its line straight through a mountain by digging a tunnel, or detour around the mountain. Digging the tunnel, we assume, constitutes the more-capital-intensive method in that it requires a greater initial capital investment than the alternative. But once in existence, the tunnel would make possible, virtually forever, an annual saving in operating costs, because it would reduce the time required for trains to reach their destination. In reaching its decision, what the railway company considers is how much money the tunnel would potentially save it every year on the basis of savings of train-crew time, fuel consumption, and wear and tear of rolling stock, versus how much more it must invest to construct the tunnel in comparison with the less-capital-intensive detour around the mountain.
The railroad company will decide in favor of the tunnel if the annual savings the tunnel achieves are, when divided by the extra capital its construction requires, greater than the going rate of profit on capital. It will decide against the tunnel if the savings the tunnel achieves are, when divided by the extra capital its construction requires, less than the going rate of profit on capital. For example, imagine that the existence of the tunnel would make possible an annual saving in operating costs of $1 million per year in comparison with the alternative route, and that at the same time, the construction of the tunnel requires $10 million more of capital investment than the alternative route. In this case, the railroad company will decide in favor of the tunnel if the going rate of return on capital is less than 10 percent. It will decide against the tunnel if the going rate of return on capital is more than 10 percent. This is because its investment in the tunnel will yield a rate of return of 10 percent ($1 million per year divided by $10 million). Whether or not this investment should be undertaken depends on a comparison of its profitability with the profitability of other investments. If the profitability of other investments is greater than 10 percent, then the capital that might be devoted to this investment should instead be devoted to them. If, on the other hand, the profitability of other investments is less than 10 percent, then this investment represents the better alternative, and it should be undertaken.
The essential point here is that the lower is the general rate of return on capital, the better does this particular investment appear by comparison. With a general rate of return of greater than 10 percent, this particular investment is submarginal — that is, it is insufficiently profitable to be undertaken. With a general rate of return of 10 percent, it becomes borderline. With a general rate of return of less than 10 percent, it becomes relatively attractive, and more and more so, the further below 10 percent the general rate of return falls. And as the general rate of return falls below 10 percent, still other investments become attractive by comparison. Capital-intensive improvements representing annual savings in cost equal to only 9 percent, 8 percent, 7 percent, and so on, successively become relatively attractive as the general rate of return falls below these levels. And not only in railroading, of course, but in every area of the economic system. In effect, the general rate of return operates as a standard, a test, which each particular capital-intensive improvement must pass in terms of the size of the annual cost reductions it achieves relative to the additional capital it requires. As the general rate of return falls, the standard — the passing grade, as it were — is reduced, with the result that a growing number of capital-intensive investments become relatively profitable, and the degree of capital intensiveness that pays is increased throughout the economic system. Furthermore, what applies to cost reductions applies equally to quality improvements. The additional revenues derived from these, relative to the additional capital that needs to be invested to achieve them, becomes less and less, as the general rate of return falls.
It pays to examine the same principle at work in another example. Thus, imagine a product that can be produced in a given quantity by any of three different methods of production, representing three different degrees of capital intensiveness. (The differences in capital intensiveness can be taken as reflecting different combinations of production by hand or by machine. The most-capital-intensive method uses the most machinery. The least-capital-intensive method uses the least.) We call these three methods, simply, A, B, and C. As shown in Table 16–16, method A is the least capital intensive, but also the most costly. It requires an investment of $10,000 of capital and results in $9,000 of annual costs to produce a given quantity of the product. Method B requires $20,000 of capital to produce the same quantity of the product but enables production to take place at an annual cost of only $8,000. Finally, method C requires $30,000 of capital to produce the same quantity of the product but enables production to take place at the still lower annual cost of only $7,000.
In the conditions of this example, as the revenue derived from the sale of a given quantity of the product declines, and thus, in the face of given costs, reduces profitability, the effect is to favor methods of production of greater capital intensiveness. The stimulus given to methods of greater capital intensiveness is shown in Table 16–16 by the effects on profits and the rate of profit of three different magnitudes of sales revenues. The largest magnitude of sales revenues, $11,000, which appears in the upper portion of the table, in the row labeled “Annual Sales Revenues (1),” is accompanied by profits of $2,000, $3,000, and $4,000 for methods A, B, and C respectively, and thus by corresponding rates of profit of 20 percent, 15 percent, and 131⁄3 percent respectively. These results appear lower in the table, in the respective rows “Annual Profits (1)” and “Annual Rate of Profit (1).” With sales revenues at $11,000, method A, the least-capital-intensive method, is the relatively most profitable.
When sales revenues for the same quantity of product fall to $10,000, the profits of methods A, B, and C, with their respective costs of $9,000, $8,000, and $7,000, fall to $1,000, $2,000, and $3,000, respectively. This results in the three methods of production now earning the same rate of profit on capital, given their respective capital requirements. These results are shown in the rows labeled “Annual Profits (2)” and “Annual Rate of Profit (2).”
When, finally, sales revenues fall to $9,000, as shown in the row labeled “Annual Sales Revenues (3),” the profits of method A are totally eliminated. Method B continues to show a profit of $1,000, which yields a rate of profit of 5 percent on the $20,000 of capital which must be invested in that method. But method C continues to show a profit of $2,000, which represents a rate of profit of 62⁄3 percent on the $30,000 of capital which must be invested in it. By comparison method C, the most capital intensive of the three methods, is now favored. These results appear in the rows labeled “Annual Profits (3)” and “Annual Rate of Profit (3).”
This outcome should in no way be thought paradoxical. What brings it about is the fact that the more-capital-intensive methods are the lower-cost methods. As sales revenues for a given quantity of the product fall, the only way to remain profitable is by achieving lower costs of production. The way to achieve that is by investing more capital. 94
As I have indicated, a lower rate of profit favors more capital intensiveness not only in cases in which more capital intensiveness achieves lower-cost methods of production, but also in cases in which more capital intensiveness achieves a better quality of products. An example which clearly brings out this principle is the case of thirty-year-old scotch versus eight-year-old scotch. Thirty-year-old scotch is a much higher-quality scotch than eight-year-old scotch. Its production also requires the use of substantially more capital per unit of output and is thus correspondingly more capital intensive. If thirty-year-old scotch is to be produced on a regular basis, then for every unit of scotch reaching the market in any particular year, there must be twenty-nine other units, age one through twenty-nine, in the hands of its producers. If eight-year-old scotch is to reach the market on a regular basis, there need be only seven other units — the units age one through seven — in the hands of its producers, for every unit that comes to the market in any given year.
The rate of profit on capital invested is one of the determinants of the prices of goods. And its role is the more pronounced, the more time consuming and capital intensive the production of a product is, and also the higher is the rate of profit. If the rate of profit is 10 percent per year, then for every $100 invested in a quantity of raw scotch, the price of eight-year-old scotch must provide $214, for that is the sum required to yield a 10 percent annual rate of profit on $100 compounded for eight years. By the same token, for every $100 invested in a quantity of raw scotch, the price of thirty-year-old scotch must provide the vastly larger sum of $1,745, because that is the sum required to yield a 10 percent annual rate of profit on $100 compounded for thirty years.
Observe. In this case, with the rate of profit at 10 percent, the thirty-year-old scotch must sell for more than eight times the price of the eight-year-old scotch, so greatly does the 10 percent rate of profit influence its relative price. But now let us see what happens if the rate of profit were 5 percent instead of 10 percent. To yield a rate of profit of 5 percent compounded for eight years, the eight-year-old scotch would have to sell for $148. To yield a 5 percent rate of profit compounded for thirty years, the thirty-year-old scotch would have to sell for $432. In this case, with the rate of profit at 5 percent, the thirty-year-old scotch need sell for only 2.9 times the price of the eight-year-old scotch, instead of more than 8 times the price of the eight-year-old scotch … The lower is the rate of profit, the smaller is the premium which must exist in the price of the older scotch. If the rate of profit were zero, the price of thirty or even one-hundred-year-old scotch would need to be no higher than the price of the eight-year-old scotch.
Now what is significant from the point of view of the present discussion, about the prices of the two scotches moving closer together as the rate of profit falls, is that this development is bound to favor the demand for the older, better-quality scotch. As the premium on this scotch falls, people will be able to give greater and greater consideration to its superior quality. As a result, the share of the market served by this more-capital-intensive product increases, and thus the need is created for the overall degree of capital intensiveness in this industry to go up. […]
The principle here sheds further light on the effects of a fall in the rate of profit on the use of more-capital-intensive methods of production in general. For example, with a rate of profit of 10 percent per year, a machine which costs $1,000 and lasts 10 years, must, if it is to be worthwhile, bring in each year the sum of $150 in the sales revenue of the product it helps to produce. This sum reflects an annual depreciation charge of $100 plus a 10 percent rate of return on the average capital outstanding in the machine over its life, which latter is one half of the initial capital invested, viz., $500. Thus, over its ten-year life, the machine must bring in a revenue over its cost of $500 — i.e., 10 times ($150-$100). But if the rate of profit were 5 percent instead of 10 percent, then the machine would need to bring in each year only $125, and thus, over its ten-year life, only $250 in revenue over its cost. With the reduction in the premium in the revenue from the sale of the product that is required to make a machine pay, the value of the machinery employed in production necessarily tends to increase. And, of course, identically the same principle applies to the value of the buildings employed in production. Thus, the wider principle that capital intensiveness is favored as the rate of profit falls receives further confirmation.
In a very similar way, it can be shown that as the rate of profit falls, the growth of the more-capital-intensive industries in the economic system is favored relatively to the growth of the less-capital-intensive industries … This is shown in Table 16–17. There, Industry A, with a ratio of sales to capital of 10:1, is the least capital intensive. Industry B, with a ratio of sales to capital of 1:1, is more capital intensive. Industry C, with a ratio of sales to capital of only 1:3, is the most capital intensive. (We can think of Industry A as representing supermarkets, which have an extremely rapid turnover of the portion of their capitals that is invested in inventories, and thus a very high overall ratio of sales to capital. Industry B can be taken as representing the automobile industry. And Industry C, finally, can be taken as representing the electric utility industry, almost all of whose capital is invested in power plants and wires underground, both with an extremely long life.)
The fact that these industries have such unequal rates of capital turnover (the sales to capital ratios) requires, of course, that they have correspondingly unequal profit margins — that is, profits as a percentage of sales — if they are all to earn the same rate of profit on capital invested. 95 Thus, in order for Industry A to earn a 10 percent rate of profit on capital invested, it requires a profit margin of only 1 percent. If it earns a profit of a mere 1 percent of sales, but its sales are 10 times its capital, it earns a 10 percent rate of profit on its capital. Industry B needs to earn a profit margin of 10 percent, if, with its 1:1 ratio of sales to capital, it is to earn a 10 percent rate of profit on its capital invested. And, of course, Industry C needs to earn profits on sales of fully 30 percent, if, with its 1:3 ratio of sales to capital, it is to earn a 10 percent rate of profit on its capital invested. All this is shown in the top half of Table 16–17.
The bottom half of Table 16–17 shows the profit margins that are required in the three industries if the rate of profit on capital invested is 5 percent instead of 10 percent. These lower profit margins are ½ percent, 5 percent, and 15 percent, respectively.
Now inasmuch as these lower profit margins are brought about by a fall in the selling prices of the products of the three industries, Table 16–17 implies that a decline in the rate of profit causes a relatively greater reduction in the prices of the products of more-capital-intensive industries than of less-capital-intensive industries. As the rate of profit falls from 10 percent to 5 percent, the price of the product of industry C falls by 15 percent, that of B by 5 percent, that of A by only ½ percent, for these are the extent of the price declines needed to achieve the respective reductions in profit margins. Because of this pattern of price reductions, the demand for the products of more-capital-intensive industries is favored, and therefore the need for capital intensiveness in the economic system is once more increased.
Thus, to summarize, a lower rate of profit on capital invested encourages greater capital intensiveness in the economic system by reducing the cost savings that more-capital-intensive investments must achieve relative to the additional capital required. This was shown in the example of the railroad tunnel. It is also accompanied by a more rapid wiping out of the profit margins of higher-cost, less-capital-intensive methods of production than of the profit margins of lower-cost, more-capital-intensive methods of production, with the result that the more-capital-intensive methods are rendered the comparatively more profitable. This was shown in the example of the three methods of producing the same quantity of the same product. In addition, a lower rate of profit reduces the premiums in price or in revenue that more-capital-intensive products, more capital-intensive-methods of production, and more-capital-intensive industries must bear relative to less-capital-intensive products, methods of production, and industries. This was shown in the example of scotch of different ages, the example of the additional revenue required to make the use of machinery or buildings pay, and, finally, the example of the industries of different degrees of capital intensiveness. In all these ways, a lower rate of profit favors a higher degree of capital intensiveness.
If this principle is understood, then it should now be possible to understand the claim made earlier that if for any reason the rate of profit is wiped out or made unduly low, the basis exists for an automatic restoration of profitability through net investment. All one has to realize is that when confronted with an unduly low rate of profit, businessmen are motivated to divert outlays for factors of production from some of their present lines to lines representing a higher degree of capital intensiveness, because, by comparison, these will appear as more profitable lines. Thus, if most businesses are earning little or no profit with the employment of their present amounts of capital, then what they need is more capital, in order to reduce their annual costs of production and/or to increase their sales revenues by virtue of having improved products to sell. In this situation what will happen is a withdrawal of capital from some of its present lines of employment and diversion to more-capital-intensive lines, as representing a more profitable use of existing capital. For example, unprofitable retail businesses will withdraw some of their capital from the retailing trade and make it available in the loan market, where it will be borrowed and used for the construction of things like additional railway tunnels. At the same time, some of the retailers will merge with one another, in order to carry on business more capital intensively and more economically. Such retailers will themselves probably seek additional capital.
What is present here is a shifting of productive expenditures from points less remote from showing up as costs of production to points more remote from showing up as costs of production, with the result that for a more-or-less-extended period of time a reduction takes place in the costs business subtracts both from its outlays for factors of production and from its sales revenues. 96 This reduction in costs deducted is the reflection of a larger proportion of the output of the economic system being retained within business firms, instead of being turned over to customers in the sale of inventories or lost through depreciation or expensed expenditures. On the one side, it represents the accumulation of assets, which is a hallmark of net investment and the growth in capital intensiveness. On the other side, it represents an increase in profitability. Thus, the effect of the impetus toward additional capital intensiveness is a restoration of business profitability on the strength of the additional net investment entailed.
Of course, as my discussion of the sources of profit has shown, the restoration of profitability achieved by additional net investment is not confined to the existence of that net investment itself. The net investment spring presently under discussion tends to activate the other springs to profitability as well. This is because the higher degree of capital intensiveness that is brought about operates to increase production and thus, in the long run, and indirectly, the rate of increase in the supply of a commodity money. 97 The net investment spring also activates the net consumption spring in that the elimination of negative net investment immediately allows net consumption to generate profits equal to itself. 98 Moreover, in the conditions of recovery from a depression, the accompaniment of the net investment spring is a reduction in the demand for money for holding, which, in the short run, further adds to net investment and the nominal rate of profit, by raising productive expenditure and sales revenues relative to costs.
Wage Rate Rigidities and Blockage of the Springs
Given the existence of the various springs to profitability that have now been explained, the question arises of why the economic system does not in fact always spring back to profitability in the midst of a depression. One part of the answer, of course, is that the process of financial contraction and deflation must first come to an end, so that the financial losses inherent in that process can be avoided. Another essential part of the answer, which is necessary to limit the extent of the financial contraction and deflation, is that there must be a sufficient fall in wage rates. Before the critical net-investment spring can be activated, wage rates must fall to the level required for full employment in the face of the existing demand for money and quantity of money — a demand for money that is greater than it was before the depression, and a quantity of money that is very possibly smaller than it was before the onset of the depression. The demand for money in a depression is greater both because it has been deprived of the stimulus to spending created by inflation and credit expansion, and because of the existence of the process of financial contraction itself, especially when accompanied by bank failures under a fractional reserve banking system, which serve to reduce the quantity of money.
As I explained in Chapter 13, the failure of wage rates to fall to the full-employment point causes a postponement of investment expenditures, and thus a wiping out of net investment and profitability, indeed, causes negative net investment and losses. 99 The operation of the springs to profitability comes into play only when wage rates reach the new, lower level that has become necessary for full employment, thereby eliminating the threat that present investments will be rendered unprofitable by substantial wage-rate reductions in the year or two ahead. At that point, the operation of the springs guarantees the restoration of net investment and profitability.
Capital Intensiveness and the Monetary Component in the Rate of Profit
[…] A question now arises concerning specifically the monetary component that is added to the rate of profit by virtue of the more rapid increase in the supply of commodity money that a higher degree of capital intensiveness brings about. Namely, does the monetary component in the rate of profit operate to reverse the increase in the degree of capital intensiveness that brought it about in the first place, as would a rise in the rate of net consumption or a rise in the rate of net investment brought about by carrying on the process of capital intensification too rapidly?
There is some important evidence for believing that the rise in the rate of profit caused by the monetary component does not have this effect, that it does not react back, as it were, and undermine the higher capital intensiveness on which it rests. This is because there is reason for believing that the relationship between capital intensiveness and the rate of profit pertains exclusively to that portion of the rate of profit that does not reflect the increase in the quantity of money.
The case of the thirty-year-old scotch versus the eight-year-old scotch can be used to perform an intellectual experiment that will demonstrate this point. We have seen how a fall in the rate of profit from 10 percent to 5 percent encouraged capital intensiveness by causing the price of the older scotch to fall to a greater extent than that of the younger scotch and thus to encourage the purchase of the older, more-capital-intensive scotch at the expense of the purchase of the younger, less-capital-intensive scotch. Now what we will do is see if this encouragement to greater capital intensiveness is reversed by virtue of a more rapid rate of increase in the quantity of money that restores the rate of profit to 10 percent.
We saw that the fall in the rate of profit from 10 percent to 5 percent caused the price of the thirty-year-old scotch to fall from $1,745 to $432, while it caused the price of the eight-year-old scotch to fall from $214 to $148. This implied a fall in the ratio of the price of the older to the younger scotch from over 8:1 ($1,745⁄$214) to less than 3:1 ($432⁄$148). The test of whether or not an addition to the rate of profit by virtue of an increase in the quantity of money undermines the higher capital intensiveness on which the increase in the quantity of money rests will be whether or not the change in the relative prices of the two scotches is reversed by the more rapid rate of increase in the quantity of money.
For the sake of simplicity, we can assume that a more rapid rate of increase in the quantity of money takes place that is sufficient fully to restore the rate of profit, namely, to raise it all the way back up to 10 percent from the 5 percent to which it fell on the basis of a reduction in the rate of net consumption. If in raising the rate of profit back up to 10 percent, the increase in the quantity of money raises the ratio of the price of the thirty-year-old scotch to the price of the eight-year-old scotch back to 8:1, then we will have to conclude that the rise in the rate of profit caused by the more rapid increase in the quantity of money that is attributable to greater capital intensiveness does, indeed, work against the capital intensiveness on which it rests. If, on the other hand, we find that the rise in the rate of profit attributable to the more rapid growth in the quantity of money is not accompanied by any rise in the ratio of the price of the thirty-year-old scotch to the price of the eight-year-old scotch, then we must conclude that this kind of rise in the rate of profit does not work against capital intensiveness.
Well, what do we find? We find that if the quantity of money and volume of spending in the economic system now begin to increase at an annual rate of 5 percent (which is what will operate to raise the rate of profit from 5 percent to approximately 10 percent), the price of thirty-year-old scotch tends to be elevated by a factor of 1.0530, which is an increase of 4.32 times. 100 Thus, instead of being $432, it will tend to be $432 x 4.32, or $1,867. By the same token, the price of eight-year-old scotch will tend, in eight years, to be elevated from $148 to $148 x 1.058, or to $218. On this basis, it may appear that the old 8:1 ratio is restored.
But this conclusion would be premature. Because what we must realize is that the more rapid rate of increase in the quantity of money and rise in the volume of spending does not stop its influence on the price of the eight-year-old scotch after eight years. It goes on influencing the price of the eight-year-old scotch year after year. In fact, it influences the price of eight-year-old scotch that will be available in thirty years fully as much as it influences the price of the thirty-year-old scotch that will be available in thirty years. The price of eight-year-old scotch to be available thirty years from now will also tend to be increased by a factor of 1.0530 — that is, by exactly the same factor as the price of the thirty-year-old scotch. Eight-year-old scotch, thirty years from now, will tend to sell for $148 x 4.32, or $639. The thirty year old scotch, at $1,867, is not eight times as expensive, but less than 3 times as expensive ($1,867⁄$639), just as it was with a rate of return of only 5 percent.
What is decisive in bringing about this result is the fact that the more rapid rate of increase in the quantity of money and volume of spending go on acting on the price of the younger scotch year after year. If, on the other hand, the rise in the rate of profit had been the result of a rise in the rate of net consumption, the price of eight-year-old scotch would have been increased, but the price of eight-year-old scotch thirty years from now would not have tended to be any higher than the price of eight-year-old scotch eight years from now. A rise in the rate of profit attributable to a rise in the rate of net consumption would have raised the prices of the eight-year-old and thirty-year-old scotches unequally, for it would have operated on the price of the one for just eight years and on the price of the other for thirty years. 101 But a rise in the rate of profit attributable to a more rapid rate of increase in the quantity of money is accompanied by equivalent percentage increases in both prices, because the more rapid increase in the quantity of money goes on affecting both prices year after year.
Thus, this case shows that the rise in the rate of profit that results from greater capital intensiveness bringing about a more rapid rate of increase in the supply of commodity money does not react back and undermine the higher degree of capital intensiveness. The case must be understood as demonstrating this fact as a general proposition, because every instance of greater or lesser degrees of capital intensiveness represents merely the outlay of sums of money for longer or shorter times in advance of the sale of the product to whose production the sums of money contribute. In other words, every instance of different degrees of capital intensiveness can be conceived of as the scotch case or combinations of the scotch case.
This conclusion can be readily confirmed in such cases as that of the railway tunnel. In cases of this kind, the increase in the quantity of money and volume of spending would operate to increase the annual savings in operating costs to the same extent as they operated to increase the nominal rate of profit, for they would operate to make the wages and prices that constituted the operating costs higher each year by the same percentage as they added to the rate of profit. Thus, in such cases, the higher rate of profit brought about by the increase in the quantity of money would not serve to discourage greater capital intensiveness if the greater capital intensiveness were profitable otherwise.
Nevertheless, I have not yet been able satisfactorily to verify this finding in terms of examples of different methods of production capable of producing the same quantity of a given product, and of industries with different capital turnover ratios. In these cases, looking simply at the examples themselves, it appears that a rise in the rate of profit caused by the addition of a monetary component does operate to discourage capital intensiveness. This is because what is present is a rise in sales revenues relative to costs and thus a favoring of less-capital-intensive methods. In view of the fact that, independently of this, the increase in the quantity of money can be shown to have a substantial effect on the rate of net consumption, and thereby without question to undermine capital intensiveness, it is clearly best if the rate of increase in the quantity of money is moderate, as it would be under a 100-percent-reserve gold standard. 102
APPLICATIONS OF THE INVARIABLE-MONEY/NET-CONSUMPTION ANALYSIS
2. Why Capital Accumulation and the Falling Prices Caused by Increased Production Do Not Imply a Falling Rate of Profit
And just what are the answers to the above two questions concerning whether or not capital accumulation and the falling prices caused by increased production imply a falling rate of profit? On the basis of Figure 17–1, the answers are clearly in the negative. This is because Figure 17–1 shows that in every year, from Year 3 on, while capital goes on accumulating at a rate of 20 percent and prices fall at the inversely proportionate rate of 162⁄3 percent, the rate of profit remains constant at slightly more than 5 percent.
This rate of profit reflects the existence year after year of 1,000 monetary units of sales revenues in the economic system, 900 monetary units of productive expenditure (which is the sum of 600 of demand for capital goods plus 300 of wage payments or demand for labor), and 1,900 of total monetary value of accumulated capital. These data result in an amount of profit of 100 — viz., 1,000 of sales revenues minus 900 of costs generated by the previous year’s productive expenditure. When this amount of profit is divided by the 1,900 of capital, the resulting rate of profit is 5.26 percent.
The value of accumulated capital from Year 3 on is the sum of opening inventories of capital goods with a cost value of 540 and consumers’ goods with a cost value of 360, plus 1,000 units of cash to be paid out. The cost values of 540 and 360 for the opening inventories of capital goods and consumers’ goods derive from the preceding year’s productive expenditure of 900 applied 60 percent to the production of capital goods and 40 percent to the production of consumers’ goods. These cost values, when the goods in question are sold for the 600 annual demand for capital goods and the 400 annual demand for consumers’ goods, imply an annual amount of profit of 100 units of money (100 = 600 – 540 + 400 – 360). As I say, the division of this 100 of profit by the 1,900 of monetary value of accumulated capital then gives an average rate of profit of 5.26 percent.
As promised, Figure 17–1 also contains the explanation of why capital accumulation and the falling prices caused by increased production take place without a fall in the rate of profit. The explanation is that the only fall in the rate of profit that is present is a one-time fall, resulting from the fall in the rate of net consumption from an initial level of 200⁄1,800 in Year 1 to 100⁄1,900 in Year 2 and thereafter, that is, from 11.11 percent to 5.26 percent. (In Year 2, this fall in the rate of net consumption is accompanied by the existence of 100 of net investment. Thus, the fall in the rate of profit to 5.26 percent does not take place until Year 3, with the disappearance of net investment. 4)
The one-time fall in the rate of net consumption is the foundation of a permanent rise in the relative production of capital goods to a level sufficient to achieve capital accumulation. Once the initial increase in the supply of capital goods is achieved in Year 2, on the basis of this rise in their relative production, further increases in the supply of capital goods take place on the basis of the increased productive ability bestowed by the existence of a larger supply of capital goods in the current year compared with the year before. Thus a continually growing relative demand for and production of capital goods, and the continually falling rate of net consumption (and thus rate of profit) that would achieve them, are not required for capital accumulation. On the contrary, the larger supply of capital goods in Year 2 than in Year 1 all by itself makes possible a larger supply of capital goods in Year 3 than in Year 2, and the same holds true mutatis mutandis in all subsequent years.
This is because all by itself the larger supply of capital goods in Year 2 than in Year 1 enlarges the total productive power of Year 2 as compared with Year 1. And thus, with the same relatively greater concentration on the production of capital goods, namely, the 60⁄40 ratio, the greater productive power of Year 2 as compared with Year 1 results in a larger supply of capital goods as well as consumers’ goods becoming available in Year 3 as compared with Year 2. In exactly the same way, the larger supply of capital goods in Year 3 as compared with Year 2 increases the total productive power of Year 3 as compared with Year 2. … And so on, indefinitely, with each year’s larger supply of capital goods as compared with the year before, serving to increase its total productive power as compared with the year before and thus, so long as a sufficiently high relative production of capital goods continues, to further increase the supply of capital goods available in the following year.
As explained in Chapter 14, in order for capital accumulation to continue on the foundation of prior increases in the supply of capital goods, technological progress is necessary. But granted that it is present, capital accumulation continues without any further necessary connection to a fall in the rate of profit. Indeed, Figure 17–1 implies that any further fall in the rate of profit would be the result not of capital accumulation, but of factors working to bring about an acceleration of the rate of capital accumulation — namely, a further fall in the rate of net consumption and corresponding further increase in the relative demand for and production of capital goods.
For example, an acceleration of capital accumulation would be the result of a further fall in net consumption from 100 to 50, and corresponding further rise in the production of capital goods relative to consumers’ goods to a 65:35 ratio, reflecting a 650-demand for capital goods and a 350-demand for consumers’ goods. In these circumstances, the supply of capital goods and the ability to produce would increase at a 30 percent annual rate instead of a 20 percent annual rate. 5
To be sure, if technological progress does not take place, capital accumulation cannot continue in this way. But no significant capital accumulation could then be accomplished in any case, no matter how much the rate of net consumption and the rate of profit might fall. As we have seen, in the absence of technological progress over the course of the last two centuries, no great increase in the supply of capital goods could have occurred — period. As explained in Chapter 14, an economy whose technological limits are described by sailing ships, oxcarts, and forges is simply incapable of accumulating the kind of capital that can be accumulated only on the basis of railroads and steel mills, and then airplanes and petrochemical plants, and the continuing technological progress that all these goods presuppose. 6
Figure 17–1 makes it possible to understand the error of the economists who believe that capital accumulation implies a falling rate of profit. The error consists, at least in part, of thinking only of what is necessary to bring about the first accumulation of additional capital goods in an economy that up to that point has been stationary, and then failing to consider what the effect will be of the possession of those additional capital goods on the subsequent ability to produce capital goods.
This failure to consider the consequences of the possession of more capital goods on the production of capital goods is the result of the habit of most economists of focusing almost exclusively on the production of consumers’ goods, as though all that were produced were consumers’ goods, and as though capital goods came into existence only by the allegedly very different and unrelated process of saving. 7 As I have previously explained, this very bad habit is a result of all the utterly confused notions about aggregate production and aggregate spending that I refuted in Chapter 15, notions which imply that aggregate production and aggregate spending are essentially coextensive with the production of and demand for consumers’ goods alone. 8 This mistaken constellation of ideas leads most economists to believe in effect that all capital accumulation must take place in the same way as it does in Year 2, that is, on the basis of greater saving in the context of an invariable money [see pp. 536-540] and thus on the basis of an increase in the demand for capital goods relative to the demand for consumers’ goods. If that were in fact the only way in which capital accumulation could occur, capital accumulation would imply a falling rate of profit, because then it would almost certainly imply a falling rate of net consumption. 9
That most economists mistakenly believe this is the only way in which capital accumulation occurs is implicit in their assuming that capital accumulation takes place only by virtue of an act of saving in conditions in which all other things are equal. The condition “all other things equal” includes the demand for and supply of money — that is, it necessarily implies the existence of an invariable money. Repeated acts of saving under an invariable money would result in a falling rate of profit. But, as we know, such acts of saving are unnecessary. Each act of saving in such conditions stands in the same relation to capital accumulation as does force to the acceleration of mass in the world of physics. Most economists are unaware of this because they do not carry their analysis to the point of seeing what the effect of the additional capital goods accumulated on the basis of saving is on the further production and supply of capital goods. They do not do this because they do not even stop to realize that capital goods are used to produce capital goods. And they do not do this, in turn, because they are blinded by the mistaken belief that the only goods which are produced are consumers’ goods, whose production allegedly “counts” the total of production, and that it is “double counting” to consider the production of capital goods separately.
Apart from the above constellation of errors, the notion that capital accumulation implies a falling rate of profit is probably the result of nothing more than the fallacy of composition, as described in connection with the discussion of Say’s Law and the consequences of relative overinvestment. 10 Here, the fact that the rate of profit earned in any given industry falls insofar as additional capital investment in it takes place relative to the rest of the economic system, is mistakenly taken as the basis for assuming that additional capital investment in the economic system as a whole reduces the general rate of profit.
The explanation of the ability of prices to fall without the rate of profit being reduced is first of all the fact that what determines the rate of profit under the conditions of an invariable money is the rate of net consumption. So long as the rate of net consumption is the same, then — apart from the temporary role played by net investment — the rate of profit is the same. The fact that production increases and prices fall implies nothing whatever about the rate of profit. In such circumstances, precisely as Figure 17–1 makes it possible to see, an increase in the supply of products is preceded by an equivalent increase in the supply and or productivity of the factors of production used to produce them. This prior equivalent increase in the supply and or productivity of the factors of production implies an equivalent and prior reduction in the average unit costs of production, with the result that when prices fall because of an increase in production, there is no reduction in the rate of profit.
Thus, for example, the supply of products available for sale at the beginning of Year 4 increases in the ratio of 6 to 5 over the supply available at the beginning of Year 3. That is, in Year 4 it is 1.728K of capital goods versus the 1.44K of capital goods of Year 3, which is an increase of 20 percent, and 1.115C of consumers’ goods versus the .96C of consumers’ goods of Year 3, which is also an increase of 20 percent. Given that the respective demands for capital goods and consumers’ goods remain fixed at 600 and 400 monetary units respectively, the inescapable inference is that prices fall in the inverse proportion of 5 to 6. However, it can be clearly seen in Figure 17–1 that this fall in prices does not represent any fall whatsoever in the rate of profit in Year 4 in comparison with Year 3. The rate of profit in both years is 5.26 percent, reflecting 100 of net consumption, and thus 100 of profit, divided by 1,900 of capital.
What happens, as the necessary accompaniment of the increase in production in conditions of an invariable money and a constant rate of net consumption, is that the 20 percent larger supply of capital goods and consumers’ goods in Year 4 in comparison with Year 3, is the result of a preceding 20 percent larger supply of capital goods in Year 3 in comparison with Year 2, and a preceding 20 percent increase in the productivity of labor. That preceding increase in the supply of capital goods (namely, the 1.44K of capital goods of Year 3 versus the 1.2K of capital goods of Year 2) coming in the face of a fixed 600 monetary units of demand for capital goods, implies a preceding fall — back in Year 3 — in the prices of capital goods in the ratio of 5 to 6, the same ratio by which the prices of capital goods and consumers’ goods now fall in Year 4. For the rest, the ability of the same 1L of labor to produce a 20 percent larger supply of goods for sale at the beginning of Year 4 in comparison with the supply available at the beginning of Year 3 implies a 20 percent rise in the average productivity of labor in Year 3 in comparison with Year 2, and thus an inversely proportionate fall in unit labor costs in Year 3 in comparison with Year 2. The reason that unit labor costs fall in this way, is that a rise in the productivity of labor always implies an inversely proportionate fall in the quantity of labor required to produce a unit of product. If the productivity of labor increases by 20 percent — that is, if the same quantity of labor now can produce six-fifths the output as before — the consequence is that the quantity of labor required to produce any given unit of output is now on average only five-sixths as great as before. And thus, as is the case in Figure 17–1, with the same total wages — 300 monetary units — paid to the same total quantity of labor — 1L — and thus unchanged average wage rates, unit labor costs fall to five-sixths of their previous level. Unit labor costs, of course, are nothing but the product of wage rates times the required quantity of labor. With average wage rates the same and the required quantity of labor per unit only five-sixths as great, unit labor costs are five-sixths as great.
Thus, the fall in prices in Year 4 is preceded by a fully equivalent fall in average unit costs of production: both costs on account of capital goods — whose prices fall in the same proportion as the prices of the products they help to produce, and fall first — and costs on account of labor — whose productivity rises in proportion to the larger supply of products it helps to produce, and whose cost per unit of product therefore also falls in the same proportion as the selling prices of the products, and falls first.
Despite the fact that average profit per unit also falls — viz., in the same proportion as the price and unit cost — the result is, of course, that the aggregate amount of profit remains the same. This is because the fall in average profit per unit is precisely offset by the increase in production and supply that causes it and that at the same time is in inverse proportion to it. The result of this is that when the reduced average profit per unit is multiplied by the inversely proportionate larger number of units, the aggregate amount of profit is the same.
And so things can continue in Year 5 and all the other subsequent years, which lack of space makes it impossible actually to show in Figure 17–1. In each year, prices, unit costs, and profits per unit all fall in the ratio of 5 to 6, and, because this is the result of production and supply increasing in the ratio of 6 to 5, the respective arithmetical products of these quantities times the quantity of goods produced and sold — namely, aggregate sales revenues, aggregate costs, and aggregate profits — always remain constant.
Indeed, the fixity of aggregate sales revenues and aggregate costs is the starting point of analysis in most of Figure 17–1, and the constancy of aggregate profit is directly derivable from their fixity. (It is, of course, simply the difference between them.) It is their fixity that accounts for the fall in prices, unit costs, and profits per unit always being in inverse proportion to changes in production and supply, so long as their fixity continues.
It is implicit in the preceding discussion, that nothing whatever depends on any constant rate of increase in production being maintained. It will always work out that the fall in cost per unit — both labor cost per unit and capital-goods cost per unit — will be in proportion to the fall in prices and, of course, will precede the fall in prices inasmuch as the sums giving rise to the costs are expended prior to the receipt of the sales revenues. Thus, if it had happened, for example, that the increase in supply at the beginning of Year 4 in comparison with Year 3 had been only 10 percent instead of 20 percent, that is, that the production of Year 3 had been in the ratio of 11 to 10 to that of Year 2, rather than 6 to 5, then the fall in prices in Year 4 would have been in the ratio of 10 to 11, instead of 5 to 6.
At the same time, in the face of this lesser increase in output relative to the same quantity of labor, the rise in the productivity of labor in Year 3 in comparison with Year 2 would also have been only 10 percent. Thus the fall in unit labor costs would have been in the correspondingly lower ratio of 10 to 11, just as the fall in prices. For now ten-elevenths rather than five-sixths of the previous quantity of labor would have been required to produce any given unit of output, and thus with the same average wage rates (resulting from the constancy of the demand for labor at 300 monetary units and of the supply of labor at 1L), unit labor costs would have been reduced to this, more limited extent.
By the same token, the 20 percent larger supply of capital goods in Year 3 in comparison with Year 2 would have had to be employed with a diminished productivity to result in an increase in output of only 10 percent. The corollary of this diminished productivity of capital goods is a corresponding increase in the quantity of capital goods employed per unit of product. Specifically, if six-fifths the capital goods result in the production of only eleven-tenths the output, it follows both that the output per unit of capital goods has fallen in the ratio of 11 to 12 and that the quantity of capital goods required per unit of output has risen in the inverse ratio of 12 to 11. (A rise in output in the ratio of 11:10, divided by the preceding increase in the supply of capital goods in the ratio of 6:5, implies an output per unit of capital goods of 55:60, which, of course, reduces to 11:12. When the output per unit of capital goods is only eleven-twelfths, twelve-elevenths is the quantity of capital goods required to produce the average unit of output.) Twelve-elevenths the quantity of capital goods per unit of output times five-sixths the prices of capital goods is sixty sixty-sixths, which reduces to ten-elevenths. This is the reduction in the capital-goods cost per unit of output, i.e., the same as the reduction in the price of the product.
In exactly the same way, if the increase in production and supply in Year 4 in comparison with Year 3 had been more than 20 percent, the correspondingly greater fall in prices would have been accompanied by a correspondingly greater productivity of labor and productivity of capital goods, which would have resulted once again in unit costs of production falling to the same extent as selling prices, and falling first.
Thus, the principle here is that the fall in prices and the prior fall in unit costs must always be in the same proportion, when a larger output is sold for a given amount of sales revenues and is produced on the basis of a given outlay of money for factors of production. Selling prices fall because of the division of a constant amount of sales revenues by a larger output. Unit costs fall to precisely the same extent, because of the division of a constant amount of expenditure for factors of production by that same larger output. In terms of Figure 17–1, the relationships are that the price level of any given year equals 1,000 of sales revenues divided by the total output of the year before, which constitutes the supply available for sale at the start of the current year. The unit-cost level of any given year equals 900 of productive expenditure from the year before, divided by that same output. Thus, the more rapidly output increases, the lower becomes the price and unit-cost levels in precisely the same proportion. Aggregate profit meanwhile always remains at 1,000 – 900, that is, at 100, and the average rate of profit at 100⁄1,900. 11
In the context of Figure 17–1, of course, the productive expenditure of any year shows up as the next year’s total costs of production. But the equality of productive expenditure and costs of production does not depend on this. As has been shown, under an invariable money, it tends to exist no matter how the productive expenditures of any given year are distributed with respect to production for future years. Productive expenditure and costs always tend toward equality, so long as the quantity of money and volume of spending in the economic system remain the same. 12
Thus, the rate of profit is totally unaffected by the mere rate of increase in physical production and corresponding rate of fall in prices. So long as sales revenues, productive expenditure, and the amount of capital invested stay the same, the amount and rate of profit remain the same, no matter how rapidly production increases and prices fall. For it is then always merely a question of dividing two unequal expenditures or demands — viz., the demand for products, which constitutes sales revenues, and the demand for factors of production, which constitutes productive expenditure and gives rise to equivalent costs — by more rapidly growing denominators. No matter how rapid the growth in these “supply denominators,” so to speak, and no matter how rapid the fall in prices, there is no effect on the amount of profit, which is the difference between the two “demand numerators,” to coin another expression. And so long as the amount of capital invested is the same, there can also be no difference in the average rate of profit. 13
Once again, in terms of Figure 17–1, the relationships are that the price level of any given year equals 1,000 of sales revenues divided by the total output of the year before — which is the supply of goods available for sale at the start of the current year — while the unit-cost level equals 900 of productive expenditure from the year before, divided by that same total output. The more rapidly output increases, the lower become the price and unit-cost levels in precisely the same proportion, for all that is reflected is the division of 1,000 and 900 by a denominator that is increased in the same proportion in both instances and, indeed, is always exactly the same in both instances. Aggregate profit meanwhile always remains at 1,000 – 900. In sum, where S represents aggregate output (the output of capital goods and consumers’ goods together), the general price level equals 1,000/S, the unit-cost level equals 900/S, and aggregate profit equals 1,000 – 900. The principle, to say it yet again, in somewhat different words, is that profit depends on the difference between the demand numerators, not on the relationship between one of the demand numerators and its supply denominator. That is, profit depends on the difference between the demand for the products of business and the demand for factors of production by business, on sales revenues minus productive expenditure — in a word, on net consumption — not on prices or the change in prices.
Observe that the only fall in the rate of profit implied by Figure 17–1 occurs in Year 3, and that it occurs not as the result of any increase in production and consequent fall in prices, but as the result of the preceding fall in the rate of net consumption and the subsequent elimination of the net investment that took place on the basis of the fall in net consumption. Furthermore, even that one-time fall in the rate of profit, which, it cannot be repeated too often, is in no way caused by the increase in production and fall in prices, would in no way be diminished by any lesser rate of increase in production and fall in prices. If somehow the supply of goods in Year 3 had not increased over the supply in Year 2, prices would not have fallen in Year 3. But the fall in the rate of profit would have been exactly the same. The situation then would merely have been that instead of 1.44K of capital goods and .96C of consumers’ goods having been produced for outlays of 540 and 360 units of money respectively, only 1.2K of capital goods and .8C of consumers’ goods would have been produced for the same outlays. The result would have been exactly the same rise in aggregate costs and fall in the amount and rate of profit but no increase in production or fall in prices, and, of course, no fall in unit costs of production.
Confirmation of Fact That Falling Prices Caused by Increased Production Do Not Constitute Deflation
[…] The only possible associated element which could temporarily make the repayment of debt more difficult is the fall in the rate of net consumption that results in a corresponding one-time reduction in the rate of profit at the same time that it inaugurates the increase in production and fall in prices. In Figure 17–1, this is the fall in the rate of net consumption that takes place in Year 2 and which lowers the rate of profit in Year 3. If interest rates on loans had not been reduced in anticipation of this fall in the rate of profit, repayment of debt would be rendered more difficult until they were. But, as just shown, even this would not be the result of the increase in production and fall in prices and would not be helped in any way if the increase in production and fall in prices were less or altogether nonexistent. It would be strictly the result of the one-time, delimited fall in the rate of net consumption and thus in the rate of profit.
In fact, however, it is likely that in the period of transition to a lower rate of profit, the rate of interest would fall pretty much in pace with the rate of profit, if not in advance of the fall in the rate of profit. For one thing, in reality the fall in the rate of profit resulting from a fall in the rate of net consumption would not be sudden and precipitous, as it is in Figure 17–1. A more or less extended period of time would exist during which net investment would take place, which would both increase the degree of capital intensiveness in the economic system and to a greater or lesser extent offset the fall in the rate of net consumption. And the fall in the rate of net consumption itself would likely be slow and gradual rather than occur all at once in a single year. Thus the decline in the rate of profit would be gradual. As the rate of profit fell, it would be accompanied by a gradual fall in the rate of interest.
In addition, the very fact that the process is the result of a decline in the rate of net consumption and corresponding rise in saving operates to reduce the rate of interest immediately. This is because the rate of interest falls as soon as additional savings appear on the loan market in the face of the prevailing initial rate of profit. Because of this, it is probable that the fall in the rate of interest would actually precede the fall in the rate of profit, which, of course, for its part, would be delayed insofar as net investment went on. In addition, the declining rate of interest would give rise to numerous refinancings, thereby tending to reduce the burden of interest payments throughout the economic system. Thus, in the case of a fall in the rate of profit caused by a fall in the rate of net consumption, there would be no sudden plunge in the rate of profit in the face of a large volume of contractually fixed interest rates geared to a substantially higher rate of profit, which is what occurs in a period of deflation or financial contraction.
Indeed, the very fact that a fall in the rate of net consumption entails a rise in saving and productive expenditure, extensive net investment and the formation of new capital giving rise to a higher degree of capital intensiveness, and makes possible a correspondingly greater availability of credit, characterizes it as the very opposite of a period of deflation or financial contraction. In a deflation or financial contraction, productive expenditure falls, net investment becomes negative, capital values decline, and credit becomes largely unobtainable.
Furthermore, looking now at matters over the longer term, once we recall that a by-product of a growing ability to produce is a growing quantity of commodity money, and the effect on the rate of profit of increases in the quantity of money, it becomes obvious that the falling prices resulting from increasing production are almost certain to be accompanied by a positive addition to the rate of profit. They are also almost certain to be accompanied by a growing ability to repay debt, because of the growing volume of sales revenues taken in by the average seller as the result of the increasing quantity of money. 15 It should always be kept in mind that in the context of economic progress under a system of commodity money, the fall in prices is the result of a combination of circumstances in which there is an increase in money and spending, but in which the increase in production and supply outstrips the increase in money and spending.
At the same time, of course, it also becomes obvious that the fall in the rate of profit that is the accompaniment of launching or accelerating the process of capital accumulation by means of a fall in the rate of net consumption, is in part reversed by that same positive addition to the rate of profit that accompanies increasing production and its by-product an increasing quantity of commodity money. This is because the increasing production and its monetary by-product are the result of the capital accumulation launched by the fall in the rate of net consumption.
More on the Relationship Between Technological Progress and the Rate of Profit
Observe that Figure 17–1 also fully confirms the discussion in Chapter 13 concerning the alleged effects of technological progress on the rate of profit. It makes it possible to see that technological progress does not raise the rate of profit by “increasing the demand for capital,” but rather prevents the fall in prices caused by increasing production from lowering the rate of profit. This is because the actual effect of technological progress is, along with increasing the supply of consumers’ goods, to increase the supply and lower the prices of capital goods and to raise the productivity of labor, both of which, as shown, cause unit costs to fall to the same extent as prices and to do so prior to the fall in prices, so that when prices fall there is no fall in the amount or rate of profit. Indeed, it is only by virtue of increasing the supply of capital goods and/or the productivity of labor that technological progress serves to increase the supply of consumers’ goods. And thus the fall in the prices of consumers’ goods that technological progress is undeniably accountable for is inseparably connected with a preceding fall in the unit costs of production, for which technological progress bears equal responsibility. 16
The only positive connection between technological progress and the rate of profit is by way of the increase in the quantity of commodity money that is the by-product of a growing ability to produce. Insofar as technological progress underlies a growing ability to produce, and thus a growing quantity of commodity money, it is indirectly the source of an addition to the rate of profit, namely, of the monetary component in the rate of profit. Furthermore, insofar as this monetary component is at the same time the net investment component in the rate of profit, technological progress may be said to be the indirect source of net investment and the net investment component in the rate of profit. 17
This last connection is doubly ironic when understood against the backdrop of the prevailing Keynesian fallacies, which regard net investment not only as in no way based on technological progress, but also as requiring technological progress to offset its allegedly negative effects on the rate of profit. The double irony is the fact that the only way in which technological progress does contribute to the rate of profit is precisely in its capacity as the source of net investment, which, far from reducing the rate of profit, represents a major component of the rate of profit. Just as technological progress is not required as an “outlet” for capital goods accumulated merely by means of saving, but is itself the source of capital goods, so in its relation to the increase in the supply of commodity money it is not an outlet for net investment, but is itself the source of net investment. And this net investment, through the contribution it makes to the rate of profit, can in turn be described as providing its own outlet for profitable investment.
Ricardo’s Insights on Capital Accumulation
The fundamental relationship between technological progress and increases in production, on the one side, and the rate of profit, on the other, is clearly understood by Ricardo, who writes:
The rate of profits is never increased by a better distribution of labour, by the invention of machinery, by the establishment of roads and canals, or by any means of abridging labour either in the manufacture or in the conveyance of goods. These are causes which operate on price, and never fail to be highly beneficial to consumers; since they enable them with the same labour, or with the value of the same labour, to obtain in exchange a greater quantity of the commodity to which the improvement is applied; but they have no effect whatever on profit. 18
Ricardo, of course, writes in the context of an invariable money [see pp. 536-540], which for him signifies the employment of the same total quantity of labor in the economic system, while for us it means the expenditure of the same total amount of money to buy newly produced goods. And, of course, he refers to the general or average rate of profit, not to the particular rates of profit of innovators or of those who must compete against the innovators. As we know, technological progress increases the profits of the innovators and decreases the profits of those against whom the innovators compete. What it does not do is raise the general or average rate of profit — the rate of profit that is earned taking innovators and laggards together — except, of course, to the extent that it results in an increase in the supply of commodity money and thus in the volume of spending in the economic system.
With no less remarkable insight, Ricardo implicitly grasps the role of technological progress in capital accumulation and sees that in the context of an invariable money, capital can be accumulated without continuous acts of saving, that is, without continuous increases in productive expenditure and the demand for capital goods relative to the demand for consumers’ goods. In his chapter “Value and Riches, Their Distinctive Properties,” he declares:
From what has been said, it will be seen that the wealth of a country may be increased in two ways: it may be increased by employing a greater portion of revenue in the maintenance of productive labour, which will not only add to the quantity, but to the value of the mass of commodities; or it may be increased without employing any additional quantity of labour, by making the same quantity more productive, which will add to the abundance, but not to the value of commodities.
In the first case, a country would not only become rich, but the value of its riches would increase. It would become rich by parsimony — by diminishing its expenditure on objects of luxury and enjoyment, and employing those savings in reproduction.
In the second case, there will not necessarily be either any diminished expenditure on luxuries and enjoyments, or any increased quantity of productive labour employed, but, with the same labour, more would be produced; wealth would increase, but not value. Of these two modes of increasing wealth, the last must be preferred, since it produces the same effect without the privation and diminution of enjoyments which can never fail to accompany the first mode. Capital is that part of the wealth of a country which is employed with a view to future production, and may be increased in the same manner as wealth. An additional capital will be equally efficacious in the production of future wealth, whether it be obtained from improvements in skill and machinery [viz., technological progress and or a larger previous supply of capital goods], or from using more revenue reproductively [viz, saving]; for wealth always depends on the quantity of commodities produced, without any regard to the facility with which the instruments employed in production may have been procured. 19
All one need do to make these passages fully accord with the views I have been propounding is to substitute for the fixity of the quantity of labor as the basis of an invariable money, the fixity of the quantity of money itself and thus of the total volume of spending to buy newly produced goods. Then it is clear that in such a context, saving — viz., a fall in consumption expenditure and rise in productive expenditure — represents an increase in the monetary value of the capital employed in production, and, if productive expenditure remains at the higher level, an increase in the total cost-value of commodities. This is the way capital accumulation begins in Figure 17–1, when net consumption falls from 200 monetary units to 100 and the rise in productive expenditure increases the cost value of output from 800 to 900 monetary units. It is also clear that capital accumulation can take place without further such saving, as the rest of Figure 17–1 shows. Indeed, Ricardo argued that it is even possible for capital accumulation to take place in the face of smaller aggregate value of capital — in the face of a smaller relative production of capital goods. He writes in his chapter “On Wages”:
Or capital may increase without its value increasing, and even while its value is actually diminishing . . . the addition may be made by the aid of machinery, without any increase, and even with an absolute diminution in the proportional quantity of labor required to produce [the goods constituting capital]. The quantity of capital may increase, while neither the whole together, nor any part of it singly, will have a greater value than before, but may actually have a less. 20
Such a situation can be imagined in terms of the economic system shifting from the conditions of Figure 17–1 to conditions somewhere between those of Figure 17–1 and those of Figure 16–2. In such an intermediate situation, represented, for example, by the demand for capital goods being 550 instead of 600, and total productive expenditure being 850 instead of 900, capital accumulation would continue, though at a less rapid rate than in Figure 17–1. It would be accompanied by a reduction in the total value of accumulated capital and in the total cost value of the output produced. It would also be accompanied by a rise in the amount and rate of profit.
As the next section of this chapter will show, however, there are more or less strict limits to the extent to which capital accumulation is possible in the face of a fall in productive expenditure and the relative demand for capital goods, and thus to the case Ricardo describes. This is because the ability to implement technological advances vitally depends on the relative production of capital goods. 21
The Rate of Profit and the Demand for Money
Preceding discussion has shown repeatedly that as far as the rate of profit is concerned, there is a fundamental distinction between falling prices caused by increasing production and falling prices caused by a falling quantity of money and volume of spending. Essentially, only the latter is associated with a fall in the rate of profit. The former is not. 22
It is also necessary to realize that there is a fundamental distinction with respect to the effect on the demand for money for holding, between a fall in the rate of profit caused by a fall in the quantity of money and volume of spending — i.e., deflation — and a fall in the rate of profit caused by a fall in the rate of net consumption. Only the former operates to raise the demand for money for holding. The latter does not.
There are two reasons for this. First, unlike a fall in the quantity of money and volume of spending, a fall in the rate of net consumption cannot render the rate of profit negative. At most, it can only reduce the rate of profit to a lower positive number. 23 Second, as we have seen, in the nature of the case, a fall in the rate of profit caused by a fall in the rate of net consumption is accompanied by an increase in the supply of savings and thus an increase in the availability of credit. 24 As I showed in Chapter 12, a greater supply of savings and a consequent greater availability of credit operate to reduce the demand for money for holding. It follows that in such an environment, any tendency of a lower rate of return on capital to increase the demand for money for holding, by virtue of reducing the advantages of investing in comparison with holding cash, is necessarily accompanied by offsetting factors that work in the opposite direction. 25
Of course, beyond this, a fall in the rate of net consumption is virtually certain to result in a less than equivalent fall in the rate of profit, because of its indirect effects on the rate of increase in the supply of a commodity money, as we have also seen. 26 Finally, as I will show later in this chapter, the effect of any increase in the demand for money for holding that for any reason might occur is ultimately to raise the rate of net consumption and rate of profit. 27
10. More on Saving and “Hoarding”: “Hoarding” as a Long-Run Cause of a Rise in the Rate of Profit
The fear of saving is perhaps even more widespread than the fear of production. I have already refuted one leading root of this fear, namely, the confusion of an increase in saving with an increase in the demand for money for cash holding. 68 Here it is necessary to add to that critique the observation that to the extent that people do desire to make provision for the future in the form of cash holding rather than in the form of business investment, the long-run effect, contrary to popular belief, is not to reduce, but to increase the rate of profit.
This is because insofar as net consumption takes place in proportion to accumulated savings in the form of cash holdings, a rise in the ratio of cash holdings in the economic system to capital in forms other than cash holdings means a rise in the ratio of net consumption, hence profit, to capital in forms other than cash. For example, if people wished to hold fully half of their accumulated savings in the form of cash and only half in the form of capital invested in assets other than cash, a net-consumption rate of 2 percent would generate an amount of profit equal to 4 percent of the capital invested in assets other than cash. 69 In the most extreme case imaginable, in which all provision for the future took place in the form of cash holding, the rate of profit would be infinite, for there would be a demand for consumers’ goods, hence, the existence of sales revenues, but neither productive expenditure, costs of production, nor capital. The effect on the rate of profit would thus be the same as if people made no provision for the future.
69. To the extent that the cash holdings were outside of business firms, the rate of profit on the whole of the capital invested in business firms, including the cash holdings of business firms, would be correspondingly increased.
“Cash hoarding” operates to reduce the rate of profit only in the short-run, insofar as it represents an increase in the demand for money for holding above its previous level and thereby brings about a decrease in the volume of spending and sales revenues. Here the result is to reduce net investment and, indeed, even to turn it negative. However, once the demand for money for holding stops increasing and stabilizes at the higher level, and the economic system becomes adjusted to the accompanying lower level of spending — viz., once costs deducted from sales revenues fall to equality with the lower level of productive expenditure — then the effect of the rise in the ratio of net consumption to capital other than cash is felt and the rate of profit rises. In other words, the negative effect of cash hoarding on the rate of profit is purely transitory. The long-run effect is to increase the rate of profit.
Implications for the Critique of Keynesianism
That cash hoarding does serve in the long-run to raise the rate of profit provides an answer to the pretended fear of the Keynesians that in a free economy the rate of profit will be too low to make investment worthwhile and will thus lead to a limitless rise in “liquidity preference” — viz., cash hoarding. 70 The answer is that if the rate of profit ever were too low to make investment worthwhile and thus did result in cash hoarding, the effect of such cash hoarding, as we have just seen, would be to restore the rate of profit to a point high enough to make investment worthwhile.
The point I have just made in criticism of the Keynesians bears a mild resemblance to the so-called Pigou effect propounded by the neo-Keynesians, a resemblance which, frankly, embarrasses me, inasmuch as I consider the “Pigou effect” to be extremely weak as a criticism of Keynes. 71 The similarity is simply that both my criticism and the Pigou effect recognize a connection between consumption and accumulated savings in the form of cash holdings and that the existence of this connection has negative implications for essential doctrines of Keynes. The difference is that while the Pigou effect claims merely that because of this connection, consumption expenditure will not fall in full proportion to a fall in wages and prices and thus that at some point a fall in wages and prices is capable of leading to full employment, my criticism here is that every increase in the relative significance of cash holdings operates directly to raise the rate of profit and thus to eliminate the central stumbling block to full employment claimed by the Keynesians, namely, the allegedly too-low rate of profit. However, as I show in Chapter 18, there are other forces operating far more directly and powerfully to raise the rate of profit when wage rates and prices fall, so that it is not at all necessary that the influence of greater relative cash holdings ever come into play. And in fact it would not, since recovery from a depression and the restoration of the rate of profit that is part of that recovery are accompanied by a reduced demand for money for holding, not an increased demand.
Indeed, contrary to the Keynesians, the truth is that apart from some short-term, relatively inconsequential funds that might be held as cash rather than lent out, as the result of a lower rate of profit, the rate of profit in a free economy can never be too low to make investment worthwhile, even in the conditions of an invariable money. This is because in a free economy, the average rate of profit and interest must always be significantly positive, for in such an economy there is no government intervention in money and banking, thus no inflation or credit expansion, and thus no financial contractions or depressions. 72
As we have seen, in the absence of inflation and credit expansion and thus of financial contraction and deflation, a positive rate of profit and interest is guaranteed by virtue of the operation of net consumption and net investment. Even if the saving of wage earners temporarily made net consumption negative, net investment and the consequent accumulation of capital and savings would take place to the point of sufficiently enlarging capital and accumulated savings relative to current income, to render net consumption positive once again. 73 The positive rate of profit that net consumption and net investment guarantee means that investment must be worthwhile. 74 In an economy with a commodity money, which is what any free-market economy would be, and in which, therefore, the rate of profit contains a significant monetary component, the impossibility of the rate of profit being too low to make investment worthwhile is doubly strong.