Rothbard’s Criticism of Keynesianism

Man, Economy, and State, 2nd edition, Murray N. Rothbard.

Chapter 11 – Money and Its Purchasing Power

5. The Demand for Money


One of the most obvious influences on the demand for money is expectation of future changes in the exchange-value of money. Thus, suppose that, at a certain point in the future, the PPM [i.e., purchasing power of the monetary unit] of money is expected to drop rapidly. How the demand-for-money schedule now reacts depends on the number of people who hold this expectation and the strength with which they hold it. It also depends on the distance in the future at which the change is expected to take place. The further away in time any economic event, the more its impact will be discounted in the present by the interest rate. Whatever the degree of impact, however, an expected future fall in the PPM will tend to lower the PPM now. For an expected fall in the PPM means that present units of money are worth more than they will be in the future, in which case there will be a fall in the demand-for-money schedule as people tend to spend more money now than at the future date. A general expectation of an imminent fall in the PPM will lower the demand schedule for money now and thus tend to bring about the fall at the present moment.

Conversely, an expectation of a rise in the PPM in the near future will tend to raise the demand-for-money schedule as people decide to “hoard” (add money to their cash balance) in expectation of a future rise in the exchange-value of a unit of their money. The result will be a present rise in the PPM.

An expected fall in the PPM in the future will therefore lower the PPM now, and an expected rise will lead to a rise now. The speculative demand for money functions in the same manner as the speculative demand for any good. An anticipation of a future point speeds the adjustment of the economy toward that future point. Just as the speculative demand for a good speeded adjustment to an equilibrium position, so the anticipation of a change in the PPM speeds the market adjustment toward that position. Just as in the case of any good, furthermore, errors in this speculative anticipation are “self-correcting.” Many writers believe that in the case of money there is no such self-correction. They assert that while there may be a “real” or underlying demand for goods, money is not consumed and therefore has no such underlying demand. The PPM and the demand for money, they declare, can be explained only as a perpetual and rather meaningless cat-and-mouse race in which everyone is simply trying to anticipate everyone else’s anticipations.

There is, however, a “real” or underlying demand for money. Money may not be physically consumed, but it is used, and therefore it has utility in a cash balance. Such utility amounts to more than speculation on a rise in the PPM. This is demonstrated by the fact that people do hold cash even when they anticipate a fall in the PPM. Such holdings may be reduced, but they still exist, and as we have seen, this must be so in an uncertain world. In fact, without willingness to hold cash, there could be no monetary-exchange economy whatever.

The speculative demand therefore anticipates the underlying nonspeculative demands, whatever their source or inspiration. Suppose, then, that there is a general anticipation of a rise in the PPM (a fall in prices) not reflected in underlying supply and demand. It is true that, at first, this general anticipation raises, ceteris paribus, the demand for money and the PPM. But this situation does not last. For now that a pseudo “equilibrium” has been reached, the speculative anticipators, who did not “really” have an increased demand for money, sell their money (buy goods) to reap their gains. But this means that the underlying demand comes to the fore, and this is less than the money stock at that PPM. The pressure of spending then lowers the PPM again to the true equilibrium point. This may be diagramed as in Figure 77.


Money stock is 0S; the true or underlying money demand is DD, with true equilibrium point at A. Now suppose that the people on the market erroneously anticipate that true demand will be such in the near future that the PPM will be raised to 0E. The total demand curve for money then shifts to DsDs, the new total demand curve including the speculative demand. The PPM does shift to 0E as predicted. But now the speculators move to cash in their gain, since their true demand for money really reflects DD rather than DsDs. At the new price 0E, there is in fact an excess of money stock over quantity demanded, amounting to CF. Sellers rush to sell their stock of money and buy goods, and the PPM falls again to equilibrium. Hence, in the field of money as well as in that of specific goods, speculative anticipations are self-correcting, not “self-fulfilling.” They speed the market process of adjustment.


Long-run influences on the demand for money in a progressing economy will tend to be manifold, and in both directions. On the one hand, an advancing economy provides ever more occasions for new exchanges as more and more commodities are offered on the market and as the number of stages of production increases. These greater opportunities tend greatly to increase the demand-for-money schedule. If an economy deteriorates, fewer opportunities for exchange exist, and the demand for money from this source will fall.

The major long-run factor counteracting this tendency and tending toward a fall in the demand for money is the growth of the clearing system. 8 Clearing is a device by which money is economized and performs the function of a medium of exchange without being physically present in the exchange.

8. On the clearing system, see Mises, Theory of Money and Credit, pp. 281–86.

A simplified form of clearing may occur between two people. For example, A may buy a watch from B for three gold ounces; at the same time, B buys a pair of shoes from A for one gold ounce. Instead of two transfers of money being made, and a total of four gold ounces changing hands, they decide to perform a clearing operation. A pays B two ounces of money, and they exchange the watch and the shoes. Thus, when a clearing is made, and only the net amount of money is actually transferred, all parties can engage in the same transactions at the same prices, but using far less cash. Their demand for cash tends to fall.

There is obviously little scope for clearing, however, as long as all transactions are cash transactions. For then people have to exchange one another’s goods at the same time. But the scope for clearing is vastly increased when credit transactions come into play. These credits may be quite short-term. Thus, suppose that A and B deal with each other quite frequently during a year or a month. Suppose they agree not to pay each other immediately in cash, but to give each other credit until the end of each month. Then B may buy shoes from A on one day, and A may buy a watch from B on another. At the end of the period, the debts are canceled and cleared, and the net debtor pays one lump sum to the net creditor.

Once credit enters the picture, the clearing system can be extended to as many individuals as find it convenient. The more people engage in clearing operations (often in places called “clearinghouses”) the more cancellations there will be, and the more money will be economized. At the end of the week, for example, there may be five people engaged in clearing, and A may owe B ten ounces, B owe C ten ounces, C owe D, etc., and finally E may owe A ten ounces. In such a case, 50 ounces’ worth of debt transactions and potential cash transactions are settled without a single ounce of cash being used.

Clearing, then, is a process of reciprocal cancellations of money debts. It permits a huge quantity of monetary exchanges without actual possession and transfer of money, thereby greatly reducing the demand for money. Clearing, however, cannot be all-encompassing, for there must be some physical money which could be used to settle the transaction, and there must be physical money to settle when there is no 100-percent cancellation (which rarely occurs).


A popular fallacy rejects the concept of “demand for money” because it is allegedly always unlimited. This idea misconceives the very nature of demand and confuses money with wealth or income. It is based on the notion that “people want as much money as they can get.” In the first place, this is true for all goods. People would like to have far more goods than they can procure now. But demand on the market does not refer to all possible entries on people’s value scales; it refers to effective demand, to desires made effective by being “demanded,” i.e., by the fact that something else is “supplied” for it. Or else it is reservation demand, which takes the form of holding back the good from being sold. Clearly, effective demand for money is not and cannot be unlimited; it is limited by the appraised value of the goods a person can sell in exchange and by the amount of that money which the individual wants to spend on goods rather than keep in his cash balance.

Furthermore, it is, of course, not “money” per se that he wants and demands, but money for its purchasing power, or “real” money, money in some way expressed in terms of what it will purchase. (This purchasing power of money, as we shall see below, cannot be measured.) More money does him no good if its purchasing power for goods is correspondingly diluted.


… A man may allocate his money to consumption, investment, or addition to his cash balance. His time preferences govern the proportion which an individual devotes to present and to future goods, i.e., to consumption and to investment. Now suppose a man’s demand-for-money schedule increases, and he therefore decides to allocate a proportion of his money income to increasing his cash balance. There is no reason to suppose that this increase affects the consumption/investment proportion at all. It could, but if so, it would mean a change in his time preference schedule as well as in his demand for money.

If the demand for money increases, there is no reason why a change in the demand for money should affect the interest rate one iota. There is no necessity at all for an increase in the demand for money to raise the interest rate, or a decline to lower it — no more than the opposite. In fact, there is no causal connection between the two; one is determined by the valuations for money, and the other by valuations for time preference.

Let us return to the section in chapter 6 on Time Preference and the Individual’s Money Stock. Did we not see there that an increase in an individual’s money stock lowers the effective time-preference rate along the time-preference schedule, and conversely that a decrease raises the time-preference rate? Why does this not apply here? Simply because we were dealing with each individual’s money stock and assuming that the “real” exchange-value of each unit of money remained the same. His time-preference schedule relates to “real” monetary units, not simply to money itself. If the social stock of money changes or if the demand for money changes, the objective exchange-value of a monetary unit (the PPM) will change also. If the PPM falls, then more money in the hands of an individual may not necessarily lower the time-preference rate on his schedule, for the more money may only just compensate him for the fall in the PPM, and his “real money stock” may therefore be the same as before. This again demonstrates that the money relation is neutral to time preference and the pure rate of interest.

An increased demand for money, then, tends to lower prices all around without changing time preference or the pure rate of interest. Thus, suppose total social income is 100, with 70 allocated to investment and 30 to consumption. The demand for money increases, so that people decide to hoard a total of 20. Expenditure will now be 80 instead of 100, 20 being added to cash balances. Income in the next period will be only 80, since expenditures in one period result in the identical income to be allocated to the next period. 9 If time preferences remain the same, then the proportion of investment to consumption in the society will remain roughly the same, i.e., 56 invested and 24 consumed. Prices and nominal money values and incomes fall all along the line, and we are left with the same capital structure, the same real income, the same interest rate, etc. The only things that have changed are nominal prices, which have fallen, and the proportion of total cash balances to money income, which has increased.

9. Since no one can receive a money income unless someone else makes a money expenditure on his services. (See chapter 3 above.)

A decreased demand for money will have the reverse effect. Dishoarding will raise expenditure, raise prices, and, ceteris paribus, maintain the real income and capital structure intact. The only other change is a lower proportion of cash balances to money income.

The only necessary result, then, of a change in the demand-for-money schedule is precisely a change in the same direction of the proportion of total cash balances to total money income and in the real value of cash balances. Given the stock of money, an increased scramble for cash will simply lower money incomes until the desired increase in real cash balances has been attained.

If the demand for money falls, the reverse movement occurs. The desire to reduce cash balances causes an increase in money income. Total cash remains the same, but its proportion to incomes, as well as its real value, declines. 10

10. Strictly, the ceteris paribus condition will tend to be violated. An increased demand for money tends to lower money prices and will therefore lower money costs of gold mining. This will stimulate gold mining production until the interest return on mining is again the same as in other industries. Thus, the increased demand for money will also call forth new money to meet the demand. A decreased demand for money will raise money costs of gold mining and at least lower the rate of new production. It will not actually decrease the total money stock unless the new production rate falls below the wear-and-tear rate. Cf. Jacques Rueff, “The Fallacies of Lord Keynes’ General Theory” in Henry Hazlitt, ed., The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960), pp. 238–63.


(1) Social Income, Expenditures, and Unemployment

The Keynesian “consumption function” plays its part in establishing an alleged law that there exists a certain level of total income, say A, above which expenditures will be less than income (net hoarding), and below which expenditures will be greater than income (net dishoarding). But the basic Keynesian worry is hoarding, when total income must decline. This situation may be diagramed as in Figure 78.


In this graph, money income is plotted on both the horizontal and the vertical axes. Hence, a 45-degree straight line between the axes is equal to social income. 12 To illustrate: A social income of 100 on the horizontal axis will correspond to, and equal, a social income of 100 on the vertical axis. The coordinates of these figures will meet at a point equidistant between the two axes. The Keynesian law asserts social expenditures to be lower than social income above point A, and higher than social income below point A, so that A will be the equilibrium point for social income to equal expenditure. For if social income is higher than A, social expenditures will be lower than income, and income will therefore tend to decline from one day to the next until the equilibrium point A is reached. If social income is lower than A, dishoarding will occur, expenditures will be higher than income, until finally A is reached again.

Below, we shall investigate the validity of this alleged law and the “consumption function” on which it rests. But suppose that we now grant the validity of such a law; the only comment can be an impertinent: So what? What if there is a fall in the national income? Since the fall need only be in money terms, and real income, real capital, etc., may remain the same, why any alarm? The only change is that the hoarders have accomplished their objective of increasing their real cash balances and increasing the real value of the monetary unit. It is true that the picture is rather more complex for the transition process until equilibrium is reached, and this will be treated further below … But the Keynesian system attempts to establish the perniciousness of the equilibrium position, and this it cannot do. […]

The Keynesian attempt to salvage meaning for their doctrine rests on one point and one point alone — the second major pillar of their system. This is the thesis that money social income and level of employment are correlated, and that the latter is a function of the former. This assumes that a certain “full employment” level of social income exists below which there is correspondingly greater unemployment. This can be diagramed as in Figure 79.


On the previous diagram is superimposed a vertical FF line, which represents the point of alleged “full-employment” social income. If the intersection A is below (to the left of) the FF line, then there is permanent unemployment corresponding to the distance by which A falls short of that line.

Keynesians have also attempted, with little success, to give meaning to an equilibrium position where A falls to the right of the FF line, identifying this with inflation. Inflation, as we shall see below, is a dynamic process, the essence of which is change. The Keynesian system centers around the equilibrium position and therefore is hardly well equipped to analyze an inflationary situation.

The nub of the Keynesian critique of the free market economy, then, rests on the involuntary unemployment allegedly caused by too low a level of social expenditures and income. But how can this be, since we have previously explained that there can be no involuntary unemployment in a free market? The answer has become evident (and is admitted in the most intelligent of the Keynesian writings): The Keynesian “under-employment equilibrium” occurs only if money wage rates are rigid downward, i.e., if the supply curve of labor below “full employment” is infinitely elastic. Thus, suppose there is a “hoarding” (an increased demand for money), and social income falls. The result is a fall in the monetary demand curves for labor factors, as well as in all other monetary demand curves. We would expect the general supply curve of labor factors to be vertical. Since only money wage rates are being changed while real wage rates (in terms of purchasing power) remain the same, there will be no shift in labor/leisure preferences, and the total stock of labor offered on the market will remain constant. At any rate, certainly no involuntary unemployment will arise.

How then can the Keynesian case arise? How can the supply of labor remain horizontal at the old money wage rate? In only two ways: (1) if people voluntarily agree with the unions, which insist that no one be employed at lower than the old money wage rate. Since selling prices are falling, maintaining the old money wage rate is equivalent to demanding a higher real wage rate. We have seen above that the unions’ raising of real wage rates causes unemployment. But this unemployment is voluntary, since the workers acquiesce in the imposition of a higher minimum real wage rate, below which they will not undercut the union and accept employment. Or (2) unions or government coercively impose the minimum wage rate. But this is an example of a hampered market, not the free market to which we are confining our analysis here.

Situation (1) or (2) may be diagramed as in Figure 80.


The original demand curve for labor is DD (for simplicity of exposition we assume as meaningful the concept of “demand for labor” in general). Total stock of labor in the society is 0F, or at least that is the stock put forward upon the market. Now an increase in the demand for money shifts all demand curves downward as all money prices fall. If wage rates are free to fall, the intersection point will move from H to C and nominal wage rates reduced accordingly, from FH to FC. There is still “full employment” at level 0F. Now suppose however, that a union sets a minimum money wage rate of 0B (or FH). Then the supply-of-labor curve becomes BHG; horizontal up to FG and vertical from there on. The new demand curve D’D’ will now intersect the supply of labor at point E instead of point C. Total amount of labor now employed is reduced to BE, and EH are now unemployed as a result of the union action.

Keynes’ own exposition tended to run in terms of real rather than money magnitudes — real social income, real expenditures, etc. Such an analysis obscures dynamic considerations, since transactions take place at least superficially in monetary terms on the market. However, the essential conclusion of our analysis remains unchanged if we pursue it directly in real terms. Instead of falling, demand curves in real terms will now remain the same. This is true for the labor market as well. Instead of being depicted on a diagram as a horizontal line at existing wage rates, the effect of union action would have to be shown as a horizontally imposed increase in real wage rates (the result of keeping money wage rates constant while selling prices fall). The relevant diagram is shown in Figure 81. The facts depicted in this diagram are the same as in the previous diagram: unions causing unemployment (EH) by insisting on an excessively high money (and therefore real) wage (0B).


The sum and substance of the “Keynesian Revolution” was the thesis that there can be an unemployment equilibrium on the free market. As we have seen, the only sense in which this is true was known years before Keynes: that widespread union maintenance of excessively high wage rates will cause unemployment.

Keynes believed that while other elements of the economic system, including prices, were set basically in real terms, workers bargained even ultimately only in terms of money wages — that unions insisted on minimum money wage rates downward, but would passively accept falling real wages in the form of rising prices, money wage rates remaining the same. The Keynesian prescription for eliminating unemployment therefore rests specifically on the “money illusion” — that unions will impose minimum money wage rates, but are too stupid to impose minimum real wage rates per se. Unions, however, have learned about purchasing-power problems and the distinction between money and real rates; indeed, it hardly requires much reasoning ability to grasp this distinction. Ironically, Keynes’ advocacy of inflation based on the “money illusion” rested on the historical experience (which we shall treat more fully below) that, during an inflation, selling prices rise faster than wage rates. Yet an economy in which unions impose minimum wage rates is precisely an economy in which unions will be alive to any losses in their real, as well as their money, wages. Inflation, therefore, cannot be used as a means of duping unions into relieving unemployment. […]

The Keynesians object that to allow rigid money wage rates to become flexible downward would further lower monetary demand for goods, and therefore monetary income. But this completely confuses wage rates with aggregate payroll, or total income going to wages. That the former falls does not mean that the latter falls. On the contrary, total income is, as we have seen, determined by total expenditures in the previous period of time. Lower wage rates will cause the hiring of those made unemployed by the old excessively high wage rates. The fact that labor is now cheaper relatively to land factors will cause investors to expend a greater proportion on labor vis-à-vis land than before. And the employment of unemployed labor increases production and therefore aggregate real income. Furthermore, even if payrolls also decline, prices and wage rates can adjust — but this will be taken up in the next section on liquidity preference.

(2) “Liquidity Preference”

Those Keynesians who recognize the grave difficulties of their system fall back on one last string in their bow — “liquidity preference.” Intelligent Keynesians will concede that involuntary unemployment is a “special” or rare case, and Lindahl goes even further to say that it could be only a short-run and not a long-run equilibrium phenomenon. Neither Modigliani nor Lindahl, however, is thoroughgoing enough in his critique of the Keynesian system, particularly of the “liquidity preference” doctrine.

The Keynesian system, as is quite clear from the mathematical portrayals of it given by its followers, suffers grievously from the mathematical-economic sin of “mutual determination.” The use of mathematical functions, which are reversible at will, is appropriate in physics, where we do not know the causes of the observed movements. Since we do not know the causes, any mathematical law explaining or describing movements will be reversible, and, as far as we are concerned, any of the variables in the function is just as much “cause” as another. In praxeology, the science of human action, however, we know the original cause — motivated action by individuals. This knowledge provides us with true axioms. From these axioms, true laws are deduced. They are deduced step by step in a logical, cause-and-effect relationship. Since first causes are known, their consequent effects are also known. Economics therefore traces unilinear cause-and-effect relations, not vague “mutually determining” relations.

This methodological reminder is singularly applicable to the Keynesian theory of interest. For the Keynesians consider the rate of interest (a) as determining investment and (b) as being determined by the demand for money to hold “for speculative purposes” (liquidity preference). In practice, however, they treat the latter not as determining the rate of interest, but as being determined by it. The methodology of “mutual determination” has completely obscured this sleight of hand. Keynesians might object that all demand and supply curves are “mutually determining” in their relation to price. But this facile assertion is not correct. Demand curves are determined by utility scales, and supply curves by speculation and the stock produced by given labor and land factors, which is ultimately governed by time preferences.

The Keynesians therefore treat the rate of interest, not as they believe they do — as determined by liquidity preference — but rather as some sort of mysterious and unexplained force imposing itself on the other elements of the economic system. Thus, Keynesian discussion of liquidity preference centers around “inducement to hold cash” as the rate of interest rises or falls. According to the theory of liquidity preference, a fall in the rate of interest increases the quantity of cash demanded for “speculative purposes” (liquidity preferences), and a rise in the rate of interest lowers liquidity preference.

The first error in this concept is the arbitrary separation of the demand for money into two separate parts: a “transactions demand,” supposedly determined by the size of social income, and a “speculative demand,” determined by the rate of interest. We have seen that all sorts of influences impinge themselves on the demand for money. But they are only influences working through the value scales of individuals. And there is only one final demand for money, because each individual has only one value scale. There is no way by which we can split the demand up into two parts and speak of them as independent entities. Furthermore, there are far more than two influences on demand. In the final analysis, the demand for money, like all utilities, cannot be reduced to simple determinants; it is the outcome of free, independent decisions on individual value scales. There is, therefore, no “transaction demand” uniquely determined by the size of income.

The “speculative demand” is mysterious indeed. Modigliani explains this “liquidity preference” as follows:

we should expect that any fall in the rate of interest . . . would induce a growing number of potential investors to keep their assets in the form of money, rather than securities; that is to say, we should expect a fall in the rate of interest to increase the demand for money as an asset.

This is subject to the criticism, as we have seen, that the rate of interest is here determining, and is not itself explained by any cause. Furthermore, what does this statement mean? A fall in the rate of interest, according to the Keynesians, means that less interest is being earned from bonds, and therefore there is a greater inducement to hold cash. This is correct (as long as we allow ourselves to think in terms of the interest rate as determining instead of being determined), but highly inadequate. For if a lower interest rate “induces” greater cash holdings, it also induces greater consumption, since consumption also becomes more attractive. In fact, one of the grave defects of the liquidity-preference approach is that the Keynesians never think in terms of three “margins” being decided at once. They think only in terms of two at a time. Hence, Modigliani: “Having made his consumption-saving plan, the individual has to make decisions concerning the assets he owns”; i.e., he then allocates them between money and securities. In other words, people first decide between consumption and saving (in the sense of not consuming); and then they decide between investing and hoarding these savings. But this is an absurdly artificial construction. People decide on all three of their alternatives, weighing one against each of the others. To say that people first decide between consuming and not consuming and then choose between hoarding and investing is just as misleading as to say that people first choose how much to hoard and then decide between consumption and investment. 22

22. See the critique of the Keynesian doctrine by Tjardus Greidanus, The Value of Money (2nd ed.; London: Staples Press, 1950), pp. 194–215, and of the liquidity-preference theory by D.H. Robertson, “Mr. Keynes and the Rate of Interest” in Readings in the Theory of Income Distribution, pp. 439–41. In contrast to Keynes’ famous phrase that the rate of interest is “the reward for parting with liquidity,” Greidanus points out that buying consumers’ goods (or even producers’ goods in Keynes’ sense of “interest”) sacrifices liquidity and yet earns no interest “reward.” Greidanus, Value of Money, p. 211. Also see Hazlitt, Failure of the “New Economics,” pp. 186 ff.

People, therefore, allocate their money among consumption, investment, and hoarding. The proportion between consumption and investment reflects individual time preferences. Consumption reflects desires for present goods, and investment reflects desires for future goods. An increase in the demand-for-money schedule does not affect the rate of interest if the proportion between consumption and investment (i.e., time preference) remains the same.

The rate of interest, we must reiterate, is determined by time preferences, which also determine the proportions of consumption and investment. To think of the rate of interest as “inducing” more or less saving or hoarding is to misunderstand the problem completely. 23

23. Mises, Human Action, pp. 529–30.

Admitting, then, that time preference determines the proportions of consumption and investment and that the demand for money determines the proportion of income hoarded, does the demand for money play a role in determining the interest rate? The Keynesians assert that there is a relation between the rate of interest and a “speculative” demand for cash. Should the schedule of the latter rise, the former rises also. But this is not necessarily true. A greater proportion of funds hoarded can be drawn from three alternative sources: (a) from funds that formerly went into consumption, (b) from funds that went into investment, and (c) from a mixture of both that leaves the old consumption-investment proportion unchanged. Condition (a) will bring about a fall in the rate of interest; condition (b) a rise in the rate of interest, and condition (c) will leave the rate of interest unchanged. Thus hoarding may reflect either a rise, a fall, or no change in the rate of interest, depending on whether time preferences have concomitantly risen, fallen, or remained the same.

The Keynesians contend that the speculative demand for cash depends upon and determines the rate of interest in this way: if people expect that the rate of interest will rise in the near future, then their liquidity preference increases to await this rise. This, however, can hardly be a part of a long-run equilibrium theory, such as Keynes is trying to establish. Speculation, by its very nature, disappears in the ERE, and hence no fundamental causal theory can be based upon it. Furthermore, what is an interest rate? One grave and fundamental Keynesian error is to persist in regarding the interest rate as a contract rate on loans, instead of the price spreads between stages of production. The former, as we have seen, is only the reflection of the latter. A strong expectation of a rapid rise in interest rate means a strong expectation of an increase in the price spreads, or rate of net return. A fall in prices means that entrepreneurs generally expect that factor prices will fall further in the near future than their selling prices. But it requires no Keynesian labyrinth to explain this phenomenon; all we are confronted with is a situation in which entrepreneurs, expecting that factor prices will soon fall, cease investing and wait for this happy event so that their return will be greater. This is not “liquidity preference,” but speculation on price changes. It involves a modification of our previous discussion of the relation between prices and the demand for money, caused by a fact that we shall explore soon in detail, namely, that prices do not change equally and proportionately.

The expectation of falling factor prices speeds up the movement toward equilibrium and hence toward the pure interest relation as determined by time preference. 24

24. Hutt concludes that equilibrium

is secured when all services and products are so priced that they are (i) brought within the reach of people’s pockets (i.e., so that they are purchasable by existing money incomes) or (ii) brought into such a relation to predicted prices that no postponement of expenditure on them is induced. For instance, the products and services used in the manufacture of investment goods must be so priced that anticipated future money incomes will be able to buy the services and depreciation of new equipment or replacement. (Hutt, “Significance of Price Flexibility,” p. 394)

If, for example, unions keep wage rates artificially high, “hoarding” will increase as unions keep wage rates ever higher than the equilibrium rate at which “full employment” can be maintained. This induced hoarding lowers the money demand for factors and increases unemployment still further, but only because of wage-rate rigidity. 25

25. “Postponements (in purchases) arise because it is judged that a cut in costs (or other prices) is less than will eventually have to take place, or because the rate of fall of costs is insufficiently rapid.” Ibid., p. 395.

The final Keynesian bogey is that people may acquire an unlimited demand for money, so that hoards will indefinitely increase. This is termed an “infinite” liquidity preference. And this is the only case in which neo-Keynesians such as Modigliani believe that involuntary unemployment can be compatible with price and wage freedom. The Keynesian worry is that people will hoard instead of buying bonds for fear of a fall in the price of securities. Translating this into more important “natural” terms, this would mean, as we have stated, not investing because of expectation of imminent increases in the natural interest rate. Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite since people must always continue consuming, whatever their expectations. Of necessity, therefore, the demand for money could never be infinite. The existing level of consumption, in turn, will require a certain level of investment. As long as productive activities are continuing, there is no need or possibility of lasting unemployment, regardless of the degree of hoarding. 26

26. As Hutt points out, if we can conceive of a situation of infinitely elastic liquidity preference (and no such situation has ever existed), then “we can conceive of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way.” Ibid., p. 398.

A demand for money to hold stems from the general uncertainty of the market. Keynesians, however, attribute liquidity preference, not to general uncertainty, but to the specific uncertainty of future bond prices. Surely this is a highly superficial and limiting view.

In the first place, this cause of liquidity preference could occur only on a highly imperfect securities market. As Lachmann pointed out years ago in a neglected article, Keynes’ causal pattern — “bearishness” causing “liquidity preference” (demand for cash) and high interest rates — could take place only in the absence of an organized forward or futures market for securities. If such a market existed, both bears and bulls on the bond market

could express their expectations by forward transactions which do not require any cash. Where the market for securities is fully organized over time, the owner of 4% bonds who fears a rise in the rate of interest has no incentive to exchange them for cash, for he can always “hedge” by selling them forward.

Bearishness would cause a fall in forward bond prices, followed immediately by a fall in spot prices. Thus, speculative bearishness would, of course, cause at least a temporary rise in the rate of interest, but accompanied by no increase in the demand for cash. Hence, any attempted connection between liquidity preference, or demand for cash, and the rate of interest, falls to the ground.

The fact that such a securities market has not been organized indicates that traders are not nearly as worried about rising interest rates as Keynes believes. If they were and this fear loomed as an important phenomenon, then surely a futures market would have developed in securities.

Furthermore, as we have seen, interest rates on loans are merely a reflection of price spreads, so that a prediction of higher interest rates really means the expectation of lower prices and, especially, lower costs, resulting in a greater demand for money. And all speculation, on the free market, is self-correcting and speeds adjustment, rather than a cause of economic trouble.

17. Further Fallacies of the Keynesian System


Investment, though the dynamic and volatile factor in the Keynesian system, is also the Keynesian stepchild. Keynesians have differed on the causal determinants of investment. Originally, Keynes determined it by the interest rate as compared with the marginal efficiency of capital, or prospect for net return. The interest rate is supposed to be determined by the money relation; we have seen that this idea is fallacious. Actually, the equilibrium net rate of return is the interest rate, the natural rate to which the bond rate conforms. Rather than changes in the interest rate causing changes in investment, as we have seen before, changes in time preference are reflected in changes in consumption-investment decisions. Changes in the interest rate and in investment are two sides of a coin, both determined by individual valuations and time preferences.

The error of calling the interest rate the cause of investment changes, and itself determined by the money relation, is also adopted by such “critics” of the Keynesian system as Pigou, who asserts that falling prices will release enough cash to lower the interest rate, stimulate investment, and thus finally restore full employment.

Modern Keynesians have tended to abandon the intricacies of the relation between interest and investment and simply declare themselves agnostic on the factors determining investment. They rest their case on an alleged determination of consumption. 70

70. Some Keynesians account for investment by the “acceleration principle” (see below). The Hansen “stagnation” thesis — that investment is determined by population growth, the rate of technological improvement, etc. — seems happily to be a thing of the past.


If Keynesians are unsure about investment, they have, until very recently, been very emphatic about consumption. Investment is a volatile, uncertain expenditure. Aggregate consumption, on the other hand, is a passive, stable “function” of immediately previous social income. Total net expenditures determining and equaling total net income in a period (gross expenditures between stages of production are unfortunately removed from discussion) consist of investment and consumption. Furthermore, consumption always behaves so that below a certain income level consumption will be higher than income, and above that level consumption will be lower. Figure 82 depicts the relations among consumption, investment, expenditure, and social income.


The relation between income and expenditure is the same as shown in Figure 78. Now we see why the Keynesians assume the expenditure curve to have a smaller slope than income. Consumption is supposed to have the identical slope as expenditures; for investment is unrelated to income, as the determinants are unknown. Hence, investment is depicted as having no functional relation to income and is represented as a constant gap between the expenditure and consumption lines.

The stability of the passive consumption function, as contrasted with the volatility of active investment, is a keystone of the Keynesian system. This assumption is replete with so many grave errors that it is necessary to take them up one at a time.

(a) How do the Keynesians justify the assumption of a stable consumption function with the shape as shown above? One route was through “budget studies” — cross-sectional studies of the relation between family income and expenditure by income groups in a given year. Budget studies such as that of the National Resources Committee in the mid-1930’s yielded similar “consumption functions” with dishoardings increasing below a certain point, and hoardings above it (i.e., income below expenditures below a certain point, and expenditures below income above it).

This is supposed to intimate that those doing the “dissaving,” i.e., the dishoarding, are poor people below the subsistence level who incur deficits by borrowing. But how long is this supposed to go on? How can there be a continuous deficit? Who would continue to lend these people the money? It is more reasonable to suppose that the dishoarders are decumulating their previously accumulated capital, i.e., that they are wealthy people whose businesses suffered losses during that year.

(b) Aside from the fact that budget studies are misinterpreted, there are graver fallacies involved. For the curve given by the budget study has no relation whatever to the Keynesian consumption function! The former, at best, gives a cross section of the relation between classes of family expenditure and income for one year; the Keynesian consumption function attempts to establish a relation between total social income and total social consumption for any given year, holding true over a hypothetical range of social incomes. At best, one entire budget curve can be summed up to yield only one point on the Keynesian consumption function. Budget studies, therefore, can in no way confirm the Keynesian assumptions.

(c) Another very popular device to confirm the consumption function reached the peak of its popularity during World War II. This was historical-statistical correlation of national income and consumption for a definite period of time, usually the 1930’s. This correlation equation was then assumed to be the “stable” consumption function. Errors in this procedure were numerous. In the first place, even assuming such a stable relation, it would only be an historical conclusion, not a theoretical law. In physics, an experimentally determined law may be assumed to be constant for other identical situations; in human action, historical situations are never the same, and therefore there are no quantitative constants! Conditions and valuations could change at any time, and the “stable” relationship altered. There is here no proof of a stable consumption function. The dismal record of forecasts (such as those of postwar unemployment) made on this assumption should not have been surprising.

Moreover, a stable relation was not even established. Income was correlated with consumption and with investment. Since consumption is a much larger magnitude than (net) investment, no wonder that its percentage deviations around the regression equation were smaller! Furthermore, income is here being correlated with 80–90 percent of itself; naturally, the “stability” is tremendous. If income were correlated with saving, of similar magnitude as investment, there would be no greater stability in the income-saving function than in the “income-investment function.”

Thirdly, the consumption function is necessarily an ex ante relation; it is supposed to tell how much consumers will decide to spend given a certain total income. Historical statistics, on the other hand, record only ex post data, which give a completely different story. For any given period of time, for example, hoarding and dishoarding cannot be recorded ex post. In fact, ex post, on double-entry accounting records, total social income is always equal to total social expenditures. Yet, in the dynamic, ex ante, sense, it is precisely the divergence between total social income and total social expenditures (hoarding or dishoarding) that plays the crucial role in the Keynesian theory. But these divergences can never be revealed, as Keynesians believe, by study of ex post data. Ex post, in fact, saving always equals investment, and social expenditure always equals social income, so that the ex post expenditure line coincides with the income line. 71

71. See Lindahl, “On Keynes’ Economic System — Part I,” p. 169 n. Lindahl shows the difficulties of mixing an ex post income line with ex ante consumption and spending, as the Keynesians do. Lindahl also shows that the expenditure and income lines coincide if the divergence between expected and realized income affects income and not stocks. Yet it cannot affect stocks, for, contrary to Keynesian assertion, there is no such thing as hoarding or any other unexpected event leading to “unintended increase in inventories.” An increase in inventories is never unintended, since the seller has the alternative of selling the good at the market price. The fact that his inventory increases means that he has voluntarily invested in larger inventory, hoping for a future price rise.

(d) Actually, the whole idea of stable consumption functions has now been discredited, although many Keynesians do not fully realize this fact. In fact, Keynesians themselves have admitted that, in the long run, the consumption function is not stable, since total consumption rises as income rises; and that in the short run it is not stable, since it is affected by all sorts of changing factors. But if it is not stable in the short run and not stable in the long run, what kind of stability does it have? Of what use is it? We have seen that the only really important runs are the immediate and the long-run, which shows the direction in which the immediate is tending. There is no use for some sort of separate “intermediate” situation.

(e) it is instructive to turn now to the reasons that Keynes himself, in contrast to his followers, gave for assuming his stable consumption function. It is a confused exposition indeed. The “propensity to consume” out of given income, according to Keynes, is determined by two sets of factors, “objective” and “subjective.” It seems clear, however, that these are purely subjective decisions, so that there can be no separate objective determinants. In classifying subjective factors, Keynes makes the mistake of subsuming hoarding and investing motivations under categories of separate “causes”: precaution, foresight, improvement, etc. Actually, as we have seen, the demand for money is ultimately determined by each individual for all sorts of reasons, but all tied up with uncertainty; motives for investment are to maintain and increase future standards of living. By a sleight of hand completely unsupported by facts or argument Keynes simply assumes all these subjective factors to be given in the short run, although he admits that they will change in the long run. (If they change in the long run, how can his system yield an equilibrium position?) He simply reduces the subjective motives to current economic organization, customs, standards of living, etc., and assumes them to be given. The “objective factors” (which in reality are subjective, such as time-preference changes, expectations, etc.) can admittedly cause short-run changes in the consumption function (such as windfall changes in capital values). Expectations of future changes in income can affect an individual’s consumption, but Keynes simply asserts without discussion that this factor “is likely to average out for the community as a whole.” Time preferences are discussed in a very confused way, with interest rate and time preference assumed to be apart from and influencing the propensity to consume. Here again, short-run fluctuations are assumed to have little effect, and Keynes simply leaps to the conclusion that the propensity to consume is, in the short run, a “fairly” stable function.

(f) The failure of the consumption-function theory is not only the failure of a specific theory. It is a profound epistemological failure as well. For the concept of a consumption function has no place in economics at all. Economics is praxeological, i.e., its propositions are absolutely true given the existence of the axioms — the basic axiom being the existence of human action itself. Economics, therefore, is not and cannot be “empirical” in the positivist sense, i.e., it cannot establish some sort of empirical hypothesis which could or could not be true, and at best is only true approximately. Quantitative, empirico-historical “laws” are worthless in economics, since they may only be coincidences of complex facts, and not isolable, repeatable laws which will hold true in the future. The idea of the consumption function is not only wrong on many counts; it is irrelevant to economics.

Furthermore, the very term “function” is inappropriate in a study of human action. Function implies a quantitative, determined relationship, whereas no such quantitative determinism exists. People act and can change their actions at any time; no causal, constant, external determinants of action can exist. The term “function” is appropriate only to the unmotivated, repeatable motion of inorganic matter.

In conclusion, there is no reason whatever to assume that at some point, expenditures will be below income, while at lower points it will be above income. Economics does not and cannot know what ex ante expenditure will ever be in relation to income; at any point, it could be equal, or there could be net hoarding or dishoarding. The ultimate decisions are made by the individuals and are not determinable by science. There is, therefore, no stable expenditure function whatever.

America’s Great Depression, Fifth Edition, by Murray N. Rothbard.

Chapter 1 – The Positive Theory of the Cycle


There is one thing the government can do positively, however: it can drastically lower its relative role in the economy, slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment. Reducing its tax-spending level will automatically shift the societal saving-investment–consumption ratio in favor of saving and investment, thus greatly lowering the time required for returning to a prosperous economy. Reducing taxes that bear most heavily on savings and investment will further lower social time preferences. 19 Furthermore, depression is a time of economic strain. Any reduction of taxes, or of any regulations interfering with the free market, will stimulate healthy economic activity; any increase in taxes or other intervention will depress the economy further.

19 Could government increase the investment-consumption ratio by raising taxes in any way? It could not tax only consumption even if it tried; it can be shown (and Prof. Harry Gunnison Brown has gone a long way to show) that any ostensible tax on “consumption” becomes, on the market, a tax on incomes, hurting saving as well as consumption. If we assume that the poor consume a greater proportion of their income than the rich, we might say that a tax on the poor used to subsidize the rich will raise the saving–consumption ratio and thereby help cure a depression. On the other hand, the poor do not necessarily have higher time preferences than the rich, and the rich might well treat government subsidies as special windfalls to be consumed. Furthermore, Harold Lubell has maintained that the effects of a change in income distribution on social consumption would be negligible, even though the absolute proportion of consumption is greater among the poor. See Harry Gunnison Brown, “The Incidence of a General Output or a General Sales Tax,” Journal of Political Economy (April, 1939): 254–62; Harold Lubell, “Effects of Redistribution of Income on Consumers’ Expenditures,” American Economic Review (March, 1947): 157–70.

Chapter 2 – Keynesian Criticisms of the Theory


[…] Keynesians claim that “liquidity preference” (demand for money) may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression. This statement assumes that the rate of interest is determined by “liquidity preference” instead of by time preference; and it also assumes again that the link between savings and investment is very tenuous indeed, only tentatively exerting itself through the rate of interest. But, on the contrary, it is not a question of saving and investment each being acted upon by the rate of interest; in fact, saving, investment, and the rate of interest are each and all simultaneously determined by individual time preferences on the market. Liquidity preference has nothing to do with this matter. Keynesians maintain that if the “speculative” demand for cash rises in a depression, this will raise the rate of interest. But this is not at all necessary. Increased hoarding can either come from funds formerly consumed, from funds formerly invested, or from a mixture of both that leaves the old consumption–investment proportion unchanged. Unless time preferences change, the last alternative will be the one adopted. Thus, the rate of interest depends solely on time preference, and not at all on “liquidity preference.” In fact, if the increased hoards come mainly out of consumption, an increased demand for money will cause interest rates to fall — because time preferences have fallen.

In their stress on the liquidity trap as a potent factor in aggravating depression and perpetuating unemployment, the Keynesians make much fuss over the alleged fact that people, in a financial crisis, expect a rise in the rate of interest, and will therefore hoard money instead of purchasing bonds and contributing toward lower rates. It is this “speculative hoard” that constitutes the “liquidity trap,” and is supposed to indicate the relation between liquidity preference and the interest rate. But the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate — the “profit spread” on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate. What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers’ goods prices falling faster than do consumer goods’ prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned “classical” speculation on price changes. This expectation, far from being an upsetting element, actually speeds up the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from “speculative” hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.

Such intelligent neo-Keynesians as Modigliani concede that only an “infinite” liquidity preference (an unlimited demand for money) will block return to full-employment equilibrium in a free market. 4 But, as we have seen, heavy speculative demand for money speeds the adjustment process. Moreover, the demand for money could never be infinite because people must always continue consuming, on some level, regardless of their expectations. Since people must continue consuming, they must also continue producing, so that there can be adjustment and full employment regardless of the degree of hoarding. The failure to juxtapose hoarding and consuming again stems from the Keynesian neglect of more than two margins at once and their erroneous belief that hoarding only reduces investment, not consumption.

4. Some of the most damaging blows to the Keynesian system have come from friendly, but unsparing, neo-Keynesian sources; e.g., Franco Modigliani, “Liquidity Preference and the Theory of Interest and Money,” in Henry Hazlitt, ed., The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960), pp. 131–84; Erik Lindahl, “On Keynes’ Economic System,” Economic Record (May and November, 1954): 19–32, 159–71. As Hutt sums up:

[T]he apparent revolution wrought by Keynes after 1936 has been reversed by a bloodless counterrevolution conducted unwittingly by higher critics who tried very hard to be faithful. Whether some permanent benefit to our science will have made up for the destruction which the revolution left in its train, is a question which economic historians of the future will have to answer.

W.H. Hutt, “The Significance of Price Flexibility,” in Hazlitt, The Critics of Keynesian Economics., p. 402.

In a brilliant article on Keynesianism and price-wage flexibility, Professor Hutt points out that:

No condition which even distinctly resembles infinite elasticity of demand for money assets has even been recognized, I believe, because general expectations have always envisaged either (a) the attainment in the not too distant future of some definite scale of prices, or (b) so gradual a decline of prices that no cumulative postponement of expenditure has seemed profitable.

But even if such an unlikely demand arose:

If one can seriously imagine [this situation] . . . with the aggregate real value of money assets being inflated, and prices being driven down catastrophically, then one may equally legitimately (and equally extravagantly) imagine continuous price coordination accompanying the emergence of such a position. We can conceive, that is, of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way.


Sophisticated Keynesians now admit that the Keynesian theory of “underemployment equilibrium” does not really apply (as was first believed) to the free and unhampered market: that it assumes, in fact, that wage rates are rigid downward. “Classical” economists have always maintained that unemployment is caused precisely by wage rates not being allowed to fall freely; but in the Keynesian system this assumption has been buried in a mass of irrelevant equations. The assumption is there, nevertheless, and it is crucial. 6 The Keynesian prescription for unemployment rests on the persistence of a “money illusion” among workers, i.e., on the belief that while, through unions and government, they will keep money wage rates from falling, they will also accept a fall in real wage rates via higher prices. Governmental inflation, then, is supposed to eliminate unemployment by bringing about such a fall in real wage rates. In these times of ardent concentration on the cost-of-living index, such duplicity is impossible and we need not repeat here the various undesirable consequences of inflation. 7

6. See Modigliani, “Liquidity Preference and the Theory of Interest and Money,” and Lindahl, “On Keynes’ Economic System,” ibid.
7. See L. Albert Hahn, The Economics of Illusion (New York: Squier, 1949), pp. 50ff., 166ff.

It is curious that even economists who subscribe to a general theory of prices balk whenever the theory is logically applied to wages, the prices of labor services. Marginal productivity theory, for example, may be applied strictly to other factors; but, when wages are discussed, we suddenly read about “zones of indeterminacy” and “bargaining.” 8 Similarly, most economists would readily admit that keeping the price of any good above the amount that would clear the market will cause unsold surpluses to pile up. Yet, they are reluctant to admit this in the case of labor. If they claim that “labor” is a general good, and therefore that wage cuts will injure general purchasing power, it must first be replied that “general labor” is not sold on the market; that it is certain specific labor that is usually kept artificially high and that this labor will be unemployed. It is true, however, that the wider the extent of the artificially high wage rates, the more likely will mass unemployment be. If, for example, only a few crafts manage, by union or government coercion to boost the wage rate in their fields above the free-market rate, displaced workers will move into a poorer line of work, and find employment there. In that case, the remaining union workers have gained their wage increase at the expense of lower wage rates elsewhere and of a general misallocation of productive factors. The wider the extent of the rigid wages, however, the less opportunity there will be to move and the greater will be the extent and duration of the unemployment.

8. Actually, zones of indeterminacy are apt to be wide where only two or three people live on a desert island and narrow progressively the greater the population and the more advanced the economic system. No special zone adheres to the labor contract.

In a free market, wage rates will tend to adjust themselves so that there is no involuntary unemployment, i.e., so that all those desiring to work can find jobs. Generally, wage rates can only be kept above full-employment rates through coercion by government, unions, or both. Occasionally, however, the high wage rates are maintained by voluntary choice (although the choice is usually ignorant of the consequences) or by coercion supplemented by voluntary choice. It may happen, for example, that either business firms or the workers themselves may become persuaded that maintaining wage rates artificially high is their bounden duty. Such persuasion has actually been at the root of much of the unemployment of our time, and this was particularly true in the 1929 depression. Workers, for example, become persuaded of the great importance of preserving the mystique of the union: of union solidarity in “not crossing a picket line,” or not undercutting union wage rates. Unions almost always reinforce this mystique with violence, but there is no gainsaying the breadth of its influence. To the extent that workers, both in and out of the union, feel bound by this mystique, to that extent will they refuse to bid wages downward even when they are unemployed. If they do that, then we must conclude that they are unemployed voluntarily, and that the way to end their unemployment is to convince them that the mystique of the union is morally absurd. 9 However, while these workers are unemployed voluntarily, as a consequence of their devotion to the union, it is highly likely that the workers do not fully realize the consequences of their ideas and actions. The mass of men are generally ignorant of economic truths. It is highly possible that once they discovered that their unemployment was the direct result of their devotion to union solidarity, much of this devotion would quickly wither away.

9. It is immaterial to the argument whether or not the present writer believes the mystique to be morally absurd.

Both workers and businessmen may become persuaded by the mistaken idea that artificial propping of wage rates is beneficial. This factor played a great role in the 1929 depression. As early as the 1920s, “big” businessmen were swayed by “enlightened” and “progressive” ideas, one of which mistakenly held that American prosperity was caused by the payment of high wages (rates?) instead of the other way round. As if other countries had a lower standard of living because their businessmen stupidly refused to quadruple or quintuple their wage rates! By the time of the depression, then, businessmen were ripe for believing that lowering wage rates would cut “purchasing power” (consumption) and worsen the depression (a doctrine that the Keynesians later appropriated and embellished). To the extent that businessmen become convinced of this economic error, they are responsible for unemployment, but responsible, be it noted, not because they are acting “selfishly” and “greedily” but precisely because they are trying to act “responsibly.” Insofar as government reinforces this conviction with cajolery and threat, the government bears the primary guilt for unemployment.

What of the Keynesian argument, however, that a fall in wage rates would not help cure unemployment because it would slash purchasing power and therefore deprive industry of needed demand for its products? This argument can be answered on many levels. In the first place, as prices fall in a depression, real wage rates are not only maintained but increased. If this helps employment by raising purchasing power, why not advocate drastic increases in money wage rates? Suppose the government decreed, for example, a minimum wage law where the minimum was triple the going wage rates? What would happen? Why don’t the Keynesians advocate such a measure?

It is clear that the effect of such a decree would be total mass unemployment and a complete stoppage of the wheels of production. Unless . . . unless the money supply were increased to permit employers to pay such sums, but in that case real wage rates have not increased at all! Neither would it be an adequate reply to say that this measure would “go too far” because wage rates are both costs to entrepreneurs and incomes to workers. The point is that the free-market rate is precisely the one that adjusts wages — costs and incomes — to the full-employment position. Any other wage rate distorts the economic situation. 10

10. Maximum wage controls, such as prevailed in earlier centuries and in the Second World War, created artificial shortages of labor throughout the economy — the reverse of the effect of minimum wages.

The Keynesian argument confuses wage rates with wage incomes — a common failing of the economic literature, which often talks vaguely of “wages” without specifying rate or income. 11 Actually, wage income equals wage rate multiplied by the amount of time over which the income is earned. If the wage rate is per hour, for example, wage rate will equal total wage income divided by the total number of hours worked. But then the total wage income depends on the number of hours worked as well as on the wage rate. We are contending here that a drop in the wage rate will lead to an increase in the total number employed; if the total man-hours worked increases enough, it can also lead to an increase in the total wage bill, or payrolls. A fall in wage rate, then, does not necessarily lead to a fall in total wage incomes; in fact, it may do the opposite. At the very least, however, it will lead to an absorption of the unemployed, and this is the issue under discussion. As an illustration, suppose that we simplify matters (but not too drastically) and assume a fixed “wages fund” which employers can dispense to workers. Clearly, then, a reduced wage rate will permit the same payroll fund to be spread over a greater number of people. There is no reason to assume that total payroll will fall.

11. See Hutt, “The Significance of Price Flexibility,” pp. 390ff.

In actuality, there is no fixed fund for wages, but there is rather a fixed “capital fund” which business pays out to all factors of production. Ultimately, there is no return to capital goods, since their prices are all absorbed by wages and land rents (and interest, which, as the price of time, permeates the economy). Therefore, what business as a whole has at any time is a fixed fund for wages, rents, and interest. Labor and land are perennial competitors. Since production functions are not fixed throughout the economy, a widespread reduction in wage rates would cause business to substitute labor for land, labor now being relatively more attractive vis-à-vis land than it was before. Consequently, aggregate payrolls would not be the same; they would increase, because of the substitution effect in favor of labor as against land. The aggregate demand for labor would therefore be “elastic.” 12

12. Various empirical studies have maintained that the aggregate demand for labor is highly elastic in a depression, but the argument here does not rest upon them. See Benjamin M. Anderson, “The Road Back to Full Employment,” in Paul T. Homan and Fritz Machlup, eds. Financing American Prosperity (New York: Twentieth Century Fund, 1945), pp. 20–21.

Suppose, however, that the highly improbable “worst” occurs, and the demand for labor turns out to be inelastic, i.e., total payrolls decline as a result of a cut in wage rates. What then? First, such inelasticity could only be due to businesses holding off from investing in labor in expectation that wage rates will fall further. But the way to meet such speculation is to permit wage rates to fall as quickly and rapidly as possible. A quick fall to the free-market rate will demonstrate to businessmen that wage rates have fallen their maximum viable amount. Not only will this not lead businesses to wait further before investing in labor, it will stimulate businesses to hurry and invest before wage rates rise again. The popular tendency to regard speculation as a commanding force in its own right must be avoided; the more astute as forecasters and diviners of the economy the businessmen are, the more they will “speculate,” and the more will their speculation spur rather than delay the natural equilibrating forces of the market. For any mistakes in speculation — selling or buying goods or services too fast or too soon — will directly injure the businessmen themselves. Speculation is not self-perpetuating; it depends wholly and ultimately on the underlying forces of natural supply and consumer demand, and it promotes adjustment to those forces. If businessmen overspeculate in inventory of a certain good, for example, the piling up of unsold stock will lead to losses and speedy correction. Similarly, if businessmen wait too long to purchase labor, labor “shortages” will develop and businessmen will quickly bid up wage rates to their “true” free-market rates. Entrepreneurs, we remember, are trained to forecast the market correctly; they only make mass errors when governmental or bank intervention distorts the “signals” of the market and misleads them on the true state of underlying supply and demand. There is no interventionary deception here; on the contrary, we are discussing a return to the free market after a previous intervention has been eliminated.

If a quick fall in wage rates ends and even reverses withholding of the purchase of labor, a slow, sluggish, downward drift of wage rates will aggravate matters, because (a) it will perpetuate wages above free market levels and therefore perpetuate unemployment; and (b) it will stimulate withholding of labor purchases, thereby tending to aggravate the unemployment problem even further.

Second, whether or not such speculation takes place, there is still no reason why unemployment cannot be speedily eliminated. If workers do not hold out for a reserve price because of union pressure or persuasion, unemployment will disappear even if total payroll has declined.

The following diagram will illustrate this process: (see Figure 1). Quantity of Labor is on the horizontal axis; wage rate on the vertical. DLDL is the aggregate demand for Labor; IE is the total stock of labor in the society; that is, the total supply of labor seeking work. The supply of labor is represented by vertical line SLSL rather than by the usual forward-sloping supply curve, because we may abstain from any cutting of hours due to falling wage rates, and more important, because we are investigating the problem of involuntary unemployment rather than voluntary. Those who wish to cut back their hours, or quit working altogether when wage rates fall, can hardly be considered as posing an “unemployment problem” to society, and we can therefore omit them here.


In a free market, the wage rate will be set by the intersection of the labor supply curve SLSL and the demand curve DLDL, or at point E or wage rate 0I. The labor stock IE will be fully employed. Suppose, however, that because of coercion or persuasion, the wage rate is kept rigid so that it does not fall below 0A. The supply of labor curve is now changed: it is now horizontal over AC, then rises vertically upward, CSL. Instead of intersecting the demand for labor at point E the new supply of labor curve intersects it at point B. This equilibrium point now sets the minimum wage rate of 0A, but only employs AB workers, leaving BC unemployed. Clearly, the remedy for the unemployment is to remove the artificial prop keeping the supply of labor curve at AC, and to permit wage rates to fall until full-employment equilibrium is reached. 13

13. See Hutt, “The Significance of Price Flexibility,” p. 400.

Now, the critic might ask: suppose there is not only speculation that will speed adjustment, but speculation that overshoots its mark. The “speculative demand for labor” can then be considered to be DSDS, purchasing less labor at every wage rate than the “true” demand curve requires. What happens? Not unemployment, but full employment at a lower wage rate, 0J. Now, as the wage rate falls below underlying market levels, the true demand for labor becomes ever greater than the supply of labor; at the new “equilibrium” wage the gap is equal to GH. The enormous pressure of this true demand leads entrepreneurs to see the gap, and they begin to bid up wage rates to overcome the resulting “shortage of labor.” Speculation is self correcting rather than self aggravating, and wages are bid up to the underlying free-market wage 0I.

If speculation presents no problems whatever and even helps matters when wage rates are permitted to fall freely, it accentuates the evils of unemployment as long as wages are maintained above free-market levels. Keeping wage rates up or only permitting them to fall sluggishly and reluctantly in a depression sets up among businessmen the expectation that wage rates must eventually be allowed to fall. Such speculation lowers the aggregate demand curve for labor, say to DSDS. But with the supply curve of labor still maintained horizontally at AC, the equilibrium wage rate is pushed farther to the left at F. and the amount employed reduced to AF, the amount unemployed increased to FC. 14

14. Note that, in Figure 1, the SL SL line stops before reaching the horizontal axis. Actually, the line must stop at the wage yielding the minimum subsistence income. Below that wage rate, no one will work, and therefore, the supply curve of labor will really be horizontal, on the free market, at the minimum subsistence point. Certainly it will not be possible for speculative withholding to reduce wage rates to the subsistence level, for three reasons: (a) this speculative withholding almost always results in hoarding, which reduces prices all-round and which will therefore reduce the equilibrium money wage rate without reducing the equilibrium real wage rate — the relevant rate for the subsistence level, (b) entrepreneurs will realize that their speculation has overshot the mark long before the subsistence level is reached; and (c) this is especially true in an advanced capitalist economy, where the rates are far above subsistence.

Thus, even if total payrolls decline, freely falling wage rates will always bring about a speedy end to involuntary unemployment. The Keynesian linkage of total employment with total monetary demand for products implicitly assumes rigid wage rates downward; it therefore cannot be used to criticize the policy of freely-falling wage rates. But even if full employment is maintained, will not the declining demand further depress business? There are two answers to this. In the first place, what has happened to the existing money supply? We are assuming throughout a given quantity of money existing in the society. This money has not disappeared. Neither, for that matter, has total monetary spending necessarily declined. If total payrolls have declined, something else has gone up: the total retained by entrepreneurs, or by investors, for example. In fact, given the total money supply, the total flow of monetary spending will only decline if the social demand for money has increased. In other words, if “hoarding” has increased. But an increase in hoarding, in total demand for money, is, as we have seen, no social calamity. In response to the needs and uncertainties of depression, people desire to increase their real cash balances, and they can only do so, with a given amount of total cash, by lowering prices. Hoarding, therefore, lowers prices all around, but need exert no depressing effect whatever upon business. 15 Business, as we have pointed out, depends for its profitability on price differentials between factor and selling prices, not upon general price levels. 16 Decrease or increase in total monetary spending is, therefore, irrelevant to the general profitability of business.

15. On the other hand, wage rates maintained above the free-market level will discourage investment and thereby tend to increase hoarding at the expense of saving–investment. This decline in the investment–consumption ratio aggravates the depression further. Freely declining wage rates would permit investments to return to previous proportions, thus adding another important impetus to recovery. See Frederic Benham, British Monetary Policy (London: P.S. King and Son, 1932), p. 77.
16. It has often been maintained that a failing price level injures business firms because it aggravates the burden of fixed monetary debt. However, the creditors of a firm are just as much its owners as are the equity shareholders. The equity shareholders have less equity in the business to the extent of its debts. Bond-holders (long-term creditors) are just different types of owners, very much as preferred and common stock holders exercise their ownership rights differently. Creditors save money and invest it in an enterprise, just as do stockholders. Therefore, no change in price level by itself helps or hampers a business; creditor–owners and debtor–owners may simply divide their gains (or losses) in different proportions. These are mere intra-owner controversies.

Finally, there is the Keynesian argument that wage earners consume a greater proportion of their income than landlords or entrepreneurs, and therefore that a decreased total wage bill is a calamity because consumption will decline and savings increase. In the first place, this is not always accurate. It assumes (1) that the laborers are the relatively “poor” and the nonlaborers the relative “rich,” and (2) that the poor consume a greater proportion of their income than the rich. The first assumption is not necessarily correct. The President of General Motors is, after all, a “laborer,” and so also is Mickey Mantle; on the other hand, there are a great many poor landlords, farmers, and retailers. Manipulating relations between wage earners and others is a very clumsy and ineffective way of manipulating relations between poor and rich (provided we desire any manipulation at all). The second assumption is often, but not necessarily, true, as we have seen above. As we have also seen, however, the empirical study of Lubell indicates that a redistribution of income between rich and poor may not appreciably affect the social consumption–saving proportions. But suppose that all these objections are waved aside for the moment, and we concede for the sake of argument that a fall in total payroll will shift the social proportion against consumption and in favor of saving. What then? But this is precisely an effect that we should highly prize. For, as we have seen, any shift in social time preferences in favor of saving and against consumption will speed the advent of recovery, and decrease the need for a lengthy period of depression readjustment. Any such shift from consumption to savings will foster recovery. To the extent that this dreaded fall in consumption does result from a cut in wage rates, then, the depression will be cured that much more rapidly.

A final note: The surplus “quantity of labor” caused by artificially high wage rates is a surplus quantity of hours worked. This can mean (1) actual unemployment of workers, and/or (2) reduction in working time for employed workers. If a certain number of labor hours are surplus, workers can be discharged outright, or many more can find their weekly working time reduced and their payroll reduced accordingly. The latter scheme is often advanced during a depression, and is called “spreading the work.” Actually, it simply spreads the unemployment. Instead of most workers being fully employed and others unemployed, all become under-employed. Universal adoption of this proposal would render artificial wage maintenance absurd, because no one would be really benefitting from the high wage rates. Of what use are continuing high hourly wage rates if weekly wage rates are lower? The hour-reduction scheme, moreover, perpetuates underemployment. A mass of totally unemployed is liable to press severely on artificial wage rates, and out-compete the employed workers. Securing a greater mass of under-employed prevents such pressure — and this, indeed, is one of the main reasons that unions favor the scheme. In many cases, of course, the plea for shorter hours is accompanied by a call for higher hourly wage rates to “keep weekly take-home pay the same”; this of course is a blatant demand for higher real wage rates, accompanied by reduced production and further unemployment as well.

Reduction of hours to “share the work” will also reduce everyone’s real wage rate and the general standard of living, for production will not only be lower but undoubtedly far less efficient, and workers all less productive. This will further widen the gap between the artificially maintained wage rate and the free-market wage rate, and hence further aggravate the unemployment problem.

Chapter 3 – Some Alternative Explanations of Depression: A Critique


The “underconsumption” theory is extremely popular, but it occupied the “underworld” of economics until rescued, in a sense, by Lord Keynes. It alleges that something happens during the boom — in some versions too much investment and too much production, in others too high a proportion of income going to upper-income groups — which causes consumer demand to be insufficient to buy up the goods produced. Hence, the crisis and depression. There are many fallacies involved in this theory. In the first place, as long as people exist, some level of consumption will persist. Even if people suddenly consume less and hoard instead, they must consume certain minimum amounts. Since hoarding cannot proceed so far as to eliminate consumption altogether, some level of consumption will be maintained, and therefore some monetary flow of consumer demand will persist. There is no reason why, in a free market, the prices of all the various factors of production, as well as the final prices of consumer goods, cannot adapt themselves to this desired level. Any losses, then, will be only temporary in shifting to the new consumption level. If they are anticipated, there need be no losses at all.

Second, it is the entrepreneurs’ business to anticipate consumer demand, and there is no reason why they cannot predict the consumer demand just as they make other predictions, and adjust the production structure to that prediction. The underconsumption theory cannot explain the cluster of errors in the crisis. Those who espouse this theory often maintain that production in the boom outruns consumer demand; but (1) since we are not in Nirvana, there will always be demand for further production, and (2) the unanswered question remains: why were costs bid so high that the product has become unprofitable at current selling prices? The productive machine expands because people want it so, because they desire higher standards of living in the future. It is therefore absurd to maintain that production could outrun consumer demand in general.

One common variant of the underconsumption theory traces the fatal flaw to an alleged shift of relative income to profits and to the higher-income brackets during a boom. Since the rich presumably consume less than the poor, the mass does not then have enough “purchasing-power” to buy back the expanded product. We have already seen that: (1) marginally, empirical research suggests a doubt about whether the rich consume less, and (2) there is not necessarily a shift from the poor to the rich during a boom. But even granting these assumptions, it must be remembered that: (a) entrepreneurs and the rich also consume, and (b) that savings constitute the demand for producers’ goods. Savings, which go into investment, are therefore just as necessary to sustain the structure of production as consumption. Here we tend to be misled because national income accounting deals solely in net terms. Even “gross national product” is not really gross by any means; only gross durable investment is included, while gross inventory purchases are excluded. It is not true, as the underconsumptionists tend to assume, that capital is invested and then pours forth onto the market in the form of production, its work over and done. On the contrary, to sustain a higher standard of living, the production structure — the capital structure — must be permanently “lengthened.” As more and more capital is added and maintained in civilized economies, more and more funds must be used just to maintain and replace the larger structure. This means higher gross savings, savings that must be sustained and invested in each higher stage of production. Thus, the retailers must continue buying from the wholesalers, the wholesalers from the jobbers, etc. Increased savings, then, are not wasted, they are, on the contrary, vital to the maintenance of civilized living standards.

Underconsumptionists assert that expanding production exerts a depressing secular effect on the economy because prices will tend to fall. But falling prices are not depressant; on the contrary, since falling prices due to increased investment and productivity are reflected in lower unit costs, profitability is not at all injured. Falling prices simply distribute the fruits of higher productivity to all the people. The natural course of economic development, then, barring inflation, is for prices to fall in response to increased capital and higher productivity. Money wage rates will also tend to fall, because of the increased work the given money supply is called upon to perform over a greater number of stages of production. But money wage rates will fall less than consumer goods prices, and as a result economic development brings about higher real wage rates and higher real incomes throughout the economy. Contrary to the underconsumption theory, a stable price level is not the norm, and inflating money and credit in order to keep the “price level” from falling can only lead to the disasters of the business cycle. 4

4. We often come across the argument that the money supply must be increased “in order to keep up with the increased supply of goods.” But goods and money are not at all commensurate, and the entire injunction is therefore meaningless. There is no way that money can be matched with goods.

If underconsumption were a valid explanation of any crisis, there would be depression in the consumer goods industries, where surpluses pile up, and at least relative prosperity in the producers’ goods industries. Yet, it is generally admitted that it is the producers’, not the consumers’ goods industries that suffer most during a depression. Underconsumptionism cannot explain this phenomenon, while Mises’s theory explains it precisely. 56 Every crisis is marked by malinvestment and undersaving, not underconsumption.

5. For a brilliant critique of underconsumptionism by an Austrian, see F.A. Hayek, “The ‘Paradox’ of Saving,” in Profits, Interest, and Investment (London: Routledge and Kegan Paul, 1939), pp. 199–263. Hayek points out the grave and neglected weaknesses in the capital, interest, and production–structure theory of the underconsumptionists Foster and Catchings. Also see Phillips, et al., Banking and the Business Cycle, pp. 69–76.

6. The Keynesian approach stresses underspending rather than underconsumption alone; on “hoarding,” the Keynesian dichotomization of saving and investment, and the Keynesian view of wages and unemployment, see above.


There is only one way that the underconsumptionists can try to explain the problem of greater fluctuation in the producers’ than the consumer goods’ industries: the acceleration principle. The acceleration principle begins with the undeniable truth that all production is carried on for eventual consumption. It goes on to state that, not only does demand for producers’ goods depend on consumption demand, but that this consumers’ demand exerts a multiple leverage effect on investment, which it magnifies and accelerates. The demonstration of the principle begins inevitably with a hypothetical single firm or industry: assume, for example, that a firm is producing 100 units of a good per year, and that 10 machines of a certain type are needed in its production. And assume further that consumers demand and purchase these 100 units. Suppose further that the average life of the machine is 10 years. Then, in equilibrium, the firm buys one new machine each year to replace the one worn out. Now suppose that there is a 20 percent increase in consumer demand for the firm’s product. Consumers now wish to purchase 120 units. If we assume a fixed ratio of capital to output, it is now necessary for the firm to have 12 machines. It therefore buys two new machines this year, purchasing a total of three machines instead of one. Thus, a 20 percent increase in consumer demand has led to a 200 percent increase in demand for the machine. Hence, say the accelerationists, a general increase in consumer demand in the economy will cause a greatly magnified increase in the demand for capital goods, a demand intensified in proportion to the durability of the capital. Clearly, the magnification effect is greater the more durable the capital good and the lower the level of its annual replacement demand.

Now, suppose that consumer demand remains at 120 units in the succeeding year. What happens now to the firm’s demand for machines? There is no longer any need for firms to purchase any new machines beyond those necessary for replacement. Only one machine is still needed for replacement this year; therefore, the firm’s total demand for machines will revert, from three the previous year, to one this year. Thus, an unchanged consumer demand will generate a 200 percent decline in the demand for capital goods. Extending the principle again to the economy as a whole, a simple increase in consumer demand has generated far more intense fluctuations in the demand for fixed capital, first increasing it far more than proportionately, and then precipitating a serious decline. In this way, say the accelerationists, the increase of consumer demand in a boom leads to intense demand for capital goods. Then, as the increase in consumption tapers off, the lower rate of increase itself triggers a depression in the capital goods industries. In the depression, when consumer demand declines, the economy is left with the inevitable “excess capacity” created in the boom. The acceleration principle is rarely used to provide a full theory of the cycle; but it is very often used as one of the main elements in cycle theory, particularly accounting for the severe fluctuations in the capital-goods industries.

The seemingly plausible acceleration principle is actually a tissue of fallacies. We might first point out that the seemingly obvious pattern of one replacement per year assumes that one new machine has been added in each of the ten previous years; in short, it makes the highly dubious assumption that the firm has been expanding rapidly and continuously over the previous decade. 7

7. Either that, or such an expansion must have occurred in some previous decade, after which the firm — or whole economy — lapsed into a sluggish stationary state.

This is indeed a curious way of describing an equilibrium situation; it is also highly dubious to explain a boom and depression as only occurring after a decade of previous expansion. Certainly, it is just as likely that the firm bought all of its ten machines at once — an assumption far more consonant with a current equilibrium situation for that firm. If that happened, then replacement demand by the firm would occur only once every decade. At first, this seems only to strengthen the acceleration principle. After all, the replacement-denominator is now that much less, and the intensified demand so much greater. But it is only strengthened on the surface. For everyone knows that, in real life, in the “normal” course of affairs, the economy in general does not experience zero demand for capital, punctuated by decennial bursts of investment. Overall, on the market, investment demand is more or less constant during near-stationary states. But if, overall, the market can iron out such rapid fluctuations, why can’t it iron out the milder ones postulated in the standard version of the acceleration principle?

There is, moreover, an important fallacy at the very heart of the accelerationists’ own example, a fallacy that has been uncovered by W.H. Hutt. 8
We have seen that consumer demand increases by 20 percent — but why must the two extra machines be purchased in a year? What does the year have to do with it? If we analyze the matter closely, we find that the year is a purely arbitrary and irrelevant unit even within the terms of the example itself. We might just as well take a week as the time period. Then we would aver that consumer demand (which, after all, goes on continuously) increases 20 percent over the first week, thus necessitating a 200 percent increase in demand for machines in the first week (or even an infinite increase if replacement does not occur in the first week) followed by a 200 percent (or infinite) decline in the next week, and stability thereafter. A week is never used by the accelerationists because the example would then clearly not apply to real life, which does not see such enormous fluctuations in the course of a couple of weeks, and the theory could certainly not then be used to explain the general business cycle. But a week is no more arbitrary than a year. In fact, the only non-arbitrary time-period to choose would be the life of the machine (e.g. ten years). 9
Over a ten-year period, demand for machines had previously been ten and in the current and succeeding decades will be ten plus the extra two, e.g., 12: in short, over the ten-year period, the demand for machines will increase in precisely the same proportion as the demand for consumer goods — and there is no ramification effect whatever. Since businesses buy and produce over planned periods covering the lives of their equipment, there is no reason to assume that the market will not plan production accordingly and smoothly, without the erratic fluctuations manufactured by the accelerationists’ model. There is, in fact, no validity in saying that increased consumption requires increased production of machines immediately; on the contrary, it is increased saving and investment in machines, at points of time chosen by entrepreneurs strictly on the basis of expected profitability, that permits future increased production of consumer goods. 10

8. See his brilliant critique of the acceleration principle in W.H. Hutt, “Coordination and the Price System” (unpublished, but available from the Foundation for Economic Education, Irvington-on-Hudson, New York, 1955) pp. 73–117.
9. This is not merely the problem of a time lag necessary to produce the new machines; it is the far broader question of the great range of choice of the time period in which to make the investment. But this reminds us of another fallacy made by the accelerationists: that production of the new machines is virtually instantaneous.
10. The accelerationists habitually confuse consumption with production of consumer goods, and talk about one when the other is relevant.

There are other erroneous assumptions made by the acceleration principle. Its postulate of a fixed capital–output ratio, for example, ignores the ever-present possibility of substitution, more or less intensive working of different factors, etc. It also assumes that capital is finely divisible, ignoring the fact that investments are “lumpy,” and made discontinuously, especially those in a fixed plant.

[…] No mention whatever is made of the price system or of entrepreneurship. Considering the fact that all production on the market is run by entrepreneurs operating under the price system, this omission is amazing indeed. It is difficult to see how any economic theory can be taken seriously that completely omits the price system from its reckoning. A change in consumer demand will change the prices of consumer goods, yet such reactions are forgotten, and monetary and physical terms are hopelessly entwined by the theory without mentioning price changes. The extent to which any entrepreneur will invest in added production of a good depends on its price relations — on the differentials between its selling price and the prices of its factors of production. These price differentials are interrelated at each stage of production. If, for example, monetary consumer demand increases, it will reveal itself to producers of consumer goods through an increase in the price of the product. If the price differential between selling and buying prices is raised, production of this good will be stimulated. If factor prices rise faster than selling prices, production is curtailed, however, and there is no effect on production if the prices change pari passus. Ignoring prices in a discussion of production, then, renders a theory wholly invalid.

Apart from neglecting the price system, the principle’s view of the entrepreneur is hopelessly mechanistic. The prime function of the entrepreneur is to speculate, to estimate the uncertain future by using his judgment. But the acceleration principle looks upon the entrepreneur as blindly and automatically responding to present data (i.e., data of the immediate past) rather than estimating future data. Once this point is stressed, it will be clear that entrepreneurs, in an unhampered economy, should be able to forecast the supposed slackening of demand and arrange their investments accordingly. If entrepreneurs can approximately forecast the alleged “acceleration principle,” then the supposed slackening of investment demand, while leading to lower activity in those industries, need not be depressive, because it need not and would not engender losses among businessmen. Even if the remainder of the principle were conceded, therefore, it could only explain fluctuations, not depression — not the cluster of errors made by the entrepreneurs.
If the accelerationists claim that the errors are precisely caused by entrepreneurial failure to forecast the change, we must ask, why the failure? In Mises’s theory, entrepreneurs are prevented from forecasting correctly because of the tampering with market “signals” by government intervention. But here there is no government interference, the principle allegedly referring to the unhampered market. Furthermore, the principle is far easier to grasp than the Mises theory. There is nothing complex about it, and if it were true, then it would be obvious to all entrepreneurs that investment demand would fall off greatly in the following year. Theirs, and other people’s, affairs would be arranged accordingly, and no general depression or heavy losses would ensue. Thus, the hypothetical investment in seven-year locust equipment may be very heavy for one or two years, and then fall off drastically in the next years. Yet this need engender no depression, since these changes would all be discounted and arranged in advance. This cannot be done as efficiently in other instances, but certainly entrepreneurs should be able to foresee the alleged effect. In fact, everyone should foresee it; and the entrepreneurs have achieved their present place precisely because of their predictive ability. The acceleration principle cannot account for entrepreneurial error. 11

11. The “Cobweb Theorem” is another doctrine built on the assumption that all entrepreneurs are dolts, who blindly react rather than speculate and succeed in predicting the future.

One of the most important fallacies of the acceleration principle is its wholly illegitimate leap from the single firm or industry to the overall economy. Its error is akin to those committed by the great bulk of Anglo-American economic theories: the concentration on only two areas — the single firm or industry, and the economy as a whole. Both these concentrations are fatally wrong, because they leave out the most important areas: the interrelations between the various parts of the economy. Only a general economic theory is valid — never a theoretical system based on either a partial or isolated case, or on holistic aggregates, or on a mixture of the two. 12

12. Anglo-American economics suffers badly from this deficiency. The Marshallian system rested on a partial theory of the “industry,” while modern economics fragments itself further to discuss the isolated firm. To remedy this defect, Keynesians and later econometric systems discuss the economy in terms of a few holistic aggregates. Only the Misesian and Walrasian systems are truly general, being based themselves on interrelated individual exchanges. The Walrasian scheme is unrealistic, consisting solely of a mathematical analysis of an unrealizable (though important) equilibrium system.

In the case of the acceleration principle, how did the 20 percent increase in consumption of the firm’s product come about? Generally, a 20 percent increase in consumption in one field must signify a 20 percent reduction of consumption somewhere else. In that case, of course, the leap from the individual to the aggregate is peculiarly wrong, since there is then no overall boom in consumption or investment. If the 20 percent increase is to obtain over the whole economy, how is the increase to be financed? We cannot simply postulate an increase in consumption; the important question is: how can it be financed? What general changes are needed elsewhere to permit such an increase? These are questions that the accelerationists never face. Setting aside changes in the supply or demand for money for a moment, increased consumption can only come about through a decrease in saving and investment. But if aggregate saving and investment must decrease in order to permit an aggregate increase in consumption, then investment cannot increase in response to rising consumption; on the contrary, it must decline.
The acceleration principle never faces this problem because it is profoundly ignorant of economics — the study of the working of the means–ends principle in human affairs. Short of Nirvana, all resources are scarce, and these resources must be allocated to the uses most urgently demanded by all individuals in the society. This is the unique economic problem, and it means that to gain a good of greater value, some other good of lesser value to individuals must be given up. Greater aggregate present consumption can only be acquired through lowered aggregate savings and investment. In short, people choose between present and future consumption, and can only increase present consumption at the expense of future, or vice versa. But the acceleration principle neglects the economic problem completely and disastrously.

The only way that investment can rise together with consumption is through inflationary credit expansion — and the accelerationists will often briefly allude to this prerequisite. But this admission destroys the entire theory. It means, first, that the acceleration principle could not possibly operate on the free market. That, if it exists at all, it must be attributed to government rather than to the working of laissez-faire capitalism. But even granting the necessity of credit expansion cannot save the principle. For the example offered by the acceleration principle deals in physical, real terms. It postulates an increased production of units in response to increased demand. But if the increased demand is purely monetary, then prices, both of consumer and capital goods, can simply rise without any change in physical production — and there is no acceleration effect at all. In short, there might be a 20 percent rise in money supply, leading to a 20 percent rise in consumption and in investment — indeed in all quantities — but real quantities and price relations need not change, and there is no magnification of investment, in real or monetary terms. The same applies, incidentally, if the monetary increase in investment or consumption comes from dishoarding rather than monetary expansion.

It might be objected that inflation does not and cannot increase all quantities proportionately, and that this is its chief characteristic. Precisely so. But proceed along these lines, and we are back squarely and firmly in the Austrian theory of the trade cycle — and the acceleration principle has been irretrievably lost. The Austrian theory deals precisely with the distortions of market adjustment to consumption–investment proportions, brought about by inflationary credit expansion. 13 Thus, the accelerationists maintain, in effect, that the entrepreneurs are lured by increased consumption to overexpand durable investments. But the Austrian theory demonstrates that, due to the effect of inflation on prices, even credit expansion can only cause malinvestment, not “overinvestment.” Entrepreneurs will overinvest in the higher stages, and underinvest in the lower stages, of production. Total investment is limited by the total supply of savings available, and a general increase in consumption signifies a decrease in saving and therefore a decline in total investment (and not an increase or even magnified increase, as the acceleration principle claims).14 Furthermore, the Austrian theory shows that the cluster of entrepreneurial error is caused by the inflationary distortion of market interest rates. 15

13. Another defect of the accelerationist explanation of the cycle is its stress on durable capital equipment as the preeminently fluctuating activity. Actually, as we have shown above, the boom is not characterized by an undue stress on durable capital; in fact, such non-durable items as industrial raw materials fluctuate as strongly as fixed capital goods. The fluctuation takes place in producers’ goods industries (the Austrian emphasis) and not just durable producers’ goods (the accelerationist emphasis).
14. See Hutt, “Coordination and the Price System,” p. 109.
15. The acceleration principle also claims to explain the alleged tendency of the downturn in capital goods to lead downturns in consumer goods activity. However, it could only do so, even on its own terms, under the very special — and almost never realized — assumption that the sale of consumer goods describes a sine-shaped curve over the business cycle. Other possible curves give rise to no leads at all.
On the acceleration principle, also see L. Albert Hahn, Common Sense Economics (New York: Abelard–Schuman, 1956), pp. 139–43; Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949), pp. 581–83; and Simon S. Kuznets, “Relation Between Capital Goods and Finished Products in the Business Cycle,” in Economic Essays in Honor of Wesley C. Mitchell (New York: Columbia University Press, 1935), pp. 209–67.

This entry was posted in Economics and tagged . Bookmark the permalink.