Economics in One Lesson Part 6

The belief that they do so rests on a series of delusions. One of these is the fallacy of post hoc ergo propter hoc post hoc ergo propter hoc, which sees the enormous rise in wages in the last half century, due princ.i.p.ally to the growth of capital investment and to scientific and technological advance, and ascribes it to the unions because the unions were also growing during this period. But the error most responsible for the delusion is that of considering merely what a rise of wages brought about by union demands means in the short run for the particular workers who retain their jobs, while failing to trace the effects of this advance on employment, production and the living costs of all workers, including those who forced the increase. to the growth of capital investment and to scientific and technological advance, and ascribes it to the unions because the unions were also growing during this period. But the error most responsible for the delusion is that of considering merely what a rise of wages brought about by union demands means in the short run for the particular workers who retain their jobs, while failing to trace the effects of this advance on employment, production and the living costs of all workers, including those who forced the increase.

One may go further than this conclusion, and raise the question whether unions have not, in the long run and for the whole body of workers, actually prevented real wages from rising to the extent to which they otherwise might have risen. They have certainly been a force working to hold down or to reduce wages if their effect, on net balance, has been to reduce labor productivity; and we may ask whether it has not been so.

With regard to productivity there is something to be said for union policies, it is true, on the credit side. In some trades they have insisted on standards to increase the level of skill and competence. And in their early history they did much to protect the health of their members. Where labor was plentiful, individual employers often stood to make short-run gains by speeding up workers and working them long hours in spite of ultimate ill effects upon their health, because they could easily be replaced with others. And sometimes ignorant or shortsighted employers might even reduce their own profits by overworking their employees. In all these cases the unions, by demanding decent standards, often increased the health and broader welfare of their members at the same time as they increased their real wages.

But in recent years, as their power has grown, and as much misdirected public sympathy has led to a tolerance or endors.e.m.e.nt of antisocial practices, unions have gone beyond their legitimate goals. It was a gain, not only to health and welfare, but even in the long run to production, to reduce a seventy-hour week to a sixty-hour week. It was a gain to health and leisure to reduce a sixty-hour week to a forty-eight-hour week. It was a gain to leisure, but not necessarily to production and income, to reduce a forty-eight-hour week to a forty-four-hour week. The value to health and leisure of reducing the working week to forty hours is much less, the reduction in output and income more clear. But the unions now talk about, and sometimes enforce, thirty-five and thirty-hour weeks, and deny that these can or need reduce output or income. It was a gain to leisure, but not necessarily to production and income, to reduce a forty-eight-hour week to a forty-four-hour week. The value to health and leisure of reducing the working week to forty hours is much less, the reduction in output and income more clear. But the unions now talk about, and sometimes enforce, thirty-five and thirty-hour weeks, and deny that these can or need reduce output or income.

But it is not only in reducing scheduled working hours that union policy has worked against productivity. That, in fact, is one of the least harmful ways in which it has done so; for the compensating gain, at least, has been clear. But many unions have insisted on rigid subdivisions of labor which have raised production costs and led to expensive and ridiculous "jurisdictional" disputes. They have opposed payment on the basis of output or efficiency, and insisted on the same hourly rates for all their members regardless of differences in productivity. They have insisted on promotion for seniority rather than for merit. They have initiated deliberate slowdowns under the pretense of fighting "speed-ups." They have denounced, insisted upon the dismissal of, and sometimes cruelly beaten, men who turned out more work than their fellows. They have opposed the introduction or improvement of machinery. They have insisted that if any of their members have been laid off because of the installation of more efficient or more labor-saving machinery, the laid-off workers receive "guaranteed incomes" indefinitely. They have insisted on make-work rules to require more people or more time to perform a given task. They have even insisted, with the threat of ruining employers, on the hiring of people who are not needed at all.

Most of these policies have been followed under the a.s.sumption that there is just a fixed amount of work to be done, a definite "job fund" which has to be spread over as many people and hours as possible so as not to use it up too soon. This a.s.sumption is utterly false. There is actually no limit to the amount of work to be done. Work creates work. What A produces const.i.tutes the demand for what B produces.

But because this false a.s.sumption exists, and because the policies of unions are based on it, their net effect has been to reduce productivity below what it would otherwise have been. Their net effect, therefore, in the long run and for all groups of workers, has been to policies of unions are based on it, their net effect has been to reduce productivity below what it would otherwise have been. Their net effect, therefore, in the long run and for all groups of workers, has been to reduce reduce real wages-that is, wages in terms of the goods they will buy-below the level to which they would otherwise have risen. The real cause for the tremendous increase in real wages in the last century has been, to repeat, the acc.u.mulation of capital and the enormous technological advance made possible by it. real wages-that is, wages in terms of the goods they will buy-below the level to which they would otherwise have risen. The real cause for the tremendous increase in real wages in the last century has been, to repeat, the acc.u.mulation of capital and the enormous technological advance made possible by it.

But this process is not automatic. As a result not only of bad union but of bad governmental policies, it has, in fact, in the last decade, come to a halt. If we look only at the average of gross weekly earnings of private nonagricultural workers in terms of paper dollars, it is true that they have risen from $107.73 in 1968 to $189.36 in August 1977. But when the Bureau of Labor Statistics allows for inflation, when it translates these earnings into 1967 dollars, to take account of the increase in consumer prices, it finds that real real weekly earnings actually fell from $103.39 in 1968 to $103.36 in August 1977. weekly earnings actually fell from $103.39 in 1968 to $103.36 in August 1977.

This halt in the rise of real wages has not been a consequence inherent in the nature of unions. It has been the result of shortsighted union and government policies. There is still time to change both of them.

Chapter XXI.

"ENOUGH TO B BUY B BACK THE P PRODUCT"

AMATEUR WRITERS on economics are always asking for "just" prices and "just" wages. These nebulous conceptions of economic justice come down to us from medieval times. The cla.s.sical economists worked out instead, a different concept-the concept of on economics are always asking for "just" prices and "just" wages. These nebulous conceptions of economic justice come down to us from medieval times. The cla.s.sical economists worked out instead, a different concept-the concept of functional functional prices and prices and functional functional wages. Functional prices are those that encourage the largest volume of production and the largest volume of sales. Functional wages are those that tend to bring about the highest volume of employment and the largest real payrolls. wages. Functional prices are those that encourage the largest volume of production and the largest volume of sales. Functional wages are those that tend to bring about the highest volume of employment and the largest real payrolls.

The concept of functional wages has been taken over, in a perverted form, by the Marxists and their unconscious disciples, the purchasing-power school. Both of these groups leave to cruder minds the question whether existing wages are "fair." The real question, they insist, is whether or not they will work work. And the only wages that will work, they tell us, the only wages that will prevent an imminent economic crash, are wages that will enable labor "to buy back the product it creates." The Marxist and purchasing-power schools attribute every depression of the past to a preceding failure to pay such wages. And at no matter what moment they speak, they are sure that wages are still not high enough to buy back the product.

The doctrine has proved particularly effective in the hands of union leaders. Despairing of their ability to arouse the altruistic interest of the public or to persuade employers (wicked by definition) ever to be "fair," they have seized upon an argument calculated to appeal to the public's selfish motives, and frighten it into forcing employers to grant union demands.

How are we to know, however, precisely when labor does have "enough to buy back the product"? Or when it has more than enough? How are we to determine just what the right sum is? As the champions of the doctrine do not seem to have made any real effort to answer such questions, we are obliged to try to find the answers for ourselves.

Some sponsors of the theory seem to imply that the workers in each industry should receive enough to buy back the particular product they make. But they surely cannot mean that the makers of cheap dresses should get enough to buy back cheap dresses and the makers of mink coats enough to buy back mink coats; or that the men in the Ford plant should receive enough to buy Fords and the men in the Cadillac plant enough to buy Cadillacs.

It is instructive to recall, however, that the unions in the automobile industry, in the 1940s, when most of their members were already in the upper third of the country's income receivers, and when their weekly wage, according to government figures, was already 20 percent higher than the average wage paid in factories and nearly twice as great as the average paid in retail trade, were demanding a 30 percent increase so that they might, according to one of their spokesmen, "bolster our fast-shrinking ability to absorb the goods which we have the capacity to produce."

What, then, of the average factory worker and the average retail worker? If, under such circ.u.mstances, the automobile workers needed a 30 percent increase to keep the economy from collapsing, would a mere 30 percent have been enough for the others? Or would they have required increases of 55 to 160 percent to give them as much per capita purchasing power as the automobile workers? For let us remember that then as now enormous differences existed between the average wage levels of different industries. In 1976, workers in retail trade averaged weekly earnings of only $113.96, while workers in all manufacturing averaged $207.60 and those in contract construction $284.93. enormous differences existed between the average wage levels of different industries. In 1976, workers in retail trade averaged weekly earnings of only $113.96, while workers in all manufacturing averaged $207.60 and those in contract construction $284.93.

(We may be sure, if the history of wage bargaining even within individual unions within individual unions is any guide, that the automobile workers, if this last proposal had been made, would have insisted on the maintenance of their existing differentials; for the pa.s.sion for economic equality, among union members as among the rest of us, is, with the exception of a few rare philanthropists and saints, a pa.s.sion for getting as much as those above us in the economic scale already get rather than a pa.s.sion for giving those below us as much as we ourselves already get. But it is with the logic and soundness of a particular economic theory, rather than with these distressing weaknesses of human nature, that we are at present concerned.) is any guide, that the automobile workers, if this last proposal had been made, would have insisted on the maintenance of their existing differentials; for the pa.s.sion for economic equality, among union members as among the rest of us, is, with the exception of a few rare philanthropists and saints, a pa.s.sion for getting as much as those above us in the economic scale already get rather than a pa.s.sion for giving those below us as much as we ourselves already get. But it is with the logic and soundness of a particular economic theory, rather than with these distressing weaknesses of human nature, that we are at present concerned.)

2.

The argument that labor should receive enough to buy back the product is merely a special form of the general "purchasing-power" argument. The workers' wages, it is correctly enough contended, are the workers' purchasing power. But it is just as true that everyone's income-the grocer's, the landlord's, the employer's-is his purchasing power for buying what others have to sell. And one of the most important things for which others have to find purchasers is their labor services.

All this, moreover, has its reverse side. In an exchange economy everybody's money income is somebody else's cost In an exchange economy everybody's money income is somebody else's cost. Every increase in hourly wages, unless or until compensated by an equal increase in hourly productivity, is an increase in costs of production. An increase in costs of production, where the government controls prices and forbids any price increase, takes the profit from marginal producers, forces them out of business, means a shrinkage in production and a growth in unemployment. Even where a price increase is possible, the higher price discourages buyers, shrinks the market, and also leads to unemployment. If a 30 percent increase in hourly wages all around the circle forces a 30 percent increase in prices, labor can buy no more of the product than it could at the beginning; and the merry-go-round must start all over again. where a price increase is possible, the higher price discourages buyers, shrinks the market, and also leads to unemployment. If a 30 percent increase in hourly wages all around the circle forces a 30 percent increase in prices, labor can buy no more of the product than it could at the beginning; and the merry-go-round must start all over again.

No doubt many will be inclined to dispute the contention that a 30 percent increase in wages can force as great a percentage increase in prices. It is true that this result can follow only in the long run and only if monetary and credit policy permit it. If money and credit are so inelastic that they do not increase when wages are forced up (and if we a.s.sume that the higher wages are not justified by existing labor productivity in dollar terms), then the chief effect of forcing up wage rates will be to force unemployment.

And it is probable, in that case, that total payrolls, both in dollar amount and in real purchasing power, will be lower than before. For a drop in employment (brought about by union policy and not as a transitional result of technological advance) necessarily means that fewer goods are being produced for everyone. And it is unlikely that labor will compensate for the absolute drop in production by getting a larger relative share of the production that is left. For Paul H. Douglas in America and A.C. Pigou in England, the first from a.n.a.lyzing a great ma.s.s of statistics, the second by almost purely deductive methods, arrived independently at the conclusion that the elasticity of the demand for labor is somewhere between 3 and 4. This means, in less technical language, that "a 1 percent reduction in the real rate of wage is likely to expand the aggregate demand for labor by not less than 3 percent."1 Or, to put the matter the other way, "If wages are pushed up above the point of marginal productivity, the decrease in employment would normally be from three to four times as great as the increase in hourly rates" Or, to put the matter the other way, "If wages are pushed up above the point of marginal productivity, the decrease in employment would normally be from three to four times as great as the increase in hourly rates"2 so that the total incomes of the workers would be reduced correspondingly. so that the total incomes of the workers would be reduced correspondingly.

Even if these figures are taken to represent only the elasticity of the demand for labor revealed in a given period of the past, and not necessarily to forecast that of the future, they deserve the most serious consideration.

3.

But now let us suppose that the increase in wage rates is accompanied or followed by a sufficient increase in money and credit to allow it to take place without creating serious unemployment. If we a.s.sume that the previous relationship between wages and prices was itself a "normal" long-run relationship, then it is altogether probable that a forced increase of, say, 30 percent in wage rates will ultimately lead to an increase in prices of approximately the same percentage.

The belief that the price increase would be substantially less than that rests on two main fallacies. The first is that of looking only at the direct labor costs of a particular firm or industry and a.s.suming these to represent all the labor costs involved. But this is the elementary error of mistaking a part for the whole. Each "industry" represents not only just one section of the productive process considered "horizontally," but just one one section of that process considered "vertically." Thus the section of that process considered "vertically." Thus the direct direct labor cost of making automobiles in the automobile factories themselves may be less than a third, say, of the total costs; and this may lead the incautious to conclude that a 30 percent increase in wages would lead to only a 10 percent increase, or less, in automobile prices. But this would be to overlook the indirect wage costs in the raw materials and purchased parts, in transportation charges, in new factories or new machine tools, or in the dealers' mark-up. labor cost of making automobiles in the automobile factories themselves may be less than a third, say, of the total costs; and this may lead the incautious to conclude that a 30 percent increase in wages would lead to only a 10 percent increase, or less, in automobile prices. But this would be to overlook the indirect wage costs in the raw materials and purchased parts, in transportation charges, in new factories or new machine tools, or in the dealers' mark-up.

Government estimates show that in the fifteen-year period from 1929 to 1943, inclusive, wages and salaries in the United States averaged 69 percent of the national income. In the five-year period 19561960 they also averaged 69 percent of the national income! In the five-year period 19721976 wages and salaries averaged 66 percent of national income, and when supplements are added, total compensation of employees averaged 76 percent of national income. These wages and salaries, of course, had to be paid out of the national product. While there would have to be both deductions from these figures and additions to them to provide a fair estimate of "labor's" income, we can a.s.sume on this basis that labor costs cannot be less than about two-thirds of total production costs and may run above three-quarters (depending upon our definition of salaries averaged 66 percent of national income, and when supplements are added, total compensation of employees averaged 76 percent of national income. These wages and salaries, of course, had to be paid out of the national product. While there would have to be both deductions from these figures and additions to them to provide a fair estimate of "labor's" income, we can a.s.sume on this basis that labor costs cannot be less than about two-thirds of total production costs and may run above three-quarters (depending upon our definition of labor) labor). If we take the lower of these two estimates, and a.s.sume also that dollar profit margins would be unchanged, it is clear that an increase of 30 percent in wage costs all around the circle would mean an increase of nearly 20 percent in prices.

But such a change would mean that the dollar profit margin, representing the income of investors, managers and the self-employed, would then have, say, only 84 percent as much purchasing power as it had before. The long-run effect of this would be to cause a diminution of investment and new enterprise compared with what it would otherwise have been, and consequent transfers of men from the lower ranks of the self-employed to the higher ranks of wage-earners, until the previous relationships had been approximately restored. But this is only another way of saying that a 30 percent increase in wages under the conditions a.s.sumed would eventually mean also a 30 percent increase in prices.

It does not necessarily follow that wage-earners would make no relative gains. They would make a relative gain, and other elements in the population would suffer a relative loss, during the period of transition during the period of transition. But it is improbable that this relative gain would mean an absolute gain. For the kind of change in the relationship of costs to prices contemplated here could hardly take place without bringing about unemployment and unbalanced, interrupted or reduced production. So that while labor might get a wider slice of a smaller pie, during this period of transition and adjustment to a new equilibrium, it may be doubted whether this would be greater in absolute size (and it might easily be less) than the previous narrower slice of a larger pie.

4.

This brings us to the general meaning and effect of economic equilibrium equilibrium. Equilibrium wages and prices are the wages and prices that equalize supply and demand. If, either through government or private coercion, an attempt is made to lift prices above their equilibrium level, demand is reduced and therefore production is reduced. If an attempt is made to push prices below their equilibrium level, the consequent reduction or wiping out of profits will mean a falling off of supply or new production. Therefore any attempt to force prices either above or below their equilibrium levels (which are the levels toward which a free market constantly tends to bring them) will act to reduce the volume of employment and production below what it would otherwise have been.

To return, then, to the doctrine that labor must get "enough to buy back the product." The national product, it should be obvious, is neither created nor bought by manufacturing labor alone. It is bought by everyone-by white collar workers, professional men, farmers, employers, big and little, by investors, grocers, butchers, owners of small drugstores and gasoline stations-by everybody, in short, who contributes toward making the product.

As to the prices, wages and profits that should determine the distribution of that product, the best prices are not the highest prices, but the prices that encourage the largest volume of production and the largest volume of sales. The best wage rates for labor are not the highest wage rates, but the wage rates that permit full production, full employment and the largest sustained payrolls. The best profits, from the standpoint not only of industry but of labor, are not the lowest profits, but the profits that encourage most people to become employers or to provide more employment than before.

If we try to run the economy for the benefit of a single group or cla.s.s, we shall injure or destroy all groups, including the members of the very cla.s.s for whose benefit we have been trying to run it. We must run the economy for everybody.

1A. C. Pigou, The Theory of Unemployment The Theory of Unemployment (1933), p. 96. (1933), p. 96.

2Paul H. Douglas, The Theory of Wages The Theory of Wages (1934), p. 501. (1934), p. 501.

Chapter XXII.

THE F FUNCTION OF P PROFITS.

THE INDIGNATION SHOWN by many people today at the mention of the very word by many people today at the mention of the very word profits profits indicates how little understanding there is of the vital function that profits play in our economy. To increase our understanding, we shall go over again some of the ground already covered in chapter fifteen on the price system, but we shall view the subject from a different angle. indicates how little understanding there is of the vital function that profits play in our economy. To increase our understanding, we shall go over again some of the ground already covered in chapter fifteen on the price system, but we shall view the subject from a different angle.

Profits actually do not bulk large in our total economy. The net income of incorporated business in the fifteen years from 1929 to 1943, to take some ill.u.s.trative figures, averaged less than 5 percent of the total national income. Corporate profits after taxes in the five years from 1956 to 1960 averaged less than 6 percent of the national income. Corporate profits after taxes in the five years 1971 through 1975 also averaged less than 6 percent of the national income (in spite of the fact that, as a result of insufficient accounting adjustment for inflation, they were probably overstated). Yet profits are the form of income toward which there is most hostility. It is significant that while there is a word profiteer profiteer to stigmatize those who make allegedly excessive profits, there is no such word as "wageer"-or "losseer." Yet the profits of the owner of a barbershop may average much less not merely than the salary of a motion picture star or the hired head of a steel corporation, but less even than the average wage for skilled labor. to stigmatize those who make allegedly excessive profits, there is no such word as "wageer"-or "losseer." Yet the profits of the owner of a barbershop may average much less not merely than the salary of a motion picture star or the hired head of a steel corporation, but less even than the average wage for skilled labor.

The subject is clouded by all sorts of factual misconceptions. The total profits of General Motors, the greatest industrial corporation in the world, are taken as if they were typical rather than exceptional. Few people are acquainted with the mortality rates for business concerns. They do not know (to quote from the TNEC studies) that "should conditions of business averaging the experience of the last fifty years prevail, about seven of each ten grocery stores opening today will survive into their Second year; only four of the ten may expect to celebrate their fourth birthday." They do not know that in every year from 1930 to 1938, in the income tax statistics, the number of corporations that showed a loss exceeded the number that showed a profit. The total profits of General Motors, the greatest industrial corporation in the world, are taken as if they were typical rather than exceptional. Few people are acquainted with the mortality rates for business concerns. They do not know (to quote from the TNEC studies) that "should conditions of business averaging the experience of the last fifty years prevail, about seven of each ten grocery stores opening today will survive into their Second year; only four of the ten may expect to celebrate their fourth birthday." They do not know that in every year from 1930 to 1938, in the income tax statistics, the number of corporations that showed a loss exceeded the number that showed a profit.

How much do profits, on the average, amount to?

This question is commonly answered by citing the kind of figures I presented at the beginning of this chapter-that corporate profits average less than 6 percent of the national income-or by pointing out that the average profits after income taxes of all manufacturing corporations are less than five cents per dollar of sales. (For the five years 1971 through 1975, for example, the figure was only 4.6 cents.) But these official figures, though they fall far below popular notions of the size of profits, apply only to corporation results, calculated by conventional methods of accounting. No trustworthy estimate has been made that takes into account all kinds of activity, unincorporated as well as incorporated business, and a sufficient number of good and bad years. But some eminent economists believe that over a long period of years, after allowance is made for all losses, for a minimum "riskless" interest on invested capital, and for an imputed "reasonable" wage value of the services of people who run their own business, no net profit at all may be left over, and that there may even be a net loss. This is not at all because entrepreneurs (people who go into business for themselves) are intentional philanthropists, but because their optimisim and self-confidence too often lead them into ventures that do not or cannot succeed.1 It is clear, in any case, that any individual placing venture capital runs a risk not only of earning no return but of losing his whole princ.i.p.al. In the past it has been the lure of high profits in special firms or industries that has led him to take that great risk. But if profits are limited to a maximum of, say, 10 percent or some similar figure, while the risk of losing one's entire capital still exists, what is likely to be the effect on the profit incentive, and hence on employment and production? The World War II excess-profits tax showed what such a limit can do, even for a short period, in undermining efficiency.

Yet governmental policy almost everywhere today tends to a.s.sume that production will go on automatically, no matter what is done to discourage it. One of the greatest dangers to world production today still comes from government price-fixing policies. Not only do these policies put one item after another out of production by leaving no incentive to make it, but their long-run effect is to prevent a balance of production in accordance with the actual demands of consumers. When the economy is free, demand so acts that some branches of production make what some government officials regard as "excessive," "unreasonable," or even "obscene" profits. But that very fact not only causes every firm in that line to expand its production to the utmost, and to reinvest its profits in more machinery and more employment; it also attracts new investors and producers from everywhere, until production in that line is great enough to meet demand, and the profits in it again fall to (or below) the general average level.

In a free economy, in which wages, costs and prices are left to the free play of the compet.i.tive market, the prospect of profits decides what articles will be made, and in what quant.i.ties-and what articles will not be made at all. If there is no profit in making an article, it is a sign that the labor and capital devoted to its production are misdirected: the value of the resources that must be used up in making the article is greater than the value of the article itself.

One function of profits, in brief, is to guide and channel the factors of production so as to apportion the relative output of thousands of different commodities in accordance with demand. No bureaucrat, no matter how brilliant, can solve this problem arbitrarily. Free prices and free profits will maximize production and relieve shortages quicker than any other system. Arbitrarily fixed prices and arbitrarily limited profits can only prolong shortages and reduce production and employment. problem arbitrarily. Free prices and free profits will maximize production and relieve shortages quicker than any other system. Arbitrarily fixed prices and arbitrarily limited profits can only prolong shortages and reduce production and employment.

The function of profits, finally, is to put constant and unremitting pressure on the head of every compet.i.tive business to introduce further economies and efficiencies, no matter to what stage these may already have been brought. In good times he does this to increase his profits further, in normal times he does it to keep ahead of his compet.i.tors, in bad times he may have to do it to survive at all. For profits may not only go to zero, they may quickly turn into losses; and a man will put forth greater efforts to save himself from ruin than he will merely to improve his position.

Contrary to a popular impression, profits are achieved not by raising prices, but by introducing economies and efficiencies that cut costs of production. It seldom happens (and unless there is a monopoly it never happens over a long period) that every every firm in an industry makes a profit. The price charged by all firms for the same commodity or service must be the same; those who try to charge a higher price do not find buyers. Therefore the largest profits go to the firms that have achieved the lowest costs of production. These expand at the expense of the inefficient firms with higher costs. It is thus that the consumer and the public are served. firm in an industry makes a profit. The price charged by all firms for the same commodity or service must be the same; those who try to charge a higher price do not find buyers. Therefore the largest profits go to the firms that have achieved the lowest costs of production. These expand at the expense of the inefficient firms with higher costs. It is thus that the consumer and the public are served.

Profits, in short, resulting from the relationships of costs to prices, not only tell us which goods it is most economical to make, but which are the most economical ways to make them. These questions must be answered by a socialist system no less than by a capitalist one; they must be answered by any conceivable economic system; and for the overwhelming bulk of the commodities and services that are produced, the answers supplied by profit and loss under compet.i.tive free enterprise are incomparably superior to those that could be obtained by any other method.

I have been putting my emphasis on the tendency to reduce costs of production because this is the function of profit-and-loss that seems to be least appreciated. Greater profit goes, of course, to the man who makes a better better mousetrap than his neighbor as well as to the man who makes one more efficiently. But the function of profit in rewarding and stimulating superior quality and innovation has always been recognized. mousetrap than his neighbor as well as to the man who makes one more efficiently. But the function of profit in rewarding and stimulating superior quality and innovation has always been recognized.

1Cf. Frank H. Knight, Risk, Uncertainty and Profit Risk, Uncertainty and Profit (1921). In any period in which there has been net capital acc.u.mulation, however, the presumption is strong that there must also have been overall net profits from previous investment. (1921). In any period in which there has been net capital acc.u.mulation, however, the presumption is strong that there must also have been overall net profits from previous investment.

Chapter XXIII.

THE M MIRAGE OF I INFLATION.

I HAVE HAVE found it necessary to warn the reader from time to time that a certain result would necessarily follow from a certain policy "provided there is no inflation." In the chapters on public works and on credit I said that a study of the complications introduced by inflation would have to be deferred. But money and monetary policy form so intimate and sometimes so inextricable a part of every economic process that this separation, even for expository purposes, was very difficult; and in the chapters on the effect of various government or union wage policies on employment, profits and production, some of the effects of differing monetary policies had to be considered immediately. found it necessary to warn the reader from time to time that a certain result would necessarily follow from a certain policy "provided there is no inflation." In the chapters on public works and on credit I said that a study of the complications introduced by inflation would have to be deferred. But money and monetary policy form so intimate and sometimes so inextricable a part of every economic process that this separation, even for expository purposes, was very difficult; and in the chapters on the effect of various government or union wage policies on employment, profits and production, some of the effects of differing monetary policies had to be considered immediately.

Before we consider what the consequences of inflation are in specific cases, we should consider what its consequences are in general. Even prior to that, it seems desirable to ask why inflation has been constantly resorted to, why it has had an immemorial popular appeal, and why its siren music has tempted one nation after another down the path to economic disaster.

The most obvious and yet the oldest and most stubborn error on which the appeal of inflation rests is that of confusing "money" with wealth. "That wealth consists in money, or in gold and silver," wrote Adam Smith more than two centuries ago, "is a popular notion which naturally arises from the double function of money, as the instrument of commerce, and as the measure of value.... To grow rich is to get money, and wealth and money, in short, are, in common language, considered as in every respect synonymous." ago, "is a popular notion which naturally arises from the double function of money, as the instrument of commerce, and as the measure of value.... To grow rich is to get money, and wealth and money, in short, are, in common language, considered as in every respect synonymous."

Real wealth, of course, consists in what is produced and consumed: the food we eat, the clothes we wear, the houses we live in. It is railways and roads and motor cars; ships and planes and factories; schools and churches and theaters; pianos, paintings and books. Yet so powerful is the verbal ambiguity that confuses money with wealth, that even those who at times recognize the confusion will slide back into it in the course of their reasoning. Each man sees that if he personally had more money he could buy more things from others. If he had twice as much money he could buy twice as many things; if he had three times as much money he would be "worth" three times as much. And to many the conclusion seems obvious that if the government merely issued more money and distributed it to everybody, we should all be that much richer.

These are the most naive inflationists. There is a second group, less naive, who see that if the whole thing were as easy as that the government could solve all our problems merely by printing money. They sense that there must be a catch somewhere; so they would limit in some way the amount of additional money they would have the government issue. They would have it print just enough to make up some alleged "deficiency," or "gap."

Purchasing power is chronically deficient, they think, because industry somehow does not distribute enough money to producers to enable them to buy back, as consumers, the product that is made. There is a mysterious "leak" somewhere. One group "proves" it by equations. On one side of their equations they count an item only once; on the other side they unknowingly count the same item several times over. This produces an alarming gap between what they call "A payments" and what they call "A + B payments." So they found a movement, put on green uniforms, and insist that the government issue money or "credits" to make good the missing B payments. issue money or "credits" to make good the missing B payments.

The cruder apostles of "social credit" may seem ridiculous; but there are an indefinite number of schools of only slightly more sophisticated inflationists who have "scientific" plans to issue just enough additional money or credit to fill some alleged chronic or periodic deficiency, or gap, which they calculate in some other way.

2.

The more knowing inflationists recognize that any substantial increase in the quant.i.ty of money will reduce the purchasing power of each individual monetary unit-in other words, that it will lead to an increase in commodity prices. But this does not disturb them. On the contrary, it is precisely why they want the inflation. Some of them argue that this result will improve the position of poor debtors as compared with rich creditors. Others think it will stimulate exports and discourage imports. Still others think it is an essential measure to cure a depression, to "start industry going again," and to achieve "full employment."1 There are innumerable theories concerning the way in which increased quant.i.ties of money (including bank credit) affect prices. On the one hand, as we have just seen, are those who imagine that the quant.i.ty of money could be increased by almost any amount without affecting prices. They merely see this increased money as a means of increasing everyone's "purchasing power," in the sense of enabling everybody to buy more goods than before. Either they never stop to remind themselves that people collectively cannot buy twice as much goods as before unless twice as much goods are produced, or they imagine that the only thing that holds down an indefinite increase in production is not a shortage of manpower, working hours or productive capacity, but merely a shortage of monetary demand: if people want the goods, they a.s.sume, and have the money to pay for them, the goods will almost automatically be produced. increase in production is not a shortage of manpower, working hours or productive capacity, but merely a shortage of monetary demand: if people want the goods, they a.s.sume, and have the money to pay for them, the goods will almost automatically be produced.

On the other hand is the group-and it has included some eminent economists-that holds a rigid mechanical theory of the effect of the supply of money on commodity prices. All the money in a nation, as these theorists picture the matter, will be offered against all the goods. Therefore the value of the total quant.i.ty of money multiplied by its "velocity of circulation" must always be equal to the value of the total quant.i.ty of goods bought. Therefore, further (a.s.suming no change in velocity of circulation), the value of the monetary unit must vary exactly and inversely with the amount put into circulation. Double the quant.i.ty of money and bank credit and you exactly double the "price level;" triple it, and you exactly triple the price level. Multiply the quant.i.ty of money n n times, in short, and you must multiply the prices of goods times, in short, and you must multiply the prices of goods n n times. times.

There is not s.p.a.ce here to explain all the fallacies in this plausible picture.2 Instead we shall try to see just why and how an increase in the quant.i.ty of money raises prices. Instead we shall try to see just why and how an increase in the quant.i.ty of money raises prices.

An increased quant.i.ty of money comes into existence in a specific way. Let us say that it comes into existence because the government makes larger expenditures than it can or wishes to meet out of the proceeds of taxes (or from the sale of bonds paid for by the people out of real savings). Suppose, for example, that the government prints money to pay war contractors. Then the first effect of these expenditures will be to raise the prices of supplies used in war and to put additional money into the hands of the war contractors and their employees. (As, in our chapter on price-fixing, we deferred for the sake of simplicity some complications introduced by an inflation, so, in now considering inflation, we may pa.s.s over the complications introduced by an attempt at government price-fixing. When these are considered it will be found that they do not change the essential a.n.a.lysis. They lead merely to a sort of backed-up or "repressed" inflation that reduces or conceals some of the earlier consequences at the expense of aggravating the later ones.) now considering inflation, we may pa.s.s over the complications introduced by an attempt at government price-fixing. When these are considered it will be found that they do not change the essential a.n.a.lysis. They lead merely to a sort of backed-up or "repressed" inflation that reduces or conceals some of the earlier consequences at the expense of aggravating the later ones.) The war contractors and their employees, then, will have higher money incomes. They will spend them for the particular goods and services they want. The sellers of these goods and services will be able to raise their prices because of this increased demand. Those who have the increased money income will be willing to pay these higher prices rather than do without the goods; for they will have more money, and a dollar will have a smaller subjective value in the eyes of each of them.

Let us call the war contractors and their employees group A, and those from whom they directly buy their added goods and services group B. Group B, as a result of higher sales and prices, will now in turn buy more goods and services from a still further group, C. Group C in turn will be able to raise its prices and will have more income to spend on group D, and so on, until the rise in prices and money incomes has covered virtually the whole nation. When the process has been completed, nearly everybody will have a higher income measured in terms of money. But (a.s.suming that production of goods and services has not increased) prices prices of goods and services will have increased correspondingly. The nation will be no richer than before. of goods and services will have increased correspondingly. The nation will be no richer than before.

This does not mean, however, that everyone's relative or absolute wealth and income will remain the same as before. On the contrary, the process of inflation is certain to affect the fortunes of one group differently from those of another. The first groups to receive the additional money will benefit the most. The money incomes of group A, for example, will have increased before prices have increased, so that they will be able to buy almost a proportionate increase in goods. The money incomes of group B will advance later, when prices have already increased somewhat; but group B will be better off in terms of goods. Meanwhile, however, the groups that have still had no advance whatever in their money incomes will find themselves compelled to pay higher prices for the things they buy, which means that they will be obliged to get along on a lower standard of living than before. increased somewhat; but group B will be better off in terms of goods. Meanwhile, however, the groups that have still had no advance whatever in their money incomes will find themselves compelled to pay higher prices for the things they buy, which means that they will be obliged to get along on a lower standard of living than before.

We may clarify the process further by a hypothetical set of figures. Suppose we divide the community arbitrarily into four main groups of producers, A, B, C and D, who get the money income benefit of the inflation in that order. Then when money incomes of group A have already increased 30 percent, the prices of the things they purchase have not yet increased at all. By the time money incomes of group B have increased 20 percent, prices have still increased an average of only 10 percent. When money incomes of group C have increased only 10 percent, however, prices have already gone up 15 percent. And when money incomes of group D have not yet increased at all, the average prices they have to pay for the things they buy have gone up 20 percent. In other words, the gains of the first groups of producers to benefit by higher prices or wages from the inflation are necessarily at the expense of the losses suffered (as consumers) by the last groups of producers that are able to raise their prices or wages.

It may be that, if the inflation is brought to a halt after a few years, the final result will be, say, an average increase of 25 percent in money incomes, and an average increase in prices of an equal amount, both of which are fairly distributed among all groups. But this will not cancel out the gains and losses of the transition period. Group D, for example, even though its own incomes and prices have at last advanced 25 percent, will be able to buy only as much goods and services as before the inflation started. It will never compensate for its losses during the period when its income and prices had not risen at all, though it had to pay up to 30 percent more for the goods and services it bought from the other producing groups in the community, A, B and C.

3.

So inflation turns out to be merely one more example of our central lesson. It may indeed bring benefits for a short time to favored groups, but only at the expense of others. And in the long run it brings ruinous consequences to the whole community. Even a relatively mild inflation distorts the structure of production. It leads to the overexpansion of some industries at the expense of others. This involves a misapplication and waste of capital. When the inflation collapses, or is brought to a halt, the misdirected capital investment-whether in the form of machines, factories or office buildings-cannot yield an adequate return and loses the greater part of its value.

Nor is it possible to bring inflation to a smooth and gentle stop, and so avert a subsequent depression. It is not even possible to halt an inflation, once embarked upon, at some preconceived point, or when prices have achieved a previously agreed upon level; for both political and economic forces will have got out of hand. You cannot make an argument for a 25 percent advance in prices by inflation without someone's contending that the argument is twice as good for an advance of 50 percent, and someone else's adding that it is four times as good for an advance of 100 percent. The political pressure groups that have benefited from the inflation will insist upon its continuance.

It is impossible, moreover, to control the value of money under inflation. For, as we have seen, the causation is never a merely mechanical one. You cannot, for example, say in advance that a 100 percent increase in the quant.i.ty of money will mean a 50 percent fall in the value of the monetary unit. The value of money, as we have seen, depends upon the subjective valuations of the people who hold it. And those valuations do not depend solely on the quant.i.ty of it that each person holds. They depend also on the quality quality of the money. In wartime the value of a nation's monetary unit, not on the gold standard, will of the money. In wartime the value of a nation's monetary unit, not on the gold standard, will rise on the foreign exchanges with victory and fall with defeat, regardless of changes in its quant.i.ty. The present valuation will often depend upon what people expect the rise on the foreign exchanges with victory and fall with defeat, regardless of changes in its quant.i.ty. The present valuation will often depend upon what people expect the future future quant.i.ty of money to be. And, as with commodities on the speculative exchanges, each person's valuation of money is affected not only by what he thinks its value is but by what he thinks is going to be quant.i.ty of money to be. And, as with commodities on the speculative exchanges, each person's valuation of money is affected not only by what he thinks its value is but by what he thinks is going to be everybody else's everybody else's valuation of money. valuation of money.

All this explains why, when hyperinflation has once set in, the value of the monetary unit drops at a far faster rate than the quant.i.ty of money either is or can be increased. When this stage is reached, the disaster is nearly complete; and the scheme is bankrupt.