The General Theory of Employment, Interest and Money Part 8

Chapter 18.

THE GENERAL THEORY OF EMPLOYMENT RE-.

STATED.

I.

We have now reached a point where we can gather together the threads of our argument. To begin with, it may be useful to make clear which elements in the economic system we usually take as given, which are the independent variables of our system and which are the dependent variables.

We take as given the existing skill and quant.i.ty of available labour, the existing quality and quant.i.ty of available equipment, the existing technique, the degree of compet.i.tion, the tastes and habits of the consumer, the disutility of different intensities of labour and of the activities of supervision and organisation, as well as the social structure including the forces, other than our variables set forth below, which determine the distribution of the national income. This does not mean that we a.s.sume these factors to be constant; but merely that, in this place and context, we are not considering or taking into account the effects and consequences of changes in them.

Our independent variables are, in the first instance, the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest, though, as we have already seen, these are capable of further a.n.a.lysis.

Our dependent variables are the volume of employment and the national income (or national dividend) measured in wage-units.

The factors, which we have taken as given, influence our independent variables, but do not completely determine them. For example, the schedule of the marginal efficiency of capital depends partly on the existing quant.i.ty of equipment which is one of the given factors, but partly on the state of long-term expectation which cannot be inferred from the given factors. But there are certain other elements which the given factors determine so completely that we can treat these derivatives as being themselves given. For example, the given factors allow us to infer what level of national income measured in terms of the wage-unit will correspond to any given level of employment; so that, within the economic framework which we take as given, the national income depends on the volume of employment, i.e. on the quant.i.ty of effort currently devoted to production, in the sense that there is a unique correlation between the two.

Furthermore, they allow us to infer the shape of the aggregate supply functions, which embody the physical conditions of supply, for different types of products;?that is to say, the quant.i.ty of employment which will be devoted to production corresponding to any given level of effective demand measured in terms of wage-units. Finally, they furnish us with the supply function of labour (or effort); so that they tell us inter alia at what point the employment function for labour as a whole will cease to be elastic.

The schedule of the marginal efficiency of capital depends, however, partly on the given factors and partly on the prospective yield of capital-a.s.sets of different kinds; whilst the rate of interest depends partly on the state of liquidity-preference (i.e. on the liquidity function) and partly on the quant.i.ty of money measured in terms of wage-units. Thus we can sometimes regard our ultimate independent variables as consisting of (i) the three fundamental psychological factors, namely, the psychological propensity to consume, the psychological att.i.tude to liquidity and the psychological expectation of future yield from capital-a.s.sets, (2) the wage-unit as determined by the bargains reached between employers and employed, and (3) the quant.i.ty of money as determined by the action of the central bank; so that, if we take as given the factors specified above, these variables determine the national income (or dividend) and the quant.i.ty of employment. But these again would be capable of being subjected to further a.n.a.lysis, and are not, so to speak, our ultimate atomic independent elements.

The division of the determinants of the economic system into the two groups of given factors and independent variables is, of course, quite arbitrary from any absolute standpoint. The division must be made entirely on the basis of experience, so as to correspond on the one hand to the factors in which the changes seem to be so slow or so little relevant as to have only a small and comparatively negligible short-term influence on our quaesitum; and on the other hand to those factors in which the changes are found in practice to exercise a dominant influence on our quaesitum. Our present object is to discover what determines at any time the national income of a given economic system and (which is almost the same thing) the amount of its employment; which means in a study so complex as economics, in which we cannot hope to make completely accurate generalisations, the factors whose changes mainly determine our quaesitum. Our final task might be to select those variables which can be deliberately controlled or managed by central authority in the kind of system in which we actually live.

II.

Let us now attempt to summarise the argument of the previous chapters; taking the factors in the reverse order to that in which we have introduced them.

There will be an inducement to push the rate of new investment to the point which forces the supply- price of each type of capital-a.s.set to a figure which, taken in conjunction with its prospective yield, brings the marginal efficiency of capital in general to approximate equality with the rate of interest. That is to say, the physical conditions of supply in the capital-goods industries, the state of confidence concerning the prospective yield, the psychological att.i.tude to liquidity and the quant.i.ty of money (preferably calculated in terms of wage-units) determine, between them, the rate of new investment.

But an increase (or decrease) in the rate of investment will have to carry with it an increase (or decrease) in the rate of consumption; because the behaviour of the public is, in general, of such a character that they are only willing to widen (or narrow) the gap between their income and their consumption if their income is being increased (or diminished). That is to say, changes in the rate of consumption are, in general, in the same direction (though smaller in amount) as changes in the rate of income. The relation between the increment of consumption which has to accompany a given increment of saving is given by the marginal propensity to consume. The ratio, thus determined, between an increment of investment and the corresponding increment of aggregate income, both measured in wage-units, is given by the investment multiplier.

Finally, if we a.s.sume (as a first approximation) that the employment multiplier is equal to the investment multiplier, we can, by applying the multiplier to the increment (or decrement) in the rate of investment brought about by the factors first described, infer the increment of employment.

An increment (or decrement) of employment is liable, however, to raise (or lower) the schedule of liquidity-preference; there being three ways in which it will tend to increase the demand for money, inasmuch as the value of output will rise when employment increases even if the wage-unit and prices (in terms of the wage-unit) are unchanged, but, in addition, the wage-unit itself will tend to rise as employment improves, and the increase in output will be accompanied by a rise of prices (in terms of the wage-unit) owing to increasing cost in the short period.

Thus the position of equilibrium will be influenced by these repercussions; and there are other repercussions also. Moreover, there is not one of the above factors which is not liable to change without much warning, and sometimes substantially. Hence the extreme complexity of the actual course of events. Nevertheless, these seem to be the factors which it is useful and convenient to isolate. If we examine any actual problem along the lines of the above schematism, we shall find it more manageable; and our practical intuition (which can take account of a more detailed complex of facts than can be treated on general principles) will be offered a less intractable material upon which to work.

III.

The above is a summary of the General Theory. But the actual phenomena of the economic system are also coloured by certain special characteristics of the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest, about which we can safely generalise from experience, but which are not logically necessary. In particular, it is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. Moreover, the evidence indicates that full, or even approximately full, employment is of rare and short-lived occurrence. Fluctuations may start briskly but seem to wear themselves out before they have proceeded to great extremes, and an intermediate situation which is neither desperate nor satisfactory is our normal lot. It is upon the fact that fluctuations tend to wear themselves out before proceeding to extremes and eventually to reverse themselves, that the theory of business cycles having a regular phase has been founded. The same thing is true of prices, which; in response to an initiating cause of disturbance, seem to be able to find a level at which they can remain, for the time being, moderately stable.

Now, since these facts of experience do not follow of logical necessity, one must suppose that the environment and the psychological propensities of the modern world must be of such a character as to produce these results. It is, therefore, useful to consider what hypothetical psychological propensities would lead to a stable system; and, then, whether these propensities can be plausibly ascribed, on our general knowledge of contemporary human nature, to the world in which we live.

The conditions of stability which the foregoing a.n.a.lysis suggests to us as capable of explaining the observed results are the following: (i) The marginal propensity to consume is such that, when the output of a given community increases (or decreases) because more (or less) employment is being applied to its capital equipment, the multiplier relating the two is greater than unity but not very large.

(ii) When there is a change in the prospective yield of capital or in the rate of interest, the schedule of the marginal efficiency of capital will be such that the change in new investment will not be in great disproportion to the change in the former; i.e. moderate changes in the prospective yield of capital or in the rate of interest will not be a.s.sociated with very great changes in the rate of investment.

(iii) When there is a change in employment, money-wages tend to change in the same direction as, but not in great disproportion to, the change in employment; i.e. moderate changes in employment are not a.s.sociated with very great changes in money-wages. This is a condition of the stability of prices rather than of employment.

(iv) We may add a fourth condition, which provides not so much for the stability of the system as for the tendency of a fluctuation in one direction to reverse itself in due course; namely, that a rate of investment, higher (or lower) than prevailed formerly, begins to react unfavourably (or favourably) on the marginal efficiency of capital if it is continued for a period which, measured in years, is not very large. (i) Our first condition of stability, namely, that the multiplier, whilst greater than unity, is not very great, is highly plausible as a psychological characteristic of human nature. As real income increases, both the pressure of present needs diminishes and the margin over the established standard of life is increased; and as real income diminishes the opposite is true. Thus it is natural?at any rate on the average of the community?that current consumption should be expanded when employment increases, but by less than the full increment of real income; and that it should be diminished when employment diminishes, but by less than the full decrement of real income. Moreover, what is true of the average of individuals is likely to be also true of governments, especially in an age when a progressive increase of unemployment will usually force the State to provide relief out of borrowed funds.

But whether or not this psychological law strikes the reader as plausible a priori, it is certain that experience would be extremely different from what it is if the law did not hold. For in that case an increase of investment, however small, would set moving a c.u.mulative increase of effective demand until a position of full employment had been reached; while a decrease of investment would set moving a c.u.mulative decrease of effective demand until no one at all was employed. Yet experience shows that we are generally in an intermediate position. It is not impossible that there may be a range within which instability does in fact prevail. But, if so, it is probably a narrow one, outside of which in either direction our psychological law must unquestionably hold good. Furthermore, it is also evident that the multiplier, though exceeding unity, is not, in normal circ.u.mstances, enormously large. For, if it were, a given change in the rate of investment would involve a great change (limited only by full or zero employment) in the rate of consumption.

(ii) Whilst our first condition provides that a moderate change in the rate of investment will not involve an indefinitely great change in the demand for consumption-goods our second condition provides that a moderate change in the prospective yield of capital-a.s.sets or in the rate of interest will not involve an indefinitely great change in the rate of investment. This is likely to be the case owing to the increasing cost of producing a greatly enlarged Output from the existing equipment. If, indeed, we start from a position where there are very large surplus resources for the production of capital-a.s.sets, there may be considerable instability within a certain range; but this will cease to hold good as soon as the surplus is being largely utilised. Moreover, this condition sets a limit to the instability resulting from rapid changes in the prospective yield of capital-a.s.sets due to sharp fluctuations in business psychology or to epoch-making inventions?though more, perhaps, in the upward than in the downward direction.

(iii) Our third condition accords with our experience of human nature. For although the struggle for money-wages is, as we have pointed out above, essentially a struggle to maintain a high relative wage, this struggle is likely, as employment increases, to be intensified in each individual case both because the bargaining position of the worker is improved and because the diminished marginal utility of his wage and his improved financial margin make him readier to run risks. Yet, all the same, these motives will operate within limits, and workers will not seek a much greater money-wage when employment improves or allow a very great reduction rather than suffer any unemployment at all.

But here again, whether or not this conclusion is plausible a priori, experience shows that some such psychological law must actually hold. For if compet.i.tion between unemployed workers always led to a very great reduction of the money-wage, there would be a violent instability in the price-level.

Moreover, there might be no position of stable equilibrium except in conditions consistent with full employment; since the wage-unit might have to fall without limit until it reached a point where the effect of the abundance of money in terms of the wage-unit on the rate of interest was sufficient to restore a level of full employment. At no other point could there be a resting-place.

(iv) Our fourth condition, which is a condition not so much of stability as of alternate recession and recovery, is merely based on the presumption that capital-a.s.sets are of various ages, wear out with time and are not all very long-lived; so that if the rate of investment falls below a certain minimum level, it is merely a question of time (failing large fluctuations in other factors) before the marginal efficiency of capital rises sufficiently to bring about a recovery of investment above this minimum. And similarly, of course, if investment rises to a higher figure than formerly, it is only a question of time before the marginal efficiency of capital falls sufficiently to bring about a recession unless there are compensating changes in other factors.

For this reason, even those degrees of recovery and recession, which can occur within the limitations set by our other conditions of stability, will be likely, if they persist for a sufficient length of time and are not interfered with by changes in the other factors, to cause a reverse movement in the opposite direction, until the same forces as before again reverse the direction.

Thus our four conditions together are adequate to explain the outstanding features of our actual experience;?namely, that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.

But we must not conclude that the mean position thus determined by 'natural' tendencies, namely, by those tendencies which are likely to persist, failing measures expressly designed to correct them, is, therefore, established by laws of necessity. The unimpeded rule of the above conditions is a fact of observation concerning the world as it is or has been, and not a necessary principle which cannot be changed.

Chapter 19.

CHANGES IN MONEY-WAGES.

I.

It would have been an advantage if the effects of a change in money-wages could have been discussed in an earlier chapter. For the cla.s.sical theory has been accustomed to rest the supposedly self-adjusting character of the economic system on an a.s.sumed fluidity of money-wages; and, when there is rigidity, to lay on this rigidity the blame of maladjustment.

It was not possible, however, to discuss this matter fully until our own theory had been developed. For the consequences of a change in money-wages are complicated. A reduction in money-wages is quite capable in certain circ.u.mstances of affording a stimulus to output, as the cla.s.sical theory supposes. My difference from this theory is primarily a difference of a.n.a.lysis; so that it could not be set forth clearly until the reader was acquainted with my own method.

The generally accepted explanation is, as I understand it, quite a simple one. It does not depend on roundabout repercussions, such as we shall discuss below. The argument simply is that a reduction in money-wages will cet. par. stimulate demand by diminishing the price of the finished product, and will therefore increase output and employment up to the point where the reduction which labour has agreed to accept in its money-wages is just offset by the diminishing marginal efficiency of labour as output (from a given equipment) is increased.

In its crudest form, this is tantamount to a.s.suming that the reduction in money-wages will leave demand unaffected. There may be some economists who would maintain that there is no reason why demand should be affected, arguing that aggregate demand depends on the quant.i.ty of money multiplied by the income-velocity of money and that there is no obvious reason why a reduction in money-wages would reduce either the quant.i.ty of money or its income-velocity. Or they may even argue that profits will necessarily go up because wages have gone down. But it would, I think, be more usual to agree that the reduction in money-wages may have some effect on aggregate demand through its reducing the purchasing power of some of the workers, but that the real demand of other factors, whose money incomes have not been reduced, will be stimulated by the fall in prices, and that the aggregate demand of the workers themselves will be very likely increased as a result of the increased volume of employment, unless the elasticity of demand for labour in response to changes in money-wages is less than unity. Thus in the new equilibrium there will be more employment than there would have been otherwise except, perhaps, in some unusual limiting case which has no reality in practice.

It is from this type of a.n.a.lysis that I fundamentally differ; or rather from the a.n.a.lysis which seems to lie behind such observations as the above. For whilst the above fairly represents, I think, the way in which many economists talk and write, the underlying a.n.a.lysis has seldom been written down in detail.

It appears, however, that this way of thinking is probably reached as follows. In any given industry we have a demand schedule for the product relating the quant.i.ties which can be sold to the prices asked; we have a series of supply schedules relating the prices which will be asked for the sale of different quant.i.ties on various bases of cost; and these schedules between them lead up to a further schedule which, on the a.s.sumption that other costs are unchanged (except as a result of the change in output), gives us the demand schedule for labour in the industry relating the quant.i.ty of employment to different levels of wages, the shape of the curve at any point furnishing the elasticity of demand for labour. This conception is then transferred without substantial modification to industry as a whole; and it is supposed, by a parity of reasoning, that we have a demand schedule for labour in industry as a whole relating the quant.i.ty of employment to different levels of wages. It is held that it makes no material difference to this argument whether it is in terms of money-wages or of real wages. If we are thinking in terms of money-wages, we must, of course, correct for changes in the value of money; but this leaves the general tendency of the argument unchanged, since prices certainly do not change in exact proportion to changes in money-wages.

If this is the groundwork of the argument (and, if it is not, I do not know what the groundwork is), surely it is fallacious. For the demand schedules for particular industries can only be constructed on some fixed a.s.sumption as to the nature of the demand and supply schedules of other industries and as to the amount of the aggregate effective demand. It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our a.s.sumption that the aggregate effective demand is fixed.

Yet this a.s.sumption reduces the argument to an ignoratio elenchi. For, whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same aggregate effective demand as before will be a.s.sociated with an increase in employment, the precise question at issue is whether the reduction in money-wages will or will not be accompanied by the same aggregate effective demand as before measured in money, or, at any rate, by an aggregate effective demand which is not reduced in full proportion to the reduction in money-wages (i.e. which is somewhat greater measured in wage-units). But if the cla.s.sical theory is not allowed to extend by a.n.a.logy its conclusions in respect of a particular industry to industry as a whole, it is wholly unable to answer the question what effect on employment a reduction in money-wages will have. For it has no method of a.n.a.lysis wherewith to tackle the problem. Professor Pigou's Theory of Unemployment seems to me to get out of the cla.s.sical theory all that can be got out of it; with the result that the book becomes a striking demonstration that this theory has nothing to offer, when it is applied to the problem of what determines the volume of actual employment as a whole. II Let us, then, apply our own method of a.n.a.lysis to answering the problem. It falls into two parts. (i) Does a reduction in money-wages have a direct tendency, cet. par., to increase employment, 'cet. par.' being taken to mean that the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest are the same as before for the community as a whole? And (2) does a reduction in money- wages have a certain or probable.tendency to affect employment in a particular direction through its certain or probable repercussions on these three factors?

The first question we have already answered in the negative in the preceding chapters. For we have shown that the volume of employment is uniquely correlated with the volume ofeffective demand measured in wage-units, and that the effective demand, being the sum of the expected consumption and the expected investment, cannot change, if the propensity to consume, the schedule of marginal efficiency of capital and the rate of interest are all unchanged. If, without any change in these factors, the entrepreneurs were to increase employment as a whole, their proceeds will necessarily fall short of their supply-price.

Perhaps it will help to rebut the crude conclusion that a reduction in money-wages will increase employment 'because it reduces the cost of production', if we follow up the course of events on the hypothesis most favourable to this view, namely that at the outset entrepreneurs expect the reduction in money-wages to have this effect. It is indeed not unlikely that the individual entrepreneur, seeing his own costs reduced, will overlook at the outset the repercussions on the demand for his product and will act on the a.s.sumption that he will be able to sell at a profit a larger output than before. If, then, entrepreneurs generally act on this expectation, will they in fact succeed in increasing their profits?

Only if the community's marginal propensity to consume is equal to unity, so that there is no gap between the increment of income and the increment of consumption; or if there is an increase in investment, corresponding to the gap between the increment of income and the increment of consumption, which will only occur if the schedule of marginal efficiencies of capital has increased relatively to the rate of interest. Thus the proceeds realised from the increased output will disappoint the entrepreneurs and employment will fall back again to its previous figure, unless the marginal propensity to consume is equal to unity or the reduction in money-wages has had the effect of increasing the schedule of marginal efficiencies of capital relatively to the rate of interest and hence the amount of investment. For if entrepreneurs offer employment on a scale which, if they could sell their output at the expected price, would provide the public with incomes out of which they would save more than the amount of current investment, entrepreneurs are bound to make a loss equal to the difference; and this will be the case absolutely irrespective of the level of money-wages. At the best, the date of their disappointment can only be delayed for the interval during which their own investment in increased working capital is filling the gap.

Thus the reduction in money-wages will have no lasting tendency to increase employment except by virtue of its repercussion either on the propensity to consume for the community as a whole, or on the schedule of marginal efficiencies of capital, or on the rate of interest. There is no method of a.n.a.lysing the effect of a reduction in money-wages, except by following up its possible effects on these three factors.

The most important repercussions on these factors are likely, in practice, to be the following: (1) A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.

What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume.

The effect of the transfer from entrepreneurs to rentiers is more open to doubt. But if rentiers represent on the whole the richer section of the community and those whose standard of life is least flexible, then the effect of this also will be unfavourable. What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable.

(2) If we are dealing with an unclosed system, and the reduction of money-wages is a reduction relatively to money-wages abroad when both are reduced to a common unit, it is evident that the change will be favourable to investment, since it will tend to increase the balance of trade. This a.s.sumes, of course, that the advantage is not offset by a change in tariffs, quotas, etc. The greater strength of the traditional belief in the efficacy of a reduction in money-wages as a means of increasing employment in Great Britain, as compared with the United States, is probably attributable to the latter being, comparatively with ourselves, a closed system.

(3) In the case of an unclosed system, a reduction of money-wages, though it increases the favourable balance of trade, is likely to worsen the terms of trade. Thus there will be a reduction in real incomes, except in the case of the newly employed, which may tend to increase the propensity to consume.

(4) If the reduction of money-wages is expected to be a reduction relatively to money-wages in the future, the change will be favourable to investment, because as we have seen above, it will increase the marginal efficiency of capital; whilst for the same reason it may be favourable to consumption. If, on the other hand, the reduction leads to the expectation, or even to the serious possibility, of a further wage-reduction in prospect, it will have precisely the opposite effect. For it will diminish the marginal efficiency of capital and will lead to the postponement both of investment and of consumption.

(5) The reduction in the wages-bill, accompanied by some reduction in prices and in money-incomes generally, will diminish the need for cash for income and business purposes; and it will therefore reduce pro tanto the schedule of liquidity-preference for the community as a whole. Cet. par. this will reduce the rate of interest and thus prove favourable to investment. In this case, however, the effect of expectation concerning the future will be of an opposite tendency to those just considered under (4). For, if wages and prices are expected to rise again later on, the favourable reaction will be much less p.r.o.nounced in the case of long-term loans than in that of short-term loans. If, moreover, the reduction in wages disturbs political confidence by causing popular discontent, the increase in liquidity-preference due to this cause may more than offset the release of cash from the active circulation.

(6) Since a special reduction of money-wages is always advantageous to an individual entrepreneur or industry, a general reduction (though its actual effects are different) may also produce an optimistic tone in the minds of entrepreneurs, which may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital and set things moving again on a more normal basis of expectation.

On the other hand, if the workers make the same mistake as their employers about the effects of a general reduction, labour troubles may offset this favourable factor; apart from which, since there is, as a rule, no means of securing a simultaneous and equal reduction of money-wages in all industries, it is in the interest of all workers to resist a reduction in their own particular case. In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.

(7) On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarra.s.sment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency,?with severely adverse effects on investment. Moreover the effect of the lower price- level on the real burden of the national debt and hence on taxation is likely to prove very adverse to business confidence.

This is not a complete catalogue of all the possible reactions of wage reductions in the complex real world. But the above cover, I think, those which are usually the most important.

If, therefore, we restrict our argument to the case of a closed system, and a.s.sume that there is nothing to be hoped, but if anything the contrary, from the repercussions of the new distribution of real incomes on the community's propensity to spend, it follows that we must base any hopes of favourable results to employment from a reduction in money-wages mainly on an improvement in investment due either to an increased marginal efficiency of capital under (4) or a decreased rate of interest under (5). Let us consider these two possibilities in further detail.

The contingency, which is favourable to an increase in the marginal efficiency of capital, is that in which money-wages are believed to have touched bottom, so that further changes are expected to be in the upward direction. The most unfavourable contingency is that in which money-wages are slowly sagging downwards and each reduction in wages serves to diminish confidence in the prospective maintenance of wages. When we enter on a period of weakening effective demand, a sudden large reduction of money-wages to a level so low that no one believes in its indefinite continuance would be the event most favourable to a strengthening of effective demand. But this could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining. On the other hand, it would be much better that wages should be rigidly fixed and deemed incapable of material changes, than that depressions should be accompanied by a gradual downward tendency of money-wages, a further moderate wage reduction being expected to signalise each increase of; say, 1 per cent in the amount of unemployment. For example, the effect of an expectation that wages are going to sag by, say, 2 per cent in the coming year will be roughly equivalent to the effect of a rise of 2 per cent in the amount of interest payable for the same period. The same observations apply mutatis mutandis to the case of a boom.

It follows that with the actual practices and inst.i.tutions of the contemporary world it is more expedient to aim at a rigid money-wage policy than at a flexible policy responding by easy stages to changes in the amount of unemployment;?so far, that is to say, as the marginal efficiency of capital is concerned. But is this conclusion upset when we turn to the rate of interest?

It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument; though I am not aware that they have done so. If the quant.i.ty of money is itself a function of the wage- and price-level, there is indeed, nothing to hope in this direction. But if the quant.i.ty of money is virtually fixed, it is evident that its quant.i.ty in terms of wage-units can be indefinitely increased by a sufficient reduction in money-wages; and that its quant.i.ty in proportion to incomes generally can be largely increased, the limit to this increase depending on the proportion of wage-cost to marginal prime cost and on the response of other elements of marginal prime cost to the falling wage-unit.

We can, therefore, theoretically at least, produce precisely the same effects on the rate of interest by reducing wages, whilst leaving the quant.i.ty of money unchanged, that we can produce by increasing the quant.i.ty of money whilst leaving the level of wages unchanged. It follows that wage reductions, as a method of securing full employment, are also subject to the same limitations as the method of increasing the quant.i.ty of money. The same reasons as those mentioned above, which limit the efficacy of increases in the quant.i.ty of money as a means of increasing investment to the optimum figure, apply mutatis mutandis to wage reductions. Just as a moderate increase in the quant.i.ty of money may exert an inadequate influence over the long-term rate of interest, whilst an immoderate increase may offset its other advantages by its disturbing effect on confidence; so a moderate reduction in money-wages may prove inadequate, whilst an immoderate reduction might shatter confidence even if it were practicable.

There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment;?any more than for the belief that an open-market monetary policy is capable, unaided, of achieving this result. The economic system cannot be made self-adjusting along these lines.

If, indeed, labour were always in a position to take action (and were to do so), whenever there was less than full employment, to reduce its money demands by concerted action to whatever point was required to make money so abundant relatively to the wage-unit that the rate of interest would fall to a level compatible with full employment, we should, in effect, have monetary management by the trade unions, aimed at full employment, instead of by the banking system. Nevertheless while a flexible wage policy and a flexible money policy come, a.n.a.lytically, to the same thing, inasmuch as they are alternative means of changing the quant.i.ty of money in terms of wage-units, in other respects there is, of course, a world of difference between them. Let me briefly recall to the reader's mind the four outstanding considerations.

(i) Except in a socialised community where wage-policy is settled by decree, there is no means of securing uniform wage reductions for every cla.s.s of labour. The result can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expedience, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quant.i.ty of money, on the other hand, is already within the power of most governments by open-market policy or a.n.a.logous measures.

Having regard to human nature and our inst.i.tutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable.

(ii) If money-wages are inflexible, such changes in prices as occur (i.e. apart from 'administered' or monopoly prices which are determined by other considerations besides marginal cost) will mainly correspond to the diminishing marginal productivity of the existing equipment as the output from it is increased. Thus the greatest practicable fairness will be maintained between labour and the factors whose remuneration is contractually fixed in terms of money, in particular the rentier cla.s.s and persons with fixed salaries on the permanent establishment of a firm, an inst.i.tution or the State. If important cla.s.ses are to have their remuneration fixed in terms of money in any case, social justice and social expediency are best served if the remunerations of all factors are somewhat inflexible in terms of money. Having regard to the large groups of incomes which are comparatively inflexible in terms of money, it can only be an unjust person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter.

(iii) The method of increasing the quant.i.ty of money in terms of wage-units by decreasing the wage- unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quant.i.ty of money whilst leaving the wage-unit unchanged has the opposite effect.

Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.

(iv) If a sagging rate of interest has to be brought about by a sagging wage-level, there is, for the reasons given above, a double drag on the marginal efficiency of capital and a double reason for putting off investment and thus postponing recovery.

IIIIt follows, therefore, that if labour were to respond to conditions of gradually diminishing employment by offering its services at a gradually diminishing money-wage, this would not, as a rule, have the effect of reducing real wages and might even have the effect of increasing them, through its adverse influence on the volume of output. The chief result of this policy would be to cause a great instability of prices, so violent perhaps as to make business calculations futile in an economic society functioning after the manner of that in which we live. To suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth. It is only in a highly authoritarian society, where sudden, substantial, all-round changes could be decreed that a flexible wage policy could function with success. One can imagine it in operation in Italy, Germany or Russia, but not in France, the United States or Great Britain.

If, as in Australia, an attempt were made to fix real wages by legislation, then there would be a certain level of employment corresponding to that level of real wages; and the actual level of employment would, in a closed system, oscillate violently between that level and no employment at all, according as the rate of investment was or was not below the rate compatible with that level; whilst prices would be in unstable equilibrium when investment was at the critical level, racing to zero whenever investment was below it, and to infinity whenever it was above it. The element of stability would have to be found, if at all, in the factors controlling the quant.i.ty of money being so determined that there always existed some level of money-wages at which the quant.i.ty of money would be such as to establish a relation between the rate of interest and the marginal efficiency of capital which would maintain investment at the critical level. In this event employment would be constant (at the level appropriate to the legal real wage) with money-wages and prices fluctuating rapidly in the degree just necessary to maintain this rate of investment at the appropriate figure. In the actual case of Australia, the escape was found, partly of course in the inevitable inefficacy of the legislation to achieve its object, and partly in Australia not being a closed system, so that the level of money-wages was itself a determinant of the level of foreign investment and hence of total investment, whilst the terms of trade were an important influence on real wages.

In the light of these considerations I am now of the opinion that the maintenance of a stable general level of money-wages is, on a balance of considerations, the most advisable policy for a closed system; whilst the same conclusion will hold good for an open system, provided that equilibrium with the rest of the world can be secured by means of fluctuating exchanges. There are advantages in some degree of flexibility in the wages of particular industries so as to expedite transfers from those which are relatively declining to those which are relatively expanding. But the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.

This policy will result in a fair degree of stability in the price-level;?greater stability, at least, than with a flexible wage policy. Apart from 'administered' or monopoly prices, the price-level will only change in the short period in response to the extent that changes in the volume of employment affect marginal prime costs; whilst in the long period they will only change in response to changes in the cost of production due to new techniques and new or increased equipment. It is true that, if there are, nevertheless, large fluctuations in employment, substantial fluctuations in the price-level will accompany them. But the fluctuations will be less, as I have said above, than with a flexible wage policy.

Thus with a rigid wage policy the stability of prices will be bound up in the short period with the avoidance of fluctuations in employment. In the long period, on the other hand, we are still left with the choice between a policy of allowing prices to fall slowly with the progress of technique and equipment whilst keeping wages stable, or of allowing wages to rise slowly whilst keeping prices stable. On the whole my preference is for the latter alternative, on account of the fact that it is easier with an expectation of higher wages in future to keep the actual level of employment within a given range of full employment than with an expectation of lower wages in future, and on account also of the social advantages of gradually diminishing the burden of debt, the greater ease of adjustment from decaying to growing industries, and the psychological encouragement likely to be felt from a moderate tendency for money-wages to increase. But no essential point of principle is involved, and it would lead me beyond the scope of my present purpose to develop in detail the arguments on either side.

Appendix to Chapter 19 PROFESSOR PIGOU'S 'THEORY OF UNEMPLOYMENT'.

Professor Pigou in his Theory of Unemployment makes the volume of employment to depend on two fundamental factors, namely (i) the real rates of wages for which workpeople stipulate, and (2) the shape of the Real Demand Function for Labour. The central sections of his book are concerned with determining the shape of the latter function. The fact that workpeople in fact stipulate, not for a real rate of wages, but for a money-rate, is not ignored; but, in effect, it is a.s.sumed that the actual money-rate of wages divided by the price of wage-goods can be taken to measure the real rate demanded.

The equations which, as he says, 'form the starting point of the enquiry' into the Real Demand Function for Labour are given in his Theory of Unemployment, p. 90. Since the tacit a.s.sumptions, which govern the application of his a.n.a.lysis, slip in near the outset of his argument, I will summarise his treatment up to the crucial point.

Professor Pigou divides industries into those 'engaged in making wage-goods at home and in making exports the sale of which creates claims to wage-goods abroad' and the 'other' industries: which it is convenient to call the wage-goods industries and the non-wage-goods industries respectively. He supposes x men to be employed in the former and y men in the latter. The output in value of wage-goods of the x men he calls F(x); and the general rate of wages F'(x). This, though he does not stop to mention it, is tantamount to a.s.suming that marginal wage-cost is equal to marginal prime cost. Further, he a.s.sumes that x + y = ?(x), i.e. that the number of men employed in the wage-goods industries is a function of total employment. He then shows that the elasticity of the real demand for labour in the aggregate (which gives us the shape of our quaesitum, namely the Real Demand Function for Labour) can be written ?'(x) F'(x) Er = ??? ????

?(x) F"(x) So far as notation goes, there is no significant difference between this and my own modes of expression.

In so far as we can identify Professor Pigou's wage-goods with my consumption-goods, and his 'other goods' with my investment-goods, it follows that his F(x) / F'(x), being the value of the output of the wage-goods industries in terms of the wage-unit, is the same as my Cw. Furthermore, his function is (subject to the identification of wage-goods with consumption-goods) a function of what I have called above the employment multiplier k'. For ?x = k'?y,

1.

so that ?'(x) = 1 + ??

k Thus Professor Pigou's 'elasticity of the real demand for labour in the aggregate' is a concoction similar to some of my own, depending partly on the physical and technical conditions in industry (as given by his function F) and partly on the propensity to consume wage-goods (as given by his function ?); provided always that we are limiting ourselves to the special case where marginal labour-cost is equal to marginal prime cost.

To determine the quant.i.ty of employment, Professor Pigou then combines with his 'real demand for labour', a supply function for labour. He a.s.sumes that this is a function of the real wage and of nothing else. But, as he has also a.s.sumed that the real wage is a function of the number of men x who are employed in the wage-goods industries, this amounts to a.s.suming that the total supply of labour at the existing real wage is a function of x and of nothing else. That is to say, n = ?(x), where n is the supply of labour available at a real wage F'(x).

Thus, cleared of all complication, Professor Pigou's a.n.a.lysis amounts to an attempt to discover the volume of actual employment from the equations x + y = ?(x) and n = ?(x).

But there are here three unknowns and only two equations. It seems clear that he gets round this difficulty by taking n = x + y. This amounts, of course, to a.s.suming that there is no involuntary unemployment in the strict sense, i.e. that all labour available at the existing real wage is in fact employed. In this case x has the value which satisfies the equation ?(x) = ?(x) and when we have thus found that the value of x is equal to (say) n1, y must be equal to ?(n1) ? n1, and total employment n is equal to (n1).

It is worth pausing for a moment to consider what this involves. It means that, if the supply function of labour changes, more labour being available at a given real wage (so that n1 + dn1 is now the value of x which satisfies the equation ?(x) = ?(x)), the demand for the output of the non-wage-goods industries is such that employment in these industries is bound to increase by just the amount which will preserve equality between ?(n1 + dn1) and ?(n1 + dn1). The only other way in which it is possible for aggregate employment to change is through a modification of the propensity to purchase wage-goods and non- wage-goods respectively such that there is an increase of y accompanied by a greater decrease of x.