"The unsolved problems of the affluent society,” says Galbraith, are (1) “the process of consumer demand creation and its financing,” and (2) “inflation.”69 “The solution” to the first of these problems, he tells us, “or at least one part of it, is to have a reasonably satisfactory substitute for production as a source of income.”70 Here is an idea that certainly deserves some kind of a medal as a prime example of economic absurdity. Real income, all economists admit, can be measured only in goods; that is, money or money substitutes constitute income only to the extent that they can be exchanged for goods. What Galbraith is telling us, then, is that the answer to our problem is to devise some way of getting goods without producing them-some kind of magic.
But he does not stand alone. He has plenty of distinguished company. The happy hunting ground of the “something for nothing” enthusiast, the individual who refuses to recognize the conservations laws, has always been the field of economics. Here there is an unbroken line of succession from the John Laws of one era to the Francis Townsends of another, and it is hard to find an economic fallacy of any description that cannot command the support of at least one of two economists of the front rank. Thus we find the thoroughly discredited “automatically depreciating money” or “self-liquidating scrip” endorsed by both Keynes 71 and Irving Fisher,72 the “social credit” program approved by Joan Robinson73 and the performance of useless work as a means of enriching the community advocated by both Beveridge74 and Keynes75 and more recently by Myrdal.76
Mrs. Robinson’s comment on the proposed “social dividend” is particularly revealing. “To conventional minds,” she says, “this scheme seems altogether too fantastic to be taken seriously... But all the same it recommends itself to common sense. If there is unemployment on the one hand and unsatisfied needs on the other, why should not the two be brought together by the simple device of providing the needy with purchasing power to consume the products of the unemployed?” Here is a typical example of the logic of the present-day socially oriented economic reasoning. The objective of this proposal is unquestionably praiseworthy, hence let us forthwith proceed to adopt it without further ado.
The first question that the scientist asks in such a situation is Can it be done?-Is there a “simple device” by means of which we can supply the needy with purchasing power?-gets no consideration from the economist who has his eyes on the commendable objective. To him it is the kind of a problem that is solved merely by persuading the community to arrive at a decision to take action. He does not bother to follow the “dividend” back to its source to determine where the purchasing power is coming from. So far as he is concerned it just materializes out of thin air. As Schumpeter explains, “It is always a question, not of transforming purchasing power which already exists in someone’s possession, but of the creation of new purchasing power out of nothing.”77
It is particularly strange that the economist, who recognizes so clearly that the only true measure of wages is the amount of goods that they will buy, and has coined the expressive term “real wages” to designate this quantity, should be unable to see that the same principle applies to all entities that are measured in terms of money. Regardless of whether it happens to be in the form of money wage payments, money obtained from some other source, or some substitute for money, a quantity of money purchasing power is simply a claim against the goods produced, and it stands to reason that the more such claims that are issued against the same quantity of production, the less each one is worth in terms of real purchasing power. The suppliers of labor and capital services receive as payment claims against the total production of the community equal to the total value of the production. If any additional claims of any kind are issued, by providing purchasing power in some other way, as advocated by Galbraith, Keynes, Robinson, Myrdal, et al., the effect is simply to decrease the value of the original claims. All that is accomplished by such measures is to divert goods from those who would normally receive them as payments for their productive activities into the hands of other individuals who have contributed nothing toward production.
This is not necessarily an argument against such a diversion. There is much to be said in favor of subsidizing those who are involuntarily unemployed, those who are physically handicapped, etc., at the expense of those who are regularly receiving payments for productive services, but such subsidies should be recognized for what they are, and should be handled accordingly, not presented in the guise of measures to aid the economy in general. All such diversions of purchasing power from one group to another are transactions at the same economic location. As stated in Principle IV, such transactions have no effect on production in general or marketing in general. They do not enrich the community; they merely help some groups at the expense of the others.
The synthetic purchasing power which well-meaning but visionary individuals propose to distribute so freely in the form of “social dividends” or other handouts to those who have done nothing to earn them (Galbraith specifically condemns “the Puritan principle that leisure should be less amply rewarded than work78) could be obtained by taxation, but this is not popular among the supporters of the measures as it then becomes too painfully obvious that these programs merely rob Peter to pay Paul. What the socio-economist tries to do is to devise the economic equivalent of a perpetual motion machine: a scheme which will create something-purchasing power in this case-out of nothing. But the basic laws of economics are no more subject to evasion that the corresponding laws of physics. Purchasing power cannot be created except by production. All that the “something for nothing” schemes ever produce is more money, and this merely dilutes the value of the existing money. It does not add anything to real purchasing power.
A failure to distinguish between money and purchasing power is one of the great weaknesses in modern economic theory. This lack of differentiation not only opens the door to a weird assortment of “something for nothing” schemes of the type just discussed, but, even more significantly, it prevents the economist from seeing the solid and stable relationships that do exist in the economic field, those that constitute the basis for the theoretical development in this work.
For example, it is this confusion between money and purchasing power that is responsible for Samuelson’s previously quoted statement that there is no economic law to prevent the creation of purchasing power. He can see that money can be created out of nothing, and that this money can be used as purchasing power, hence he concludes that purchasing power has been created. What he fails to recognize is that the total amount of purchasing power (ability to buy goods) that was previously in existence has not been altered by the addition of more money. This money is circulating purchasing power, to be sure, but as money it is measured in dollars (or their equivalent); as purchasing power it is measured in terms of ability to buy goods. In terms of dollars, the circulating stream has been increased, but in terms of purchasing power it remains unchanged. The issuance of more money has not created purchasing power; it is merely a device whereby purchasing power can be diverted from those who now possess it to others who will presumably use it in a manner meeting the approval of those who control the diversion.
If the government issues more currency, it is able to buy goods therewith, but the ability of the recipients of normal income (wages, etc.) to buy goods is decreased proportionately. This fact is generally recognized in the case of severe currency inflation, as it has been demonstrated over and over again in actual practice, but it should be realized that this is a general principle which applies to all money inflation, including including that resulting from banking transactions. New credit money issued by the banks has buying power only to the extent that the buying power of current income from other sources is decreased. The new currency increases money purchasing power, but it does not alter the real purchasing power, ability to buy goods, The buying power of the new money is attained only by reducing the buying power of the money received as compensation by the workers and the owners of capital (Principle XV).
Any program that puts purchasing power into the hands of individuals other than those who supplied the means whereby it was produced takes this purchasing power away from other individuals, usually the general public. If the diversion is not accomplished directly by taxation it is accomplished just as surely by inflation. The net result of the futile attempts to solve Galbraith’s problem number one is therefore to push us into the jaws of his problem number two.
Inflation is the reaction of the economic mechanism to man’s attempts to get something for nothing. It is the way in which the economic system enforces payment when the members of the human race try to avoid paying the costs of their actions. Efforts to find a “substitute for production as a source of income” are attempts to get something for nothing, and if such schemes are put into operation the result is inflation. Efforts to “increase purchasing power” by subsidizing special groups are attempts to get something for nothing, and they cause inflation. Efforts to avoid high taxes by printing money with which to meet governmental expenses are attempts to get something for nothing, and they cause inflation. Efforts to improve the status of the working population by raising the level of money wages, or reducing the hours of work without cutting wages, are likewise attempts to get something for nothing, and they cause inflation. Efforts to attain prosperity by cutting taxes while government expenditures are maintained, or even increased, are attempts to get something for nothing, and these, too, cause inflation. Something for nothing is prohibited by a law that we cannot evade, and no matter how ingenious the attempt at evasion may be, the end result is always inflation, which means that the general public has to pay the bill.
General inability or unwillingness to recognize the real meaning of inflation is the cause of most of the confusion which now reigns in this area of economic thought, a confusion which led the authors of a 1963 Survey of Inflation Theory to describe their work in these words:
In this atmosphere of “chaos” that now surrounds the subject the various investigators are not even able to agree as to just what they are talking about when they speak of “inflation.” The authors of the survey just mentioned make this comment: “Indeed, disagreement over the definition of the term is symptomatic of the confusion in inflation theory.” Our first concern, therefore, will be to define the concepts with which we will be dealing. We begin by defining inflation in general.
This defines inflation in terms of its effect, which is the primary concern of the victim, the consumer who has to pay the higher price. For purposes of analysis, we are interested in the relation between the causes of inflation and that effect. From the points brought out in the discussion in Chapters 10 and 11 it is clear that the effects of a price level increase originating in the production market are quite different from those of an increase originating in the goods market, and we will therefore want to distinguish between the two. The most common cause of price increases in the production market is an increase in wage rates, but several other factors, such as increased business taxes, or lagging productivity, that increase the cost of production have the same effect. We will therefore use the term “cost inflation” for this kind of an increase in the price level.
No fully satisfactory term is available for the price level increase originating in the goods market, but since its cause is a net withdrawal from the money reservoirs which increases the flow of money purchasing power in the circulating stream, we may call it a money inflation.
The terms “demand inflation” or “demand-induced inflation” are quite commonly used in present-day economic literature with the same general significance that has been given to “money inflation” in the foregoing definition, but since we find it necessary to take some exceptions to the economists’ conception of the relation between demand and inflation it has seemed advisable to use a different term. Another terminology that is used to some extent refers to “seller’s inflation” and “buyer’s inflation,” which correspond roughly to cost inflation and money inflation respectively.
Although inflation is ordinarily regarded as an increase in goods prices, it would be equally correct to consider it a decrease in the value of money. What it actually does is to change the relation between the two, and the question as to which one is altered is merely a matter of which we take as our reference point. The usual practice is to call it a price change because money is utilized as a standard of value for economic purposes, and we therefore tend to regard money as the fixed element and price as the variable element in market transactions. However, if the conditions are such that the buying power of the local currency can be compared with that of gold or some currency enjoying more general acceptance, we then recognize variations in the relative buying power as compared to that of these more stable forms of money as being evidence of changes in the value of the local currency rather than price changes. Minor changes of this kind are accepted as no more than fluctuations in the currency exchange rate, but a significant drop in value is known as currency inflation, since this kind of a value collapse almost always results from financing government expenditures by printing currency rather than by taxation. Technically it is simply a severe money inflation.
One of the major reasons for the existing “chaos” and “confusion” in current inflation theory is that the difference between cost inflation and money inflation is not generally understood. As A. P. Lerner says, “A failure to distinguish between the two types of inflation aggravates a problem which has become a serious threat to democratic society.”80 The two kinds of inflation originate from different causes, their effects are different, the arguments for eliminating them are different, and the measures that are required for this purpose are different.
In spite of the general apprehension about the so-called “wage-price spiral,” cost inflation is not a major economic problem. Increases in wages or other elements of production cost alter the relation between fixed obligations and the general price level, and therefore alter the value balance in existing commitments, favoring some groups of individuals at the expense of others, and thus creating a social problem. When wage increases are negotiated piecemeal and unsystematically in accordance with present practice, they also result in serious inequities between different groups of workers-another social problem-but inflation or deflation originating from wage increases does not affect the ability of the consuming public as a whole to buy goods. Whatever increases take place as a result of these changes are counterbalanced by a corresponding increase in the available money purchasing power resulting from the higher wages. Furthermore, the cause of this type of inflation-too much liberality in granting the wage increases-is well known and the cure is obvious, even though it is politically unpopular, as matters now stand in the absence of a clear understanding of what is going on.
The “serious threat to democratic society” is money inflation. Unlike cost inflation, this is an unbalanced transaction. The equality between the quantity of goods in one economic stream and the quantity of money in the other, which is always maintained at the production end of the mechanism, no longer exist when these streams reach the goods market because the reservoir transactions along the way introduce or withdraw money from the auxiliary stream without altering the stream of goods.
Let us consider, by way of illustration, a situation in which an isolated community has a total annual production valued at one million dollars. The suppliers of labor and capital services receive from the producers money equivalent to the total value of the products-one million dollars-and this is exactly the amount which these suppliers of labor and capital services, in their capacity as consumers, need in order to buy the full amount of the annual production at the normal price level, the price level determined at the production end of the mechanism. Now let us assume that the government issues an additional half million dollars in currency, and uses this new money for purchases in the goods market. So far as the markets are concerned, this half million dollars is indistinguishable from the million dollars of money purchasing power generated by production, and we therefore find that 1.5 million dollars are competing in the market for goods originally valued at only one million dollars. The result is inflation. Unless there is an offsetting input into some money reservoir, the price level goes up 50 percent.
If the government uses part or all of the new money to pay wages and salaries rather than to purchase goods, the ultimate effect is the same. Normally, the government sells its services to the consumers, directly or indirectly, just as any other producer of services does, and the taxes that the consumers pay have the same economic function as the payments that they make to the other producers for the services that they receive. When the government is operating on the basis of a balanced budget, its expenditures for labor and the services of capital are equal to the receipts from taxes and other income sources, and the net resultant is zero, as it is for the private producer. In this case the effect of the government operations neither adds to nor subtracts from the amount of money available for the purchase of other goods in the markets. But if the government pays the suppliers of the labor and capital services with new money instead of collecting taxes, the total money flowing to the markets is increased by the amount of the new currency issue. The result is that the price level is inflated to the same degree as if the new money were used for direct purchase of goods.
It is frequently contended that the inflation would not occur if the new money were used exclusively for buying goods that result from additional production, since the increased volume of goods would offset the increased amount of purchasing power. Those who argue along these lines are overlooking the fact that the new production creates its own purchasing power. If additional goods valued at a half million dollars are produced as a result of the transactions we are now considering, a half million dollars is paid to those who supply the labor and capital services for the production of the additional goods, and this amount adds to the total available purchasing power. We then have 2.0 million dollars available for buying 1.5 million dollars worth of goods. The percentage effect on the price level is now somewhat less severe. The rise is only 33 percent instead of 50 percent, because of the greater total production over which the inflationary effect is spread, but the inflationary gap, the excess of money purchasing power over the available goods, is still the entire half million dollars of the new currency issue.
No one was particularly surprised that inflation occurred during World War II in spite of the the OPA and its much advertised “price control” measures, but there was a general belief, not only among the rank and file, but among economists, business leaders, and government officials as well, that when the guns were finally silenced and the productive machinery of the nation could be reconverted to the ways of peace, any further threat of runaway prices would be overwhelmed by the torrent of goods that would pour forth from our farms and factories. Here again, as in the forecast of the employment situation, the “authorities” were consistently wrong. There was not the unanimous agreement on the wrong answer that featured the estimates of post-war unemployment, but the great majority of the experts concurred. As in the case of employment, this clearly indicates that something more than mere errors of judgment was involved. The results could not be so uniformly off color unless there was some flaw in the accepted premises on which the judgments were based.
The nature of this flaw is readily apparent when we take a look at the excuses that are being offered for the poor showing made by these forecasts. On every hand we meet the contention that inflation occurred because production did not increase fast enough. It is admitted that reconversion to civilian production moved ahead much more swiftly and smoothly than was anticipated, unemployment was far below the estimates, and aside from some labor troubles and disagreement over price policies, the industrial machine rapidly shifted into high gear. Even if there were sometimes a million men out on strike, there were anywhere from five to ten million other men working that were supposed to be idle according to the estimates of these same experts. This means that the production in the immediate post-war period was substantially greater than the forecasters expected, yet we are now told that their price predictions went astray because of the failure of the industrial machine to produce goods quickly in sufficient quantities.
With the benefit of the economic principles developed in this work it can easily be seen how the experts got themselves into this untenable position. In reality it would make no difference whether the volume of production was as low as the “authorities” estimated in advance, or as high as they now think would have been necessary. We would still have had inflation in either case inasmuch as the volume of production has no bearing on inflation (Principle IX). The cause of the inflation immediately following the end of the war was an excess of available money purchasing power
It is probably hard for many persons to accustom themselves to the idea that there can be too much money purchasing power. It seems so simple to take care of any excess by producing more goods for sale. While the worst of the post-World War II inflation was under way we were continually exhorted to strive for greater production in order that there might be goods for the people to buy with their backlog of “savings.” But extra production, however great it may be, creates its own purchasing power. Every additional dollar’s worth of goods produced adds one dollar to the total purchasing power available for buying goods, and the inflationary surplus remains undiminished. Maximum production is a worth-while aim, but it is not a remedy for inflation. The inflationary unbalance can be corrected only where it originates, in the money reservoir transactions.
The inflationary results are the same regardless of the type of money reservoir transaction that is involved. Purchasing power obtained in any manner other than production can be utilized only by diverting goods away from those who are entitled to receive them in exchange for their productive services. The community as a whole cannot get something for nothing, and when any individual, or group, or the government itself, gets something for nothing by reason of one of those money purchasing power transactions that we have called reservoir withdrawals, someone else pays the bill by getting nothing for something. From the standpoint of the general public money inflation is simply a form of taxation, one which is, in a sense, dishonest, because its true character is largely concealed by the indirect manner in which it takes effect.
Furthermore, the burden of this type of inflation falls heavily on some segments of the population, while others are practically untouched. Owners of real estate, stocks of goods, or shares in corporate property holders, escape with little or no cost, as the real value of this property remains constant, and its money value therefore rises as the inflation progresses. Organized workers who are able to force compensatory wage increases suffer only to a minor degree, and many business enterprises make handsome profits out of the inflationary price rise. Most of the weight of this discriminatory “tax” bears down on the less favorably situated workers and on the recipients of fixed incomes.
When we face the issue squarely, inflationary fiscal policy is a costly economic blunder. But governments which must face elections are, as a rule, favorably disposed toward increasing expenditures, and at the same time notoriously reluctant to levy enough taxes to balance their accounts, an attitude in which they are encouraged by an influential school of economic theorists who see virtue in living on credit. As a result, inflation has become, to a considerable extent, a way of life in most nations. As matters now stand, it is not only a “serious threat to democratic society,” but also a serious threat to general world stability.
Viewed from the purchasing power standpoint, with due consideration of the dominant position of the consumer reservoirs, the causes of money inflation and its effects on the general operation of the economic system are actually very simple, and no extended discussion of the theoretical situation should be necessary. It may be helpful, however, to examine some of the current errors and misconceptions about the subject in the light of the new information that is now available.
The most serious error into which the economists have fallen, so far as their understanding of inflation is concerned, is their repudiation of Say’s Law and substitution of the concept of an essentially autonomous demand for goods-in-general. It is this fallacy of the autonomous demand that has opened the door to today’s weird assortment of inflation-producing schemes, and has muddied the waters to such an extent that the economic profession is ready and willing to give respectful attention to such outrageous ideas as Galbraith’s proposal that we should find a substitute for production as a source of income, or Hansen’s equally outrageous suggestion, contained in the following statement, that cutting employment would overcome excess demand and lead to price stability.
If Say’s Law had not been jettisoned by the economic profession, the almost incredible blunder of forgetting that cutting employment reduces the production of goods could not have occurred. As originally interpreted, Say’s Law was inaccurate, to be sure, since it is not actually a law of markets, as it was assumed to be, but a law of production. Nevertheless, any attempt at a critical analysis would have revealed what was needed in the way of a modification of the law to make it accurate. Indeed, some economists have come very close to stating the true facts, even without making a thorough analysis. G. L. S. Shackle, for instance, makes this comment:
It should be equally clear that this withdrawal of money from stock is something of a totally different nature from creating purchasing power by production of goods. At this point, therefore, it should have been evident that Say’s Law is correct so far as the relation of the production of goods to the creation of purchasing power is concerned, and that it is the variations in storage of money (the reservoir inputs and withdrawals, as we are calling them in this work) that are interfering with the application of the law to the goods markets. But the economists have insisted on taking the stand that Say’s Law is incorrect, rather than recognizing that in reality it is a correct law incorrectly applied.
A significant point in this connection is that each economist who feels called upon to explain what is wrong with Say’s Law usually comes up with his own interpretation of what the law really means. Here are some examples:
The truth is that Say’s Law has nothing to do with any of these items, either as Say originally formulated it or in the modified form in which it is employed in this work (Principle III). It is not concerned with the demand for money, or with employment, or with overproduction, or with lack of demand, or with an equilibrium between individual prices. What it says is that production of goods automatically creates the exact amount of purchasing power necessary to buy those goods, because the goods themselves are the purchasing power.
The statement that “supply creates its own demand” is a correct expression of Say’s Law if it is properly interpreted, but unfortunately it is too often misunderstood. There is a somewhat general impression that the statement means that the act of producing goods automatically insures the availability of enough buying power to purchase these goods in the markets at prices equivalent to the cost of production, the latter term being understood to mean the actual payments made by the producer for labor and the services of capital (including some return to the owners of the equity capital). While our findings indicate that in the long run this is true for the aggregate, it is quite evident, both in theory and in practice, that it is not true over shorter intervals, nor does it hold good in each individual case. This discrepancy has contributed materially to the existing distrust of Say’s Law.
The source of the difficulty can easily be located by looking at the purchasing power creation from a value standpoint. Since the goods are the purchasing power, the value of these goods, as determined by sale in the markets is the amount of purchasing power, in terms of money, that has been created, and this is the amount that the producer receives, if the economy is operating without reservoir effects. If, through miscalculation, the producer has paid out more to the suppliers of labor and capital services than the value of the goods, Say’s Law does not assure him that he will get his money back; it merely brings back to him the money equivalent of the value of the goods produced.
It was mentioned in Chapter 11 that one of the reasons for using the term “production price” rather than “cost of production” was to prevent that quantity, as it is used in this work, from being confused with the cost of production as defined in other ways. The case now under consideration shows why this is necessary, since the production price, as defined for the purposes of our analysis, includes the actual profits of the owners of the enterprise, even where these profits are negative. If an item is produced at an incremental cost of $3.00 and is sold for $2.00, the profit is minus $1.00-that is, a loss of $1.00-and the production price, as we have defined it, is $2.00. Say’s Law, as defined in this work, tells us that inasmuch as an item worth $2.00 at the current normal price level was produced, the suppliers of labor and capital services, including the owners of the enterprise, will (in the absence of reservoir transactions) get a net total of $2.00 with which to buy this item-the exact amount needed for the purpose.
Here we have another illustration of the principle that the economic situation as a whole is governed by factors which are quite distinct, and often very different, from those applicable to the individual items that make up the whole. In the production of an individual item, Say’s Law gives us no indication of how the producer will fare; he may lose all that he has put into the production process, or he may profit handsomely. In this case the profit component of the production price is indeterminate until the goods are sold. Consequently, the production price in total is not fully determined until after the goods market transaction has taken place. Say’s Law is just as valid as ever-that is, the act of production creates the exact amount of purchasing power necessary to buy the goods produced-but we cannot define this amount of purchasing power in terms of money at the production end of the system. In the modern economy, where the exchange transactions are handled through the medium of money, the law is therefore of little assistance in dealing with the production and marketing of individual items.
But in the general situation the average rate of profit is essentially fixed. It cannot fall appreciably below the interest rate because the suppliers of capital will divert this capital elsewhere if earnings are too low. It cannot rise appreciably above the interest rate because of the competition between the capital suppliers. Inasmuch as all other components of production price are fixed by actual payments to the suppliers of labor and the services of outside capital, this means that, for the economy as a whole, production price is determined in the production market. Say’s Law (Principle III) then tells us that this same amount is available as purchasing power in the goods markets, unless the equilibrium is upset by what we have called a reservoir transaction. Under normal market conditions, therefore, producers as a whole will be able to sell their products for the full production price, including normal earnings on their own invested capital.
The part that the goods markets play in this process is to establish relative values, and thus allocate the total purchasing power among the various items making up the total goods flow. The average producer gets a return which enables him to earn a profit equal to the current interest rate. The enterprise which, in the judgment of the marketplace, has been able to produce above average values from the labor and capital services that it has utilized receives more than the average share of the market proceeds; the one which produces less than the average receives less. This is strictly in accord with Say’s Law, because the larger or smaller returns to the producers are exactly matched (in the absence of any net reservoir transactions) by higher or lower prices paid by the consumers. In each case the amount received by the seller is the amount paid by the buyer.
In turning their backs on Say’s Law and adopting the autonomous demand concept, the socio-economists of the present day have undoubtedly been influenced to a considerable degree by their sociological bias, since an explanation which attributes our inability to buy as much as we would like to a lack of money or of purchasing power in general rather than to the inadequacy of our production is much more palatable to layman and economist alike. Schemes to distribute more money to consumers in one way or another are always more popular than measures which involve working harder or putting in longer hours. But it is probable that the economists’ exaggerated opinion of the importance and the capabilities of the laws of supply and demand has been an even more potent factor. In their proper field of application the supply and demand principles have been an outstanding success in a branch of knowledge which is, in general, distinguished more by its failures and shortcomings than by its successes, and under the circumstances it is only natural that the extent of the successes should be overestimated.
The truth is that along with the successful applications of supply and demand theory there have been many misapplications. The principles of supply and demand have been applied to problems to which they have no relevance, and this has contributed greatly to the confusion that now exists in several economic areas, particularly such subjects as the origin and magnitude of the total demand for goods, and the true significance of the money supply. As brought out in the preceding pages, the total demand for goods, in the sense in which this term is used in economics, is determined by production, with only limited and temporary modifications by reason of reservoir transactions. The concept of an autonomous demand, determined independently of supply, analogous to the demand for wheat and the demand for shoes, is therefore entirely without substance, and the usual supply and demand analysis is wholly inapplicable to goods-in-general.
A typical example of erroneous application of supply and demand reasoning is provided by Hansen’s statement quoted earlier in this chapter, that the demand for goods at the close of World War II was abnormally high because of the shortages resulting from the restrictions on the production of consumer goods that were in effect during the war years. So far as goods-in-general are concerned, this statement is erroneous. The demand for automobiles and for nylon hose was high for this reason, to be sure, but the abnormally high demand for these commodities was made possible only by giving them preference over other goods, and diverting to their purchase as much as necessary of the total available purchasing power. The demand for individual commodities is essentially autonomous, because of this ability to buy more of one commodity and less of another. But the demand for goods-in-general, in the sense that demand has an economic significance, cannot exceed the total available real purchasing power irrespective of whatever shortages may exist.
The demand level that prevailed immediately after the war was not abnormally high in terms of real purchasing power; it was high only in monetary terms. This demand was not due to depleted stocks of consumer goods, as Hansen and his colleagues deduced from their supply and demand theories, but to the existence of large amounts of government-created credit instruments which were available for use as money purchasing power; that is, the money purchasing power created by production was being swelled by heavy withdrawals from the reservoirs. Real purchasing power was not altered. All that was accomplished was to change the relation between real purchasing power and money purchasing power; that is, to reduce the value of money.
There is no necessary connection between consumer shortages and excess amounts of credit-created money purchasing power, and where one exists without the other, the excess money creates excess demand and causes inflation; consumer shortages do not. This can easily be verified by a wealth of actual experience. Under circumstances where there has been no abnormal shortage of goods, credit measures similar to those utilized in the United States during World War II have been, and are being, utilized freely by governments which desire to provide themselves with purchasing power in excess of the amounts that it seems expedient to raise by taxation. This invariably generates excess monetary demand leading to inflation. On the other hand, shortages of consumer goods likewise occur frequently-even chronically in some countries-but these shortages by and of themselves create neither demand nor inflation.
The cause of excess demand (in terms of money) and money inflation is not the need for goods but the use of money withdrawn from one of the money reservoirs to augment the normal flow of money purchasing power coming from production. What a nation does not have has no bearing whatever on the real economic demand for goods-in-general. It does affect the desire for goods, but desire without the ability to buy has no economic significance. The Chinese people probably desire consumer goods just as ardently as their American counterparts, but their economic demand is very much lower, simply because this demand is determined by their production.
An inflationary trend in the price of a single commodity or group of commodities may be overcome by an increase in the supply of these commodities, in accordance with the recognized supply and demand principles, but an inflation of the general price level cannot be overcome by an increase in the supply of all goods. Additional production does not alter the inflationary unbalance, as the money purchasing power stream is augmented to exactly the same extent as the stream of goods (Principle IX), and the reservoir withdrawals which cause the inflation have the same effect as before. Except to the relatively minor extent that they may be counterbalanced by goods reservoir transactions, net withdrawals from the money reservoirs always cause money inflation, and money inflation can never take place without such withdrawals.
There is a common impression that inflation can only take place when production is close to the capacity of the existing labor force and existing capital facilities. Galbraith expresses this opinion in these words: “Inflation-persistently rising prices-is obviously a phenomenon of comparatively high production. It can occur only when the demands of the economy are somewhere near the capacity of the plant and available labor force to supply them.”87 From the points brought out in the preceding paragraphs it should be evident that this viewpoint is completely wrong. Money withdrawals from the reservoirs and the accompanying money inflation can take place at any level of production. The same is true of wage increases or other increased production costs.
What Galbraith and his colleagues are doing is confusing cause and effect. Money inflation results in an inflow of money purchasing power to the producers during the current period exceeding the outflow to the suppliers of labor and capital services. Except to the extent that wage increases become necessary, or productivity decreases, the excess goes toward increasing profits. Productive operations are therefore abnormally profitable during periods of money inflation, as the records clearly indicate. The natural result is that the producers expand their operations to take advantage of this situation. Thus the correlation between inflation and a high rate of production does not have the significance that Galbraith is attaching to it. The high level of production is a result of money inflation, not a prerequisite for that type of inflation. Cost inflation has no effect on production volume as a whole, although it may have significant effects on that of individual enterprises.
As explained in Chapter 1, the essential characteristic of science, the feature that distinguishes it from all other branches of human endeavor, is that it restricts its scope to dealing with those items which are inherently factual in nature, and all of its activities are directed toward reaching conclusions that will meet the ultimate test of comparison with the observed and measured facts. In conformity with this policy, which we are here applying to the economic field, we have identified a variety of factual items that enter into economic life, and have defined them with the precision necessary for factual treatment-for example, we have made the vital distinction between money and real purchasing power. With the benefit of this better understanding of the nature of the various economic factors, we have been able to recognize some important factual relationships of a fundamental nature-the conservation of purchasing power, for instance-that have been overlooked by previous investigators. On the foundation provided by these newly identified basic relations, we have begun the development of a consistent, integrated structure of theory. This development will be extended further in the chapters thai follow, but we have now arrived at the point in the analysis of the inflation phenomenon where we can subject some of the conclusions of this analysis to the kind of a test that is required in standard scientific practice.
After the subject of cost inflation is discussed in the next chapter, Chapter 14 will utilize the results of observation to verify the entire chain of conclusions involved in the theoretical explanation of the business cycle. The theoretical sequence of events making up the cycle will be developed in detail, and the pattern thus derived will be compared with the observed pattern of events in booms and recessions to demonstrate how closely the theoretical analysis reproduces the observed events.