As stated in Chapter 3, the aims of economic science are to determine how the American individual enterprise economic system operates, and how it can be manipulated to accomplish the economic objectives defined by the appropriate agencies of society. The preceding chapters have described the operation of the economy, as seen in the light of the information derived from a systematic analysis, and have identified the economic quantities that can theoretically be modified by external influences. In preparation for a discussion of the various practical ways of exercising control over the operation of the economy, this chapter will recapitulate the control points that have been identified, and will describe the nature of the controls that can be exercised at each of these points.
With the benefit of the analysis in the preceding chapters, we are now able to explain why, as the economists themselves admit in the statements quoted in the earlier pages, economic theory has not been able to point the way to a solution of the most important economic problems of our time. This analysis shows that the economists have not ascertained how the economic mechanism actually operates, and therefore have not been able to identify the points at which it can be effectively controlled. As a result, their efforts to remedy economic ills have consisted mainly of substituting arbitrary actions for certain features of the normal operation of the system. Some of these attempt to do the impossible (direct control of the price level, for example); others (such as “creation of new jobs) are promptly counterbalanced by the operation of natural forces; and still others (of which the disastrous policy of controlling inflation by choking business activity is the prime example). apply cures that are worse than the original disease.
The detailed study of the operation of the economic system in its true status as a continuous flow process clearly indicates that the optimum production of values results if the mechanism is allowed to operate without interference. This is not an argument in favor of laissez faire economics. The economic system is not a self-sufficient mechanism. There are certain points at which decisions must be made and imposed on the system. There are other points at which arbitrary modifications may be made if the authorities in charge of the economy so desire. And both the operation of the system and the results that are obtained from it may be modified substantially by actions that are taken after the economic mechanism has completed its task, chiefly those taken in connection with the distribution of the products of economic activities.
Determination of the volume of production and employment (within the limits of the capacity of the economy) is purely a matter of decision by individuals or agencies, public or private as the case may be. These decisions may be influenced by economic actions of various kinds, and in some cases the effect of a particular influence is quite predictable, but there is no direct connection between any specific action, such as an action to “increase demand,” and the effect on production.
The employment analysis in The Road to Full Employment demonstrated that actions taken to increase employment, as well as those that have an unintended effect on employment, exert their effect through the changes that they produce in an economic function that was called the “survival limit” in that work. In order to understand the nature of this limit, it should be realized that the American economic system, and the others that operate on a private enterprise basis, are competitive systems. The criterion of performance in such a system is profitability, which measures the results of the operations of the individual firms or production units in terms of the values produced relative to the amounts of labor and capital services utilized. Within a certain range defined by the average production costs, the effective values depend on the competitive situation, not on the productivity of the individual enterprise relative to any absolute standard.
This means that in order to avoid an operating loss, which few firms can stand for more than a limited period of time, the productivity of each individual enterprise must exceed a certain percentage of the average productivity of the economy as a whole. That percentage is the survival limit. Firms whose productivity drops below the limit cannot long survive. To illustrate the effect of the limit, let us consider what would happen if we set it at 100 percent of the average; that is, we required each enterprise to exceed the average productivity in order to be allowed to continue operation. Obviously, enough of these firms would have to go out of business to account for half of the employment. Of course, we would try to replace the failures with new and more efficient enterprises. But this would not change the situation. Since the standard is an average, no matter how efficient the new firms may be, half of the new total would still find themselves below the survival limit.
What has not been appreciated heretofore, at least in connection with the employment situation, is that in a competitive economy this same principle applies wherever the survival limit is set. A limit below 100 percent of the average results in a lower percentage of business failures, and consequently a lower rate of unemployment, but it does not eliminate the adverse effect. If the survival limit remains at the level that produces five percent unemployment under the conditions currently prevailing, there will continue to be five percent unemployment indefinitely, regardless of how many new enterprises begin operation, and how many “new jobs” are created.
This is one of many places where economic quantities are in a state of equilibrium, and are therefore subject to the natural laws governing equilibrium systems, particularly Le Chatelier’s Principle, which states that disturbing an equilibrium in one direction or the other generates forces that tend to restore the original condition. In the case cited in the preceding paragraph, stimulation of business activity by means of subsidies or similar devices may have resulted in addition of x new jobs. But the operation of Le Chatelier’s Principle will restore the equilibrium condition by causing failures or curtailments that eliminate x previously existing jobs. Or, if all unemployment were eliminated by withdrawing the currently unemployed from the ranks of those seeking work, the operation of that principle would insure that enough firms would cease, or curtail, operation to bring the unemployment back up to the equilibrium rate (five percent in the example discussed).
As brought out in The Road to Full Employment, where these issues were discussed in detail, what this means is that a quasi-permanent increase in employment can be achieved only by some measure or measures that lower the survival limit. The position of that limit depends on the ratio of the irreducible components of production cost to the total cost. Taxes. other than those on income, are fixed, as is interest. Labor is generally the largest item in the producdtion cost, and under present conditions it is very difficult to reduce the wage and salary rates. The reductions that are made in the outlay for labor are therefore usually limited to what can be done in the way of reducing the working force. Aside from this limited reduction in the labor cost, and a few miscellaneous savings, the only cost items that can be eliminated to meet a financial emergency are profits and income taxes. In recent years the wage structure has become more rigid, and new taxes (Social Security, etc.) have been added. As a result, the survival limit has been increasing.
The effect on employment has been tragic. As late as 1960, the report of the President’s Commission on National Goals was able to take four percent as the “normal” unemployment rate. “In practice,” it asserted, “we must seek to keep unemployment consistently below 4 percent of the labor force.”168 25 years later, Samuelson and Nordhaus estimate the “natural rate of unemployment” at 6 percent.169 The difference is an indication of the extent to which the employment situation has deteriorated in the intervening quarter of a century.
The dependence of the rate of unemployment on the survival limit explains how inflation affects the employment situation. As brought out in the previous discussion, cost inflation due to increases in money wages has no effect on the general operation of the economic system, and therefore no effect on the survival limit. These increases in money wages do not increase real wages. But if the cost inflation is due to higher business taxes, it is one of the factors which, along with decreased flexibility of the wage structure, tends to increase the “normal” level of the survival limit and the corresponding level of unemployment, the level which is now estimated at about 6 percent. Money inflation has a greater and more direct effect. As we saw in Chapter 12, it increases the profitability of productive operations. The higher profits reduce the ratio of irreducible costs to total costs (the survival limit). Employment consequently increases.
During one period following World War II, economists noted a fairly constant relation between the amount of inflation and the unemployment rate, which received widespread attention under the name “Phillips Curve.” Belief in the existence of a stable relation of this nature has dwindled in more recent years, particularly since the coexistence of high inflation and high unemployment has become so common that the term “stagflation” has been coined to describe it. But most of the economic profession still holds to the belief that there is a “trade-off” between inflation and unemployment. so that if we want to cure, or ameliorate, one of these economic ills, we must accept at least some of the other.
The finding that there is no direct connection between inflation and employment changes this picture drastically, Most cost inflation has no effect at all on employment, since the usual cause of that form of inflation, arbitrary wage increases, changes only the money labels, not the real economic quantities. Money inflation does alter the survival limit, and through it the rate of unemployment. But the present study has revealed that inflation is only one of many influences that have the same effect. Full employment without inflation is therefore not an impossible goal, as most economists now contend, but can be reached by using some selection from among the various non-inflationary means of reducing the survival limit. A discussion of the measures that are available for this purpose is included in The Road to Full Employment.
Another point at which a decision must be made, and imposed on the economic system, is the establishment of the money wage level, and, as a consequence, the market price level. There is no way by which the economic system itself can “set the thermostat.” As brought out earlier, what this setting accomplishes is to fix the relation between money and goods at some arbitrary level.
In addition to these points at which outside control must be exercised, there are other points where it is optional. Here the free operation of the economic system would produce certain results, but all or part of the control may be assumed by governmental or other agencies. The composition of the products of the economy is one of these optional items. If the system is allowed to operate without outside interference it will produce that mixture of goods which has the highest total value, as determined by the consumers’ preferences. Almost always, however, the community as a whole, acting through government agencies, modifies this composition by restricting or prohibiting the production of some items and requiring the production of others. The range of action of this nature extends all the way from merely regulating the production of certain items-addictive drugs, for example-to comprehensive “planning” in which an attempt is made to pre-determine the entire output of the economy. The extent to which authoritarian control should be substituted for the automatic operation of the economic system is a matter of opinion, or judgment, and therefore outside the scope of economic science.
Another point where outside control is optional is in the determination of relative wages. Although the general relation between money and wages, the money wage level, must be set arbitrarily, the economic system will establish relative wages for different occupations if it is permitted to do so. However, in most countries, including the United States, relative wage rates are set by some legal or extra-legal process, and are based more on the political and economic strength of the various occupational groups than on any value criteria. In an era when resort to force as a means of resolving conflicting claims is quite generally condemned, the persistence of “tooth and claw” policies for the determination of relative wage rates is a strange anomaly. And certainly the results of these policies do not conform to any standards of justice or equity. It can hardly be denied that free operation of the value system as in the goods markets would produce far more equitable results.
Of course, correction of this situation could only be accomplished as a part of a more general program that would address other major problems of the economy, and thereby attract a wider range of support. Adoption of some program along the lines suggested in The Road to Full Employment to assure continuous employment for all those willing and able to work would, at least, be required. But since correction of these other weaknesses in the economic system should be undertaken in any event, reform of the procedure for wage determination is a feasible and well worth while addition to the objectives.
Price control is generally associated with wage control in economic thinking, but, as has been explained in the preceding pages, the general price level is a result of actions taken ahead of the goods markets, and therefore cannot be controlled directly. Price controls for the usual purpose-to hold down the cost of living-are thus futile. They may, however, be applied to certain individual items for special purposes, in which case whatever reductions are applied to the prices of the controlled items are offset by automatic increases in the prices of other products.
Finally, there is the question of control over interest rates. This power, exercised by the Federal Reserve system in the United States, has a significant effect on the economy, an effect that is generally detrimental, in present-day practice, where the prevailing policies call for throttling business activity as the primary means of controlling inflation.
A problem here is that the interest rate cannot be increased above the normal competitive level, or decreased below that level, without subsidizing the difference. This point is not generally recognized. It is, of course, obvious that the cost of borrowing goes up when the interest rate is raised, but most observers fail to see that maintaining an interest rate below the free market level likewise involves subsidizing an additional cost. Keeping the interest rate artificially low requires issuing new money for the purpose. The entry of this new money into the circulating stream raises the market price level. Consumers in general thus lose an amount of buying power equsl to that gained by the borrowers who get the benefit of the lower interest rate.
The foregoing identification of the points at which controls can be applied to the economic mechanism and the types of control that can be exercised, carries with it the implication that no other control is possible. This is correct. However, certain measures that are intended to control other aspects of the economy are currently considered feasible, and appropriate, on the basis of accepted economic theory, and are frequently put into effect when some modification of those features of the economy appears to be desirable. But these measures either do not accomplish the results at which they are aimed, or do so at the cost of introducing collateral effects of a detrimental nature that far outweigh the meager accomplishments. The description of the controls that are possible will therefore be supplemented by some consideration of the most important of these controls that are either not possible at all, or not feasible from a practical standpoint.
Direct control of the general price level (the usual meaning of the term “price control) is impossible, for the reasons previously explained in detail. The reasons why control over the general level of real wages cannot be exercised were also explained in the previous discussion. Control of the amount of real purchasing power available to the consumers is another impossible task. More money can be injected into the economy, but this does not add any purchasing power. It merely dilutes the value of the money previously available for purchases, and does not enable buying any more goods.
From this it follows that “increasing demand,” the centerpiece of most of the modern prescriptions for improving the performance of the economy, is impossible in real terms. The “increased demand” is simply an inflationary addition to the money purchasing power, and it has all of the disadvantages of any other money inflation, as well as the stimulating effect on business that its advocates want to produce. Furthermore, it is inevitably followed by deflation. Demand, in real terms, is determined by production, and it cannot be increased by changing the money labels.
So far, the discussion in this chapter has dealt with controls over the operation of the economic system. The objective of that operation is to put goods of the desired kinds into the hands of the individuals who have participated in the economic process. But some portion of these goods must be allocated to paying the expenses of the governmental agencies that make organized economic activity possible, and most of this is usually recaptured from the workers and suppliers of capital who receive the larger shares of the proceeds of the economy. Thus a certain amount of redistribution of the products normally takes place. This redistribution is completely under the control of the appropriate agencies of society, and it can therefore be used for a variety of purposes in addition to raising the revenues needed to pay the costs of government. Here, then, the community has at its disposal a method of control over the ultimate results of economic activity that is exercised after the economic system has completed its work.
In many cases it is possible, by means of these readjustment measures, to accomplish the same objectives that the nation is now trying to attain by the use of controls that affect the operation of the economy. There is a big advantage in so doing, because free operation of the economic system is geared to production of the maximum values, and any modification of the automatic operation therefore involves a loss of productivity. Not infrequently there are undesirable collateral effects as well. Handling the redistribution as the last act avoids these productivity losses and other adverse effects.
The minimum wage situation is a good example. As emphasized in the earlier discussion, if anyone is paid more than the market value of his services, the real earnings of the rest of the workers in the community are reduced below their market value by this same amount. (The adjustment is automatically accomplished by an inflation of the price level.) No employer can afford to pay wages above the market levels unless his competitive position is such that he can recover the added amount by adjustment of his price structure. For this reason the existing minimum wage laws do not require anyone to pay the minimum wage; they simply forbid the employers to hire anyone at a lower rate. The result in a great many cases is that the worker loses the employment opportunity.. Thus these laws are major contributors to the current rate of unemployment.
The finding that the difference between the free market wage level and whatever minimum wage is established by law adds to the price level in the goods markets points the way to a more efficient way of handling the situation. As matters now stand it is generally believed that the employers have to stand the cost of the higher wage, and public approval of such measures is relatively easy to get if someone else pays the bill. But our analysis shows that there is no “someone else,” and the consumers (that is, the general public) have to stand the additional cost in one way or another. Under these circumstances there are distinct advantages in a direct subsidy. Wages of the sub-standard workers can be allowed to find their equilibrium level in the labor markets, and whatever adjustment the community desires to make can be accomplshed by an additional payment from public funds. This would leave the cost to the general public just where if now stands, while it would avoid the unemployment ahd loss of productivity that result from the existing way of dealing with the minimum wage problem.
Of course, it may be more difficult to get public approval of minimum wages or other redistribution measures when the taxpayers understand that they have to pay the bill, but by this time the nation should be mature enough to face its problems openly, rather than having to conceal the facts in order to gain public acceptance of social policies. The costs of such policies cannot be unloaded onto business enterprises, or anyone else; they have to be borne by the general public. If that public, in their capacity as taxpayers refuse to pay, the costs are automatically assessed againt them in their capacity as consumers.
The minimum wage example illustrates the point, applicable throughout the economy, that if some adjustment of the market value of labor in favor of the less productive workers is considered advisable, it is far more efficient to make the adjustment after the economic system has done its work, rather than to introduce arbitrary modifications into the operation of the system. By so doing, the benefits of the high productivity of the freely operating economic system are retained, without in any way restricting the community control over the ultimate distribution of the products .
The methods of making these final-stage adjustments are taxation, which decreases the net proceeds to the individuals that are affected, and subsidies, which increase the net proceeds. These are familiar features of all modern economies. Thus the suggestion that social objectives should be attained by adjustments of the results of the market system, rather than by arbitrary actions intended to cause that system to produce different results, does not introduce anything new into the economic situation. It merely takes more advantage of one of the economic tools that is already in widespread use.
Much of the criticism of the individual enterprise economies (capitalist” economies to their detractors) is focused on what the critics regard as inequities in the product distribution accomplished by market forces. As expressed by Heilbroner and Thurow:
What these and other critics fail to take into consideration is that no economic system automatically accomplishes what they, or any other critical observers, regard as an equitable distribution of the products of economic activity. In all cases there has to be an arbitrary adjustment for this purpose. The difference is that in an authoritarian type of economic system the adjustment is applied mainly (entirely, in the ideal system) to the operating elements of the mechanism-wages, prices, currency controls, etc.-while in a market system it is applied mainly (entirely in the ideal system) after the economic mechanism has completed its work.
Any modification of the results that would be produced by free operation of the markets that can be accomplished in one of these ways can also be accomplished in the other manner. Thus the “contest between the costs and benefits of economic freedom” cited by Heilbroner and Thurow is non-existent. It is not necessary to sacrifice any of the advantages of efficient operation. Any “benefits” for individuals or the public at large that can be secured by authoritarian modification of the operation of the economic system can be obtained just as easily by adjustments made after the system has done its work.
It follows that any final result in the way of distribution of the products of the economy that can be attained under any other economic system can also be attained by a market system, such as the American individual enterprise system, with a much greater degree of efficiency. The only disadvantage-if it is one-is that since the last-stage adjustments are out in the open , where they can be seen for what they are, the public may not be as ready to accept them as they are to adopt a program in which the incidence of the costs is concealed. Many individuals who are quick to support the idea that the “big corporations” should be required to pay their employees a “living wage” will not be quite so quick to give their approval when they understand that any difference between that legal wage and the free market value of an individual’s services has to come out of the pockets of the general public.
Much of the support that economists have given to authoritarian economic systems has been based on their lack of confidence in the ability of the public to arrive at socially desirable answers to economic questions. “Every unwise choice on the part of consumers brings about the production of some useless or even injurious commodity,171 says one textbook. The authors contend that we should produce “only the most desirable kinds of goods, as judged by the ideals of our most enlightened thinkers.”172 The question as to who are these “enlightened thinkers” is one on which a consensus will not be easy to achieve. However, the merits of the arguments in favor of authoritarian control of this nature are a matter of opinion, and they no longer have much support outside the Marxist economies. It is not likely, therefore, that they will ever have much appeal to the American consumers, accustomed as they are to demanding, and receiving, the kind of products that they are willing to buy.
The consent of the public will also be required if any change from the existing indirect wage subsidies to direct subsidies is to be made, and this will not be easily obtained. However, it would probably be acceptable as one component of a full-scale employment program of the kind recommended in The Road to Full Employment.