Inflation and Unemployment: Contributions to a New Macroeconomic Approach (Routledge Studies in the Modern World Economy, 3)

INFLATION AND UNEMPLOYMENT

Are inflation and unemployment inevitable? This collection challenges traditional monetary theory by focusing on the role of banks and provides a new insight into the role played by bank money and capital accumulation. An international collection of contributors with wide experience of the subject also reappraise the analyses of inflation and unemployment developed by Marshall, Keynes and Robertson. This volume is published in association with the Centre for Banking Studies of Lugano, Switzerland. Alvaro Cencini is Professor of Monetary Economics at the Centre for Banking Studies of Lugano (Switzerland) and Associate Professor of International Economics at the University of Varese (Italy). Since writing his PhD at the London School of Economics he has been working on monetary theory and macroeconomics. Among his publications are Time and the Macroeconomic Analysis of Income and Monetary Theory: National and International. Mauro Baranzini is Professor of Economics at the University of Verona and was previously Associate Professor of Economics at the Catholic University of Milan and Lecturer and Tutor in Economics at The Queen’s College, Oxford. He is the author of A Theory of Wealth Distribution and Accumulation, and the editor of (among others) The Dynamics of the Wealth of Nations: Growth, Distribution and Structural Change (with G.Harcourt).

ROUTLEDGE STUDIES IN THE MODERN WORLD ECONOMY

1 INTEREST RATES AND BUDGET DEFICITSA Study of the Advanced EconomiesKanhaya L.Gupta and Bakhtiar Moazzami 2 WORLD TRADE AFTER THE URUGUAY ROUNDProspects and Policy Options for the Twenty-first CenturyEdited by Harald Sander and András Inotai 3 THE FLOW ANALYSIS OF LABOUR MARKETSInternational perspectivesEdited by Ronald Schettkat 4 INFLATION AND UNEMPLOYMENTContributions to a New Macroeconomic ApproachEdited by Alvaro Cencini and Mauro Baranzini 5 MACROECONOMIC DIMENSIONS OF PUBLIC FINANCEEssays in Honour of Vito TanziEdited by Mario I.Blejer and Teresa Ter-Minassian 6 FISCAL POLICY AND ECONOMIC REFORMSEssays in Honour of Vito TanziEdited by Mario I.Blejer and Teresa Ter-Minassian

INFLATION AND UNEMPLOYMENT Contributions to a new macroeconomic approach

Edited by Alvaro Cencini and Mauro Baranzini Published in association with the Centre for Banking Studies of Lugano, Switzerland

London and New York

First published 1996 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 Routledge is an International Thomson Publishing company This edition published in the Taylor & Francis e-Library, 2005. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” © 1996 Selection and editorial matter Alvaro Cencini and Mauro Baranzini; individual chapters, the contributors All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data A catalogue record for this book has been requested ISBN 0-203-97828-5 Master e-book ISBN

ISBN 0-415-11822-0 (Print Edition)

CONTENTS

List of contributors INTRODUCTION Alvaro Cencini and Mauro Baranzini

viii 1

Part I Inflation and unemployment: a monetary and structural framework for analysis 1

INFLATION AND DEFLATION: The two faces of the same reality Alvaro Cencini

15

Introduction

15

The quantity theory of money: a reappraisal

16

The traditional analysis of inflation: a critical survey

21

Unemployment

34

Stagflation

41

Inflation and deflation as the consequences of the same anomaly 47 2

STRUCTURAL CHANGE, ECONOMIC GROWTH AND UNEMPLOYMENT IN A VERTICALLY INTEGRATED MODEL Mauro Baranzini

57

Introduction

57

Two frameworks of analysis: the circular model and the vertically 58 integrated model Technological unemployment in the vertically integrated model

61

International mobility of labour, information and technical knowledge

64

Summing up

65

vi

Part II Inflation and deflation as monetary pathologies 3

UNEMPLOYMENT: Is there a principal cause? Bernard Schmitt

70

Introduction

70

No positive measure of unemployment can occur in an economy where the definition of the national income reduces to C+I

74

The complete demonstration of the equivalence of saving and 80 investment must be founded on a revision of the concept of money

4

Profits are definitively not to blame for any measure of positive unemployment

84

Real money, nominal money and the principal cause of unemployment

90

FROM KEYNES’S TO THE MODERN ANALYSIS OF INFLATION Xavier BradleyJean-Jacques FribouletClaude Gnos

100

Inflation from the Tract to the Treatise

101

Income and the definition of the inflationary gap

106

The General Theory and after: the confrontation between the 114 analysis of the inflationary gap and the identity between supply and demand The identity between aggregate supply and demand, the basis of 120 a new definition of the inflationary gap Part III Learning from the past 5

6

THE MARX-HAYEK CYCLE AND THE DEMISE OF OFFICIAL KEYNESIANISM Meghnad Desai

128

Introduction

128

Marx’s theory of the cycle

129

Hayek’s theory

131

Recent economc history as a Marx—Hayek cycle

134

Some analytical summing up

139

UNEMPLOYMENT AND PRICE STABILITY: Aspects of the Marshallian legacy on the monetary economy Peter Groenewegen

141

vii

Marshall and the monetary economy

143

The monetary economy in Robertson and Keynes

153

Concluding comments

160

References

167

Author index

177

Subject index

180

CONTRIBUTORS

Mauro Baranzini is Professor of Economics at the University of Verona and at the Centre for Banking Studies in Lugano. Among his main contributions are: A Theory of Wealth Distribution and Accumulation; Advances in Economic Theory and Foundations of Economics: Structures of Inquiry and Economic Theory. Xavier Bradley is Senior Research Fellow at the Centre d’Etudes Monétaires et Financières, University of Bourgogne. Among his contributions are: ‘Le multiplicateur et la formation du revenu’, ‘La finance et le circuit de la monnaie’ and ‘Définition de l’inflation: actualité de la problématique keynésienne des unités de salaire’. Alvaro Cencini is Professor of Monetary Economics at the Centre for Banking Studies in Lugano and Associate Professor of International Economics at the University of Varese. Among his publications are: Time and the Macroeconomic Analysis of Income; Money, Income and Time; and Monetary Theory: National and International. Lord Meghnad Desai is Professor of Economics and Director of the Centre for the Study of Global Governance at the London School of Economics. Among his main publications are The Life and Death of Monetarism, Political Economy (volume 1 of his selected works) and Macroeconomics and Monetary Theory (volume 1 of The Selected Essays of Meghnad Desai). Jean-Jacques Friboulet is Professor of Economics at the University of Fribourg. He is the author of Profit, investissement et inflation and of several articles, including ‘Développement économique et social’, and ‘Les économies du Tiers Monde’, both published by the Encyclopaedia Universalis. Claude Gnos is Associate Professor of Economics at the University of Dijon. He is the author of Production, répartition et monnaie. Among his main contributions to monetary economics are: ‘La transition vers l’union économique et monétaire: les vertus négligées de la monnaie commune’ and ‘Le circuit, réalité exhaustive’. Peter Groenewegen is Professor of Economics at the University of Sydney. Among his recent publications are the first full-length biography of Alfred Marshall, A Soaring Eagle: Alfred Marshall 1842–1924, and an edition of

ix

Marshall’s official papers to supplement those edited by Keynes in 1926, Official Papers of Alfred Marshall: A Supplement. Bernard Schmitt is Professor of Macroeconomics at the Universities of Fribourg and Dijon. Among his several publications are: Macroeconomic Theory, a Fundamental Revision, New Proposals for World Monetary Reform and Inflation, chômage et malformations du capital.

INTRODUCTION Alvaro Cencini and Mauro Baranzini

Despite some modest signs of recovery, it can hardly be denied that unemployment is an increasingly worrying symptom of the disorderly workings of our economic systems. Moreover, inflation is still far from being defeated and never stops asserting its close relationship with deflation. In such a context the need for a better understanding of stagflation is evident. This is not to deny, of course, the importance of the contributions economists have been providing since the seminal works of Ricardo on monetary economics. However, the coexistence of two apparently complementary disequilibria such as inflation and deflation is still a mystery, and very little progress has been made towards explaining the nature of their relationship. Phillips’ claim that inflation and unemployment are inversely correlated has never been effectively established, and the debate which arose after the publication of his famous article in Economica (1958) did not provide a solution to the problem. The very analysis of inflation is in itself not entirely satisfactory. The brilliant intuitions of Ricardo and Keynes have not been followed up by a thorough investigation into the monetary causes of this disequilibrium, which remains partially unexplained. The concept of excess demand and the idea that inflation is provoked by an anomalous increase in the money supply have not been followed to their extreme implications and there is still a lot of confusion about the role played by banks in the process of money creation. Generally speaking, it is usually claimed that inflation is the consequence of the behaviour of economic agents. Dishoarding, credit expansion, public expenditure, wage increases, devaluation and rises in foreign prices are successively put on trial and condemned according to the prevailing beliefs of the moment. Yet, it is not at all clear why an increase in consumption can lead to inflation given that what is saved is necessarily spent through the intermediation of the banks in which savings are deposited. The equality between saving and investment is a consequence of the banking nature of modern money, and not a matter of adjustment. Analogously, how can the identity between total demand and total supply be invalidated without betraying the laws of bank money? These are difficult questions which are symptomatic of the complexity of the problem and which must find an answer if we are to discover the peculiarity of inflation. The time has come to get rid of old, ill-conceived ideas which tend to reduce

2 ALVARO CENCINI AND MAURO BARANZINI

inflation to a problem of the price index. As is easily shown by modern monetary analysis, an increase in the cost of living is not necessarily an effect of inflation, and inflation is not necessarily reflected in an absolute variation of the price index. The loss of money’s purchasing power cannot be mixed up with the simple redistribution of income resulting, for example, from a rise in the price index due to an increase in indirect taxation (which is simply the cause of a transfer of purchasing power). Apart from the works of some great economists of the past, inflation has also benefited from the investigation carried out by the Monetarists, and from their controversy with the Keynesians. Unfortunately, the debate has not given enough relevance to the progress made by our banking systems, so that their analysis of money has remained anchored to an old-fashioned line of arguments in which money is perceived as an autonomous real asset not fully integrated in the economic system. The idea of the quantity of money as well as that of its velocity of circulation is a clear example of how money is still considered as if it were a real good, an object with a proper mass whose circulation is subject to the laws of physics. Fruitful as this material concept of money might at first appear, it takes us no nearer a better understanding of our monetary systems. On the contrary, the lack of a correct analysis of the specific nature of bank money does not allow for any satisfactory explanation of inflation. Apart from the very particular case in which Central Banks finance public debt by money creation (a case which does not apply to the majority of industrialised countries), the pathological growth of the money supply cannot be ascribed to the inadequate decisions taken by monetary authorities. The image of money being produced by Central Banks in the same way as firms produce real goods is ill-founded. Not only is money issued mainly by secondary banks, but it is also never produced. Although the Monetarists are right in claiming that inflation has to be analysed within a monetary framework, they seem to fail in providing a theory of modern bank money. The real kernel of the problem is that they are not fully aware of the a-dimensional nature of money and the way it is associated with the world of real output. Their analysis of inflation is thus seen to beg the question, since it rests on a strict dichotomy between money and output. The conceptual shortcomings of the traditional approach to inflation are present in most analyses of unemployment. Missing the centrality of Keynes’s distinction between voluntary and involuntary unemployment, mainstream economists are often led to investigate the problem of unemployment from too narrow a point of view. It is true that this disequilibrium is seen to be the consequence of a whole variety of real and monetary causes, ranging from technological progress to monetary authorities’ policies. Whether of a structural or conjunctural origin, however, unemployment pertains to the category of voluntary unemployment and is not of a pathological nature (let us remind the reader that voluntary unemployment refers to the unemployment generated by the normal working of our economic systems and has nothing to do with the willingness to be out of work). Hence, traditional attempts to explain

INTRODUCTION 3

unemployment have systematically failed to account for the category of involuntary unemployment. As suggested by Keynes, this is the true disequilibrium we should effectively worry about. It is when part of total real output cannot be sold that the system suffers from a pathological shortage in demand leading to involuntary unemployment. The problem of unemployment must therefore be related to a situation known as deflation. Any theory which only accounted for unemployment caused by real factors would be unsatisfactory. Deflation is a monetary disequilibrium which can only be explained if we are able to work out a theory in which production, distribution and final purchase are simultaneously analysed from their monetary and real points of view. To do this, we must start from the emission of bank money and follow it until its final expenditure in order to find the anomaly leading to a pathological decrease in employment. The fact that inflation and (involuntary) unemployment are both to be investigated by considering the relationship between bank money and real output is emblematic and corroborates the thesis of their common origin. Were it not so, it would be impossible to explain their coexistence, since inflation and deflation could then only be conceived as two disequilibria of the opposite sign (D>0, D<0) which are bound to compensate for each other. The presence of stagflation is factual proof that inflation cannot be defeated through a deflationary policy and that (involuntary) unemployment cannot be reduced through an inflationary increase in the money supply. On the contrary, since both disequilibria result from the same anomaly, an increase in inflation will only pave the way to a rise in unemployment. The determination of the sequence of events leading to inflation and pathological unemployment is not an easy task. It requires a thorough analysis of the laws governing the use of bank money, and implies a disenchanted reappraisal of several ill-conceived axioms of our science. This is not to say, of course, that the analysis of the real and monetary causes of the high level of under-utilisation of resources should not be pushed farther along more traditional lines of research. The investigation into structural and conjunctural unemployment is a task which cannot be disregarded on the grounds that these disequilibria are inherent to the normal working of our economic system. Substantial progress may in fact be made following a rigorous approach in which the structural dynamics of production and unemployment are analysed by referring to ‘horizontal’ and ‘vertical’ schemes of structural specification. A synthetical vision of the problem of unemployment is therefore possible in which the structural and conjunctural approaches are associated with the monetary analyses of deflation and pathological unemployment. In this book we have attempted to lay down the first elements for a fruitful collaboration among economists who, despite their different analytical background, share the same objective of providing a satisfactory and comprehensive explanation of the disequilibria hampering the smooth development of our economies. A common feature of the contributions gathered

4 ALVARO CENCINI AND MAURO BARANZINI

here is that emphasis is laid on macroeconomic relations and on the explicative role of our science rather than on its forecasting nature. Following the path traced by Ricardo and the Classics and successively widened by Keynes, particular relevance is given to the role of money and to the shortcomings of the actual monetary systems. The works presented in this volume are a serious attempt to clarify the terms of the problem and must be seen as a contribution to the building up of a modern theory of monetary and structural macroeconomics. They do not all stem from the same conceptual framework, but they all stress the need for a new approach to the problems of inflation and unemployment. Their differences are in some cases substantial, yet, far from being a discouraging obstacle, such distinguishing features should provide a further stimulus to pursue an analysis which, though still in the making, seems rich with promise. Let us introduce the reader to the various chapters of the book by stressing the originality of each contribution as well as the common line which links them all. In the first chapter, ‘Inflation and deflation: the two faces of the same reality’, an attempt is made to reformulate the quantity theory of money in conformity with the a-dimensional concept of bank money. The aim of this operation is to elaborate an analytical instrument for the testing of traditional theories on inflation and unemployment. Demand-pull and cost-push theories of inflation are then subjected to a critical investigation in order to verify if they are capable of determining the causes of inflationary growth in the quantity of money. Having shown that the index of prices is a very unsatisfactory revealer of inflation, the author sets out to prove that this disequilibrium cannot be ascribed to the behaviour of economic agents. His conclusion is that neither demand-pull nor cost-push theories nor those which emphasise the impact of monetary policies or international transactions provide a sound explanation of inflation. Although its consequences are real, the loss of money’s purchasing power is not a physical process. Money itself is not a material object, so that the alteration of its relationship with real output can only be explained by taking into account the possibility of some kind of anomalous payment. At this stage of the argument, Alvaro Cencini refers to Bernard Schmitt’s analysis of inflation and shows that money can be deprived of its real content if the costs of production of a given output are financed through the expenditure of a positive income. In our monetary systems, this occurs every time the production of investment goods is financed out of profits. It is the investment of profit which creates the conditions for the emission of ‘empty’ money, that is, money whose purchasing power has already been spent since it was created. This does not mean, of course, that either profits or their productive investment have to be blamed for generating inflation. The anomaly lies with the structure of (monetary) payments and not with the decisions taken by firms, banks, consumers or any other economic agent. The central message of this chapter is therefore that the causes of inflation have to be individuated within the structure of banks’ bookkeeping, a conclusion which is corroborated by Cencini’s claim that unemployment is the result of the same monetary anomaly leading to inflation. Following the same methodological path

INTRODUCTION 5

of his investigation into inflation, the author first clears the way for a correct understanding of the problem. Having made clear that pathological unemployment is neither related to structural change nor to conjunctural fluctuations, he then argues that, as in the case of inflation, its causes are not imputable to the behaviour of economic agents. If firms are forced to give up production it is not because consumers save too much of their income (which, being deposited within the banking system, is entirely available for the financing of expenditure), but because they would not be able to sell their output without incurring a loss. It is because the level of the fixed capital accumulated so far has reached a critical stage that firms tend to reduce the productive investment of their profits. The link between inflation and (involuntary) unemployment is thus established by the fact that inflation entails a process of over-accumulation of fixed capital. With the growth of this pathological capital (that is of the capital generated by the investment of inflationary profits) it becomes increasingly difficult for firms to remunerate it at the market rate of interest so that they are forced to find a more profitable way of investing their gains. Stagflation describes a situation where inflation and deflation coexist. Now, this concept can be explained satisfactorily only if these two disequilibria stem from the same cause. According to the modern analysis of bank money this cause is the formation and growth of pathological capital, which leads to the emission of empty money (inflation) and to the impossibility of expanding production profitably behind a certain level of capital accumulation (deflation). In his chapter ‘Structural change, economic growth and unemployment in a vertically integrated model’ Mauro Baranzini considers a number of analytical aspects of the inter-relationship between structural change, economic growth, employment and the dynamics of the price system in a model of growth, distribution and accumulation with special reference to technological unemployment and labour mobility as a consequence of technical progress. Special emphasis is given to the recent model put forward by Luigi Pasinetti with reference to the problems of maintaining full employment in a multi-sector economic system with a growing population and different rates of technical progress in different sectors of the economy. The conditions for employment and full capacity utilisation are examined when prices are stable and also when there is inflation (or deflation). Normally such analyses are carried out, as is customary in multi-sector models, in terms of input-output relations; in Pasinetti’s framework, on the contrary, they are treated in terms of vertically integrated models. This makes it possible to consider the economic process in terms of the structural dynamics of production, of prices and of employment of the factors of production. According to this framework of inquiry both demand- and supply-sides play a relevant, and often cumulative, role in the determination of structural changes. As productivity increases, per capita income also rises and the increments (or decrements in the case of inferior goods or services) will concentrate in succession around different goods and services. Here the rate of change of

6 ALVARO CENCINI AND MAURO BARANZINI

demand for each commodity will vary continually over time and will normally be different from the rate of change of demand for any other commodity; hence the core of the problem lies in the gap between the potentialities of efficient growth of the single organisational units of production, and the highly unsteady as well as uneven nature of the expansion of demand for all commodities. In a world where technical progress becomes increasingly relevant this contrast is bound to become a crucial factor of disequilibrium. Baranzini’s chapter first focuses on the two different frameworks of analysis within which these issues may be considered: first the circular model and second the vertically integrated model. As a matter of fact economic theory may be seen as a representation of the relationships between elementary economic units such as production processes and consumption activities. Such a representation might take a different form depending on the criteria by means of which such processes and activities are linked to each other. In a number of cases this integration takes the form of circular interdependence in which the consumption activities are considered as a necessary prerequisite of the production process itself. Yet in other cases this integration takes the form of a ‘one-way’ or ‘vertical’ relationship in which the consumption of commodities appears to be the ultimate goal of the production process. Here the notion of ‘productive allocation’ is relevant. However there is no immediate connection between subsequent time periods: for any given technique of production the output level in each period depends on the amount of available resources that are not themselves produced within the economic system. In this perspective future production is disjointed from current production, and the reasons for the dynamic behaviour of the economic system are closely connected with the availability of the productive resources in each period. The nature of technological unemployment in the vertically integrated model is considered in the third section of Baranzini’s chapter. As productivity increases per capita income also rises and the increments in demand will be unequally distributed amongst different goods according to Engel’s Law. Four factors may however counteract such a disequilibrating tendency: the renewal of the working population, the growth of population, the shift of working force from one sector to another and the finding of substitute markets for products. All these factors are critically examined and their applicability and limitations are defined. Finally Baranzini considers a number of important issues related to the international mobility of labour, information and technical progress. A number of new results and asymmetries are brought to the attention of the reader. The main conclusions to be drawn from this analysis, heavily based on Pasinetti’s life-long contributions, is that the process of growth of a modern economic system with uneven technical progress is normally, though not inevitably, bound to take place with fairly strong disturbances of both the price system and the degree of capacity utilisation. The aim of Chapter 3, ‘Unemployment: is there a principal cause?’, is to show that, within a closed economy, there is a single major cause of unemployment.

INTRODUCTION 7

Bernard Schmitt maintains that involuntary unemployment is due to a deficit in total demand and sets out to prove that unemployment would never arise if the economy were to produce consumer and investment goods only. His argument is based on the consideration that the definition of national income must account for the production of goods replacing the value lost by fixed capital. Starting from the modern analysis of bank money, he first shows that, in the absence of fixed capital amortisation, Say’s Law is bound to hold good. No discrepancy can possibly occur between total supply and total demand and there is no room for involuntary unemployment to hit the economy. The fact is that, in an economy producing consumption and investment goods only, all the income generated by this production is necessarily spent on its final purchase. Schmitt proves it both in the case where households own the entire amount of income formed in the economy, and when part of their initial income is transferred to firms (as profit) and invested. The decisive point is that money and output are not two separate objects, but the two terms of an identity. Book-entry money is endowed with a positive value only insofar as it is associated with real output, so that owning money amounts to owning real goods and services. Hence, domestic output is effectively being demanded from the very moment incomes are formed. Whether owned by households only or by firms as well, income is entirely spent on the purchase of consumption and investment goods since that part of income which is saved by firms or households, and is therefore still available within the domestic banking system, defines an equivalent amount of real output. In an economy with no fixed capital Say’s Law triumphs and there can never be a shortage in total demand. However, no such economy exists in the real world, where the presence of fixed capital calls for the production of replacement goods. In the last part of his chapter, Bernard Schmitt sets out the elements of a new analysis of income in which the production of amortisation goods plays a determinant role in explaining the possible discrepancy between total demand and total supply. The problem lies in the fact that amortisation goods pertain to the categories of intermediate and final goods simultaneously. To solve it, the author refers to the modern conception of bank money and shows that, unlike the production of consumption and investment goods, the production of amortisation goods leads to an emission of nominal money. The use of fixed capital and the production of replacement goods entails a duplication in the physical production of consumption goods. The productivity of fixed capital is thus entirely accounted for by this increase in physical output. In this respect, amortisation goods are intermediate goods, leading to a new production of consumption goods. Now, amortisation goods are also final commodities for they are definitively acquired by firms from the moment of their production. Households employed in the sector producing amortisation goods are paid in a purely nominal money, devoid of any real output. The production of amortisation goods leads therefore to ‘dual physical capital’ corresponding to the nominal income generated in this sector.

8 ALVARO CENCINI AND MAURO BARANZINI

The careful reader will certainly observe that the analysis developed by Bernard Schmitt is slightly different from that of Chapter 1. In particular, the dual production of physical capital is observed here in the sector producing amortisation goods, while in Chapter 1 it is attributed to the sector producing investment goods. However, despite appearances to the contrary, there is no opposition between the two arguments which are, in fact, two alternative ways of presenting the same analysis. Given the macroeconomic character of the explanation, what really matters is the fact that, because of amortisation, firms benefit from a dual production of fixed capital, that is, from a physical output the factors of production are deprived of from the very moment they are paid by firms. As shown by Bernard Schmitt, the creation of empty money (purely nominal income) is the major cause of unemployment since it introduces a positive discrepancy between total supply and total demand. Entailing a purely nominal income, the production of replacement goods increases total supply without increasing total demand, a situation which creates an increase in unemployment as its necessary consequence if dual physical capital has the form of consumption goods. Dual physical capital being obtained by firms from the moment of its production, no real income is necessary for its purchase if it is made of investment goods. On the contrary, if it consists of consumption goods it cannot be sold on the market since no real income is available for this purpose. In this last case, firms will have no other choice but to reduce employment. Schmitt’s diagnosis of unemployment is thus based on the analysis of amortisation and on the discovery that, in the present system of payments, the production of replacement goods entails the creation of nominal incomes and the fall of the productivity of fixed capital below the rate of interest. As he suggests, the solution to this pathological state of affairs requires the implementation of a threefold distinction between the monetary department, the financial department and the department of capital at the banking level. It is only if this distinction is truly operational that nominal incomes never replace real incomes and that amortisation can occur without leading to a pathological process of capital overaccumulation which, as observed in Chapter 1, is both related to an anomalous emission of empty money (inflation) and to an un-balanced increase in total supply (deflation). Xavier Bradley, Jean-Jacques Friboulet and Claude Gnos are the authors of Chapter 4, ‘From Keynes’s to the modern analysis of inflation’. In this chapter they examine the problem of inflation starting with the works of Keynes, their aim being to show the originality of his approach, particularly concerning the analysis developed in the Treatise and in The General Theory. As is stressed from the beginning, the main innovation introduced by Keynes in his Treatise lies in his attempt to define inflation as an excess of total demand over total supply. However, Keynes did not introduce his definition at the start of his analysis. Before arriving at the concept of profit inflation, he developed a more quantitativist approach emphasising the role played by monetary authorities in determining the supply of money. In the Tract, he related inflation to real balances, attributing the

INTRODUCTION 9

responsibility for a variation in prices to the behaviour of economic agents. As stressed by Bradley, Friboulet and Gnos at this stage Keynes did not take the saving-investment relationship into account and his explanation of inflation was still in the making. With the Treatise things changed radically. Bank money became the main object of macroeconomics and, taking over the classical distinction between nominal and real money, Keynes was able to show that bank deposits are the true expression of real incomes. The foundations of modern monetary theory were thus laid down by Keynes through his analysis of bank deposits. By claiming that bank deposits are created through lending, he clearly suggested that money as such has no intrinsic value of any sort, and that its purchasing power must derive from its association with the real object of the deposit issued by the banking system. Referring to the analysis worked out by Bernard Schmitt and to his concept of monetary emission, Bradley, Friboulet and Gnos propose an interpretation of the monetary work of Keynes which breaks away from traditional mainstream economics. Money is seen as a numerical vehicle and income as the result of the association of this ‘form’ with real output, its physical ‘content’. In this context, how is it still possible to find a discrepancy between total demand and total supply? Income and real output being two aspects of the same object how can one be greater than the other? The answer given by Keynes in his Treatise calls for the possibility of a positive gap between investment and saving and is based on the distinction between profit inflation and capital inflation. The former is determined by the difference between the cost of investment and saving, and is the mark of a monetary anomaly leading to a decrease in the purchasing power of money. Linking the possible discrepancy between total demand and total supply to the formation of profits and to their subsequent investment, Keynes opens the way to the modern analysis of inflation. From the behaviour of economic agents, attention is focused on the structure of monetary payments and particularly on the consequences deriving from the non-respect of the distinction between money and income. Inflation is thus related to the formation of capital deriving from the investment of profits. As stressed by the authors of this chapter, the difference between the cost of investment and saving (the true cause of inflation according to the Treatise) constitutes a capital because the monetisation of investment is financed by an income produced in a previous period. Their analysis is here closely related to that developed in Chapter 1 and shows how the works of Keynes can be interpreted in such a way as to evidentiate the existence of a red line between his approach and the modern theory of money. Of course, this does not mean that this interpretation is to be considered more ‘genuine’ than the others. The point is obviously not that of trying to explain what Keynes really had in mind when writing this or that text. Much more fruitful and up to the task of scientific inquiry is to try to work out the elements of his analysis which can be incorporated into a modern theory

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capable of explaining the mysteries which traditional monetary economy has not been able to unveil. This is the approach followed by Bradley, Friboulet and Gnos who, in the second part of their chapter show how inflation can be explained as a difference between demand and supply even though total supply is always necessarily equal to total demand. As they point out, in The General Theory Keynes was not able to overcome this apparent contradiction, and his analysis of inflation was still elaborated in terms of the quantity theory of money. But how can inflation be determined by an increase in the quantity of money given that such an increase has a simultaneous and equivalent effect on total supply and total demand? The neoclassical dichotomy between real and monetary variables is a theoretical shortcoming which leaves real output totally undetermined. The attempt to explain inflation by supposing that money (total demand) is determined autonomously from real output (total supply) and that these two quantities must adjust to one another is bound to fail since, as observed by the Classics and by Keynes himself, money and product are the two faces of one and the same object. The way out of the dead end requires a fresh look at bank money and at the monetary process of production. Following Keynes’s analysis of the ‘finance motive’ the authors of the chapter suggest that a distinction can be made between ‘constant’ and ‘current’ money. On the basis that money flows logically precede money stocks, they maintain that Keynes’s concept of profit inflation can be profitably resumed to show how, although they are identical in constant money, total supply can differ from total demand in current money. Chapter 5 is dedicated by Meghnad Desai to the study of ‘The Marx-Hayek cycle and the demise of official Keynesianism’. Starting from the consideration that in all European countries Keynesian policies against unemployment have been abandoned, Desai attempts an explanation of the course of the capitalist economy since the mid-1960s in terms of the Marx-Hayek analysis of the cycle. His explicit aim is to set up ‘a framework that can encompass the success of the Keynesian Revolution as well as its decline’. The synthesis between Marx’s and Hayek’s theories of the business cycle has never been fully attempted and Desai’s paper sets out the terms of an investigation which represents a fruitful example of the way economic problems can be successfully tackled with a combined effort of apparently opposed theories. In the first part of the chapter, Marx’s and Hayek’s theories of the cycle are dealt with separately, Professor Desai’s intent being to show that whereas the decline of traditional Keynesianism can be explained by referring to Marx’s analysis, the crisis of capitalism and its restructuring are better understood by referring to Hayek’s analysis. As is known, Marx’s theory of the trade cycle is closely related to his analysis of capital accumulation. In a period when capital growth goes together with an expansion in production and employment, the rate of surplus value falls (due to a rise in real wages), then the reduction in the rate of profit pushes firms to raise the productivity of labour through an increase in fixed capital, which leads to a new increase in unemployment and brings back

INTRODUCTION 11

the trade cycle to its point of departure. This is the simplest model of business cycle which can be derived from Marx’s theory and which Desai chooses to refer to (another fruitful approach to Marx’s analysis would consist of stressing the relationship between amortisation, capital over-accumulation—which he develops in Vol. III of Capital—and the fall in the rate of profit as the source of deflation). The model elaborated by Goodwin in 1967 allows Desai to show that long run equilibrium can never be reached. However, the Marx-Goodwin model suffers from a serious limitation since it does not account for the role played by money in the process of capital accumulation. To make up for this shortcoming, Desai refers to Hayek’s theory of the trade cycle. As has been clearly shown by Desai and Redfern (1994), Hayek’s model emphasises the role of bank credit and the structure of production, and seems therefore well fitted to provide the elements missing in the Marx-Goodwin model. The synthesis between the two analyses is attempted by Desai in the second part of his chapter. By combining the Marx-Goodwin model of adjustment centred on the fluctuations of the rate of profit with Hayek’s concept of malinvestment, he works out a theoretical framework which he uses to explain the decline of Keynesianism confronted with the task of accounting for the crisis faced by advanced capitalist economies since the early 1970s. He is thus able to show that, by ignoring the role played by the reduction in the rate of profit, Keynesians were unable to provide a satisfactory remedy to the growth of unemployment. Their policies led to a rise in inflation and paved the way for the success of Monetarism in the late 1970s. In the last pages of his chapter, Desai applies Hayek’s theory of the trade cycle to Third World countries and maintains that the phase of expansion which led to the debt crisis can be explained in terms of the relationship between rates of interest, credit and bad investment. Finally, Desai’s main argument is that the evolution of the trade cycle in the advanced capitalist countries can be explained by referring to the decrease in profitability (following the Marx-Goodwin model) and to the increase in interest rates (as suggested by Hayek’s model). Though some of us would not agree entirely with the choice of models operated by Desai, there can be little doubt about his diagnosis. Both traditional Keynesianism and Monetarism have failed to provide a satisfactory explanation of monetary disequilibria and neither one nor the other has succeeded in suggesting an effective remedy for them. A new look at the problem is today a matter of necessity and Desai’s emphasis on the role played by capital accumulation and profitability is perfectly in line with the approach suggested by other contributors to this volume. In Chapter 6, ‘Unemployment and price stability: aspects of the Marshallian legacy on the monetary economy’, Peter Groenewegen analyses some aspects of Marshall’s contribution to monetary theory. His starting point is Marshall’s conception of money as a measuring rod for aggregating heterogeneous production costs. According to Groenewegen, the approach to economics propounded by Marshall is thus based on the role played by money and on the

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need to overcome the (neo)classical dichotomy between monetary and real variables. In the first part of his chapter, the author shows how Marshall came to be interested in business fluctuations and in their connection with a credit economy. Following Mill’s analysis of monetary theory, Marshall ascribed great significance to credit cycles in his explanation of the disturbances arising in the level of activity and employment. It is interesting to observe, with Groenewegen, that although Marshall’s account of the credit cycle confirmed the validity of Say’s Law, his analysis allowed for income to be hoarded. One is thus led to ask what would Marshall have claimed had he been aware that, being of a banking nature, modern money can only be saved in the form of a bank deposit and that, precisely because of this and because of the rules of double entry bookkeeping, it is necessarily lent from the moment it is saved. Another important aspect of Marshall’s analysis of monetary disturbances is the link he establishes between price instability and fluctuations in trade and unemployment. As claimed by Groenewegen, his approach is strongly influenced by the belief that fluctuations in prices are essentially influenced by movements of general confidence, enterprise and credit, that is by factors which he calls ‘creatures of opinion’ (Marshall 1888:3). Analysing unemployment, Marshall distinguished between structural, seasonal and cyclical unemployment. In his paper Groenewegen chooses to emphasise Marshall’s analysis of cyclical unemployment which, as he points out, remained an unfinished work. Credit fluctuations have a particular relevance in explaining the amplitude in output and unemployment fluctuations over the cycle. Marshall attributed great significance to the credit cycle, and Groenewegen attempts to show this by considering the contributions of two of the most famous students of Marshall: Robertson and Keynes. By referring to Robertson’s book A Study of Industrial Fluctuations, he argues that, even though some of Robertson’s arguments do not depend on the existence of a monetary economy, they admit to a monetary cycle enhancing the amplitude of the cycle. Marshall and Robertson disagree about which policy to adopt to counteract business fluctuations (the first making a claim for price stability and the second accepting a rise in prices as a necessary incentive to increase investment), and Groenewegen sees this as the result of the way the two authors consider the relationship between price and output fluctuations. By stressing the importance Robertson attributed to the relationship between saving and investment, he then emphasises the resemblance between the analysis of the credit cycle developed by Keynes in his Treatise and by Robertson in his Banking Policy and the Price Level and argues that many of their common elements are already present in Marshall’s account of the credit cycle. Keynes’s later distinction between co-operative and entrepreneur economy, on the contrary, was to accentuate the divergences between the author of The General Theory and that of the Principles. As is well known, Keynes was critical of Marshall’s approach to monetary neutrality and did not share his opinion about

INTRODUCTION 13

the beneficial effects of free market mechanisms and price stability on the level of unemployment. By focusing on the principle of effective demand he rejected the classical conception of neutrality in which there is no room for chronic unemployment, and worked out a theory based on a new, macroeconomic, approach to monetary economics. However, according to Groenewegen it can be maintained that Keynes’s disagreement with Marshall is less substantial than may at first appear. He thus concludes his chapter by claiming that the Marshallian heritage of monetary analysis has been greatly, but unfairly, undermined. In particular, his explanation of the credit cycle is far more interesting than has usually been thought, partly because little of Marshall’s material on this subject was systematically elaborated. His claim for price stability as a way of fighting unemployment is gaining attention and, though we do not entirely share Groenewegen’s belief that ‘Keynesianism is nothing more than yet another manifestation of what Joan Robinson described as pre-Keynesian theory after Keynes’, we agree with him in stressing the importance of Marshall’s intuition about the strict relationship existing between unemployment and inflation.

Part I INFLATION AND UNEMPLOYMENT: A MONETARY AND STRUCTURAL FRAMEWORK FOR ANALYSIS

1 INFLATION AND DEFLATION The two faces of the same reality Alvaro Cencini

INTRODUCTION Economists are far from being unanimous about the nature of economic disequilibria and the way they should be dealt with. For example, according to the rational expectations school, money does not affect real variables both in the long- and short-run. Thus, changes in the money supply alter the general price level directly, leaving unchanged real variables such as employment, output and the real wage rate. Monetarists, instead, have always allowed for short-run real effects of monetary changes while claiming that in the long-run real equilibrium is not affected by monetary fluctuations. At the other end of the spectrum of suggested interpretations, we are faced with the claim that disequilibria arise essentially because of money. In a world of barter, as maintained by Shackle, total demand and supply are necessarily equal and ‘it is only when we introduce a substantive means of purchase, one which does not merely represent today’s products but exists or arises in its own right, outside the list of products,’ (Shackle 1967:91) that disequilibria are bound to appear. On the whole, the core of the dispute among economists is represented by the role attributed to money as a possible cause of inflation and unemployment. According to neoclassical tradition, real variables are all that matter and money is a kind of veil which can only momentarily affect the real world. The neoclassical perception of the economic system is essentially dichotomous and the theory lacks a satisfactory solution to the problem of money integration. Having mainly taken over the neoclassical approach, Monetarists develop their analysis assuming that economic agents can only momentarily be fooled by a change in the monetary stock. In the long-run expectations are adjusted to take nominal variations into account so that real variables are no longer influenced by the initial increase (or decrease) in the money supply. On the contrary, Keynesians have traditionally put money at the centre of their analysis, emphasising the role of interest rates and income distribution in the evolution of inflation and employment. Yet, despite their global monetary approach, Keynesians develop their theories in terms of equilibrium between demand and supply and are thus led to analyse the

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anomalous working of the system from the behavioural point of view. This ‘behavioural’ approach is so deeply rooted in monetary economics that even an economist such as Goodhart does not hesitate to claim that, although ‘the institution of money provides the information network which enables a complex, decentralised economy to function at all’ (Goodhart 1975:194), it is the economic agents’ irrational behaviour which is to blame for economic instability. ‘Because money is a necessary adjunct to such an economy, the disequilibria in the economy are sometimes regarded as monetary phenomena; it is, however, the inconsistency of decisions within the system, not the existence of the monetary framework, which is the proximate cause of disequilibria’ (p. 194). The aim of this chapter is to provide an alternative approach to inflation and unemployment starting from the logical rules governing bank money. It can hardly be doubted today that our economic systems are based on the use of money and that money is essentially of a banking nature. Any serious attempt to explain both inflation and unemployment has to start from this state of affairs and must consistently account for the integration of money into the real world. In order to show that economic disequilibria are neither caused by behavioural nor real factors, we shall first lay down the principles of a monetary economy by referring to the quantity theory of money. Correctly re-interpreted and secured against the devastating consequences of the neoclassical dichotomy, this theory can in fact provide the basis for a new analysis of economic reality in which money is no longer an exogenous variable. Having done this we shall then apply the principles of bank money to the traditional explanations of inflation and unemployment. This exercise will allow us to show that they all fail to provide a satisfactory answer to these problems since they rest on a truncated perception of the workings of our monetary systems. The same conclusion applies to the reiterated attempt to establish an inverse relationship between inflation and unemployment. As confirmed by factual observation, these two disequilibria are not independent of each other, yet the simultaneous presence of inflation and deflation is a reality which has been out of the reach of theoretical explanations so far. Finally, in the last section we shall outline the main features of a theory in which economic disequilibria are traced back to a formal anomaly due to the imperfect correlation existing today between the monetary structure of our systems and the laws of bank money. THE QUANTITY THEORY OF MONEY: A REAPPRAISAL According to the standard version of the quantity theory of money, an increase in the money supply leads to a proportionate increase in the level of prices through the real balance effect. This mechanism, introduced by Patinkin in his Money, Interest and Prices (1969), is based on the idea that, following an increase in the quantity of money made available in the economic system, consumers will

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attempt to finance extra purchases of goods out of their money holdings. Although the increase in the money supply cannot alter the real demand for goods, the real balance effect seems to provide an explanation as to how a monetary disequilibrium can generate a change in the level of prices, the main argument being that increased money balances allow for an increase in the desired demand for goods. Hence, though consumers cannot increase their real purchases of goods, their increased desire for them has the effect of raising their prices. It is hardly necessary to stress that this attempt to conciliate the traditional neoclassical analysis elaborated in real terms with the quantity theory of money can no longer be seriously taken into consideration. No one doubts that a desired demand is only a virtual force with no power of altering prices at all. Whatever my desire to buy a Rolls Royce, the demand for Rolls Royces does not vary in the least unless I can effectively exert it. Moreover, the neoclassical dichotomy between real and monetary variables can only be disposed of by integrating money into the real world, which means that the distinction between real and monetary demand for goods is farfetched. In today’s economic world the real demand for goods is exerted in monetary terms and any serious theory must account for this. The Monetarist starting point is the neoclassical theory of relative prices determination. Money is brought into the picture as a net asset issued by monetary authorities and demanded by the public in order to satisfy its needs for a means of exchange and a store of value. Hence the price of this new and peculiar object called money is determined, like that of any other real good, through the adjustment of its supply and its demand. Unlike single real goods, however, the price of money is determined taking into account the whole of produced output, i.e., the whole amount of goods which must be bought by money. ‘Thus the general price level can be reduced to a relative price, the relative price of money and the composite commodity’ (Flemming 1976:9). Whereas the supply of money depends on the activity of emission carried out by the banking system, the demand for money is finalised to the purchase of goods and services, and in a system of general equilibrium corresponds to the supply of real output. In the same way as in a two commodity world the supply of a defines the demand for b and vice versa, in a monetary system the supply of real output is identical to the demand for money. The determination of the general price level is thus obtained through the adjustment of two distinct masses: the mass of money and the mass of real output (Figure 1.1). This representation corresponds to the traditional version of the quantity theory of money where, according to the assumption that the level of output is independent of the size of the money supply, money is exogenously determined. Now a question can be raised here about the hypothetical exogeneity of money in a world where money is entirely of a banking nature. If banks, whether central or secondary, were to exogenously provide the economy with the quantity of money required to carry out transactions, monetary stability could be granted only by a strict control over the growth of the money supply (determined by the banking sector) relative to the growth of real output (determined by the real sector). A

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Figure 1.1 The general price level, the mass of money and the mass of real output

thorough analysis of modern bank money shows, however, that what can effectively be issued by banks is a purely numerical vehicle with no intrinsic value whatsoever. As a matter of fact, the Classics were already aware of the necessity to distinguish (nominal) money from income (real money), and economists have always implicitly refused to consider money as a net asset since they have never added the value of money to that of output when determining national wealth. Their acceptance of the equality of national income and national output is perfectly in line with Smith’s claim that money and output are the two faces of one and the same object. Modern banking confirms this. The emission of money is, first of all, an operation through which banks provide the economy with a numerical standard. In order to fulfil this task banks only need to enter the economy in their bookkeeping, an operation which, as such, does not require the presence of any real asset. Corresponding to the opening of a line of credit in favour of the economy, the emission of vehicular money becomes operative as soon as firms take advantage of it to cover their costs of production. At this moment money is so strictly associated with real output as to become its alter ego. Bookkeeping entries in the banking system reveal the nature of this relationship. Let us consider the payment of wages (direct and indirect) made by a secondary bank whatsoever, B, on behalf of firm F (Table 1.1). Having incurred a debt to the bank, firm F is entered on the assets side of B’s balance sheet, while producers, being net creditors towards the bank, are entered on the liabilities side. The payment carried out by B corresponds to the monetisation of production and gives rise to a new income. Because of this payment vehicular money is transformed into a net asset initially owned by workers and then, once transfers have been taken into account, by final income

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holders. But what about real output? How is the relationship between money and goods established? The answer is straight-forward. Having asked the bank to carry out the payment of workers on its behalf, firm F is indebted to B and the object of its debt (the very income earned by W) has the real output as its content. In other words, the goods produced by W are momentarily deposited with F (which cannot be their final holder since it is indebted to B) but they are effectively owned by the income holders who, having a net credit to B, have at their disposal the drawing right (purchasing power) over current output. Hence, through the monetisation of production, real output acquires a monetary form and is transformed into a given amount of income of which it is the real content. Money and output are thus the two sides of the same reality, and not two distinct entities with two autonomous intrinsic values. According to the analysis of the way money is issued and associated to real production, it is no longer possible to claim that the supply of money is exogenously determined. Banks act on behalf of the economy and as long as they comply with the rules of double entry bookkeeping their emissions are determined by the need to monetise and convey (repeated transfers included) real output. However, if money becomes the form of real output as soon as it is issued, how can inflation still be possible? Is it not true that if Central Banks were to finance public deficits by printing money, inflationary gaps would result from these exogenous increases in the money supply? The apparent contradiction between the endogenous determination of money and the possible exogenous increase in the quantity of money can be dealt with by observing that inflation is an anomaly which can be due precisely to the fact that, in certain circumstances, the logic of bank money requiring money to be always endogenously determined is not Table 1.1 Secondary bank liabilities Workers

x

assets Firm F (Current output)

x

complied with. Yet, another difficulty arises now. If it is plausible to blame the monetary authorities of underdeveloped countries for a great part of the inflationary increase in their domestic money supplies, the same interpretation can hardly be maintained against the Central Banks of industrialised countries. Compliance with the rules of modern banking does not allow for free monetary creation, and there can be little doubt that the most advanced banking systems work according to these rules. Where does inflation come from then? If only a small fraction of price increases can be attributed to the behaviour of monetary authorities, how can inflation reach the levels we have been accustomed to despite the fact that money is endogenously determined?

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The interrelationship between monetary and real variables allows only for a pathological variation of money with regard to its real content. However, since money and products are the twin aspects of the same object, a change in one entails an identical change in the other. Whether a computer is defined by 10 or 100 units of money is altogether irrelevant; in both cases the computer is the real content of the money used to convey it. Hence, an inflationary gap appears only if the same computer, initially associated with 100 units of money is suddenly conveyed by 120 units, that is, for example, if 20 units of empty money pathologically increase the money supply. The computer which defines the real content of 100 units of money is now conveyed by 120 units, a change that leads to a decrease in the purchasing power of every monetary unit. Let us refer to the quantity theory of money. Having rejected the neoclassical dichotomy between monetary and real variables, the traditional representation of money and output as two distinct masses must be replaced by a new representation in which one (output) is the real content of the other (Figure 1.2). Thus, an inflationary increase in the money supply is no longer supposed to be determined independently of the relationship between money and output. Equilibrium is not a matter of adjustment between two autonomous entities but a state of affairs which can be consistent either with the numerical equality of money and output or with their numerical inequality. Let us explain this. In our previous example we supposed that a computer is initially associated with 100 units of money. This means that its costs of production are equal to 100 and that its corresponding income is also equal to 100. The numerical expression of total supply, represented here by our computer, is therefore equal to that of total demand, and equilibrium is achieved together with the numerical equality of its two terms. However, if the quantity of money is suddenly increased while production remains unchanged, the numerical expression of total demand increases. In our example the numerical expression of total demand is now of 120 units, while that of total supply is still equal to 100 units. Yet, despite their numerical inequality, supply and demand are still in equilibrium since they are the two faces of the same reality. The numerical inequality simply means that the monetary expression of the computer rises from 100 to 120 units, and since this increase is due to an empty money (i.e. a money which is not associated with any production) being added to the money initially associated with the computer, its consequence is a proportionate reduction in its purchasing power. The purchase of the computer initially conveyed by 100 units of money requires now the expenditure of 120 units, which means that an income of 100 is spread over 120 units, each unit being thus endowed with a lesser purchasing power than before. According to this analysis, inflation can therefore be defined as a disequilibrium within equilibrium, where the main relationship is given by the necessary equality of total supply (real output) and total demand (income). If the quantity of money is pathologically increased, the amount of income does not vary. Supply and demand remain equal, though demand is now exerted by an increased number of monetary units. Since the new money added to the system is

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Figure 1.2 Output is the real content of money

not associated to any new production, the amount of real output remains the same. Hence, relative to the global quantity of money (full+empty money) real goods are not enough to guarantee the stability of purchasing power. As a consequence the price of real output rises and the equality between supply and demand is also re-established numerically. Equality triumphs, but at the cost of an inflationary decrease in the purchasing power of money. Equilibrium between supply and demand still holds, but this does not prevent effective demand (measured in terms of income) to be numerically different from that measured in terms of monetary units. What has still to be explained is how this disequilibrium between money and income can occur apart from the exceptional case in which monetary authorities finance public deficits by printing money. To further clarify the terms of the problem let us analyse the principal arguments traditionally advocated by mainstream economists by referring to the modern version of the quantity theory of money (where the old fashioned distinction between real and monetary variables is replaced by that between full and empty money). THE TRADITIONAL ANALYSIS OF INFLATION: A CRITICAL SURVEY The survey that has been presented illustrates that economists have failed to comprehend the theoretical problems associated with the inflationary period of the 1970s. The feeling of certainty and satisfaction which followed Phillips’ original article has evaporated. The consequence of this is that we can offer no cure for inflation with the certainty that it will work. Of course many economists would deny this. They would insist that they do understand the

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economic forces behind inflation. But their constantly changing positions, the lack of any unified approach to the problem within the profession as a whole, and the failure to achieve some measure of stability to the price level after at least a decade of trying would suggest otherwise. Hudson 1982:55–6 Does Hudson’s pessimistic conclusion still hold good? Despite a momentary reduction in the rate of inflation which has to be related to a decrease in the production of fixed capital (see ‘Stagflation’, page 44 below), the simple observation of facts seems effectively to confirm it. Let us therefore try to work out the theoretical reasons for this failure by starting from the way inflation has generally been defined and measured. ‘The rate of inflation in an economy is the rate at which the general level of prices in that economy is changing. It is the proportionate change in the general price level per unit of time’ (Flemming 1976:5). According to this definition, inflation is assimilated to an increase in the general price level and can be measured by referring to the variation of a series of price indexes (which differ from one another according to the goods put in the representative basket). The price index which is traditionally referred to when discussing the problem of inflation is the retail price index, i.e., a tax-inclusive consumption index. Hence, if in a given economy the price index increases from 100 to 110 during a period of time taken as reference (say a year), we would infer that in our economy inflation has increased at a yearly rate of 10 per cent. There are at least two good reasons, however, to consider this conclusion as highly unreliable: namely that an increase in the price index does not necessarily imply a reduction in the purchasing power of money, and that the constancy of the price index does not necessarily imply the absence of a positive inflationary gap. Let us con sider, for example, the case in which a firm is able to increase its profits through a rise in the selling price of its products. Because of the higher price of these products, the consumption price index rises, but it would be incorrect to deduce that inflation has also risen correspondingly. It is true, of course, that consumers will suffer from a reduction in their purchasing power, but what is lost by them is earned by the firm, whose purchasing power increases insofar as its profits grow. As far as domestic money is concerned, its purchasing power is not in the least affected by the new redistribution of income between consumers and firms. In terms of supply and demand, the increase in prices caused by firm F does not modify the initial relationship between total supply and total demand, since the new transfer of income from consumers to firm reduces the demand of the former while increasing that of the latter. Another example leading to the same result is given by an increase in indirect taxation. Even in this case the decision to increase the price of some goods (spirits, cigarettes, fuel) can provoke a new distribution of income, this time in favour of the state. The decrease in the consumers’ available income is perfectly matched by the increase in the income transferred to the state,

INFLATION AND DEFLATION 23

so that, on the whole, the purchasing power of domestic money remains unaltered. The effect of an increase in indirect taxation is a reduction in the consumers’ purchasing power and not that of domestic money. Generally speaking, there are increases in the price index which can be referred to as causes of an increase in the cost of living but which have nothing to do with inflation, that is, with a pathological reduction in money’s purchasing power. On the contrary, there are cases in which the presence of inflation is not revealed by a variation in the price index. Let us suppose the index of prices remains constant at the level of 100. Does this necessarily mean that the rate of inflation is equal to 0 per cent? Certainly not. It must be remembered, in fact, that our economic systems are characterised by technological progress and that one of the consequences of this is a continuous reduction in costs. Now, a reduction in costs has a repercussion on prices and should lead to a decrease in the price index. If the price index remains stable despite generalised technical progress this can only mean that the price of goods is pathologically increased by inflation. In the absence of an anomaly, the basket of commodities would become cheaper because of the reduction in costs. Thus, if it remains as expensive as before it is because inflation re-establishes its price at the previous level. The inflationary increase in prices being relative to the decrease caused by technological progress means there is no variation in the price index. The simple observation of this index is therefore misleading, particularly as regards the effective magnitude of inflation in highly industrialised countries. In conclusion, price indexes can give a rough idea of the way the standard of living evolves in time but is a very poor revealer of inflation, whose pathology requires a far better instrument of analysis. Keeping in mind that inflation is a much more serious disequilibrium than it appears to be from the observation of the price index, let us now fix our attention on the two main categories in which inflation is traditionally classified. Demand-pull inflation Starting from the Keynesian distinction of aggregate demand in consumption, investment and government spending, it is often maintained that an inflationary excess demand can result from a variation in one (or more) of these components. For example it is claimed that if consumers were to increase their propensity to spend and if production could not match this increase in demand (either because it is highly inelastic or because the system is in a situation of full employment), the general price level would rise, thus provoking a decrease in the purchasing power of domestic money. This would certainly be the case if consumers could finance their new purchases by printing money (or if banks could print it for them). A sum of empty money would thus be added to the income corresponding to the available real output and the system would witness an inflationary modification of the initial relationship between money and output. The working of modern banking, however, does not provide any support for this unrealistic

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assumption. Consumers can increase their expenditures only out of their savings or by borrowing from firms. Banks only act as simple intermediaries, transferring income from savers to consumers. Hence, since the total amount of income is not modified, no global excess demand can derive from the change in consumers’ behaviour. If they spend more, firms spend less so that, for the system as a whole, the equality between supply and demand remains unaltered at its previous level. The idea that an increase in the propensity to consume can be the cause of an excess demand derives from the wrong belief that the part of current income which is saved does not exert any demand over current output. If this were true, a decrease in savings would indeed increase the demand for goods and thus provoke a corresponding rise in prices. Now, apart from the fact that such a rise in prices would not be of an inflationary nature (since, instead of decreasing the purchasing power of money, it would simply transfer part of the consumers’ purchasing power to firms), in a monetary system demand is determined by the amount of income globally available within the banking system. The part of income that is saved is a bank deposit and is therefore still entirely available. Friedman himself seems to be aware that demand is determined by the quantity of money independently of the way it is spent. His argument against the too narrow channel of the transmission process propounded by the Keynesians can effectively be interpreted as a claim that the entire amount of money available within a banking system is necessarily spent. Like the water running down a beach which ultimately gets down to the sea (this is the image used by Friedman), money affects expenditure whether it is saved or not. Let us represent in the banking system balance sheet the entries corresponding to (1) the monetisation of production, (2) the redistribution of income between consumers and savers (of whom workers and firms can obviously be part), and (3) the expenditure of consumers for the purchase of current output (Table 1.2). As shown in entry (4), the income saved is deposited in the banking system where it defines the loan of savers in favour of firms. It is precisely because savers are creditors to the banking system and firms debtors that the income which is not spent by consumers is lent to firms. Once again banks act as intermediaries so that the entire amount of current income is spent, either directly, by consumers, or, through the intermediation of banks, by firms. Finally, the decision to save a greater or smaller part of current income has no influence over its available amount and cannot therefore modify the demand for current output. Another hypothetical cause of demand-pull inflation is traditionally identified in the excess of credit granted by banks. Even in this case, however, a simple analysis of the way banks operate is sufficient to dismiss this hypothesis, at least as far as secondary banks are concerned. The credit granted by secondary banks can be subdivided into two main categories according to whether it leads to a creation of new income or to a simple transfer. In the first case credit is granted to firms in order to finance a new production while in the second it is granted to consumers who, in this way, finance their purchases of already produced goods

INFLATION AND DEFLATION 25

and services. In both circumstances banks must comply with the rule requiring loans to be matched by equivalent deposits. During the period of time chosen as reference (usually a day) a bank’s lending can exceed its deposits, it is true, but this generally means that another bank’s deposits will correspondingly exceed its loans. Once interbank lending has been taken into account it appears that secondary banks as a whole respect the rule according to which loans are financed out of deposits. The difference between the two Table 1.2 Banking system liabilities (1) (2) (3) (4)

Workers Consumers Savers Firm Savers

assets 100 80 20 80 20

Firm Workers

100 100

Consumers Firm

80 20

cases previously referred to is that when it comes to new output the loan has as its object the income generated by the new production, whereas when the loan finances the purchase of financial assets or of already produced output it is nourished by pre-existent income. Whatever the case taken into consideration, there is usually a perfect correspondence between the income which can be lent by secondary banks and the output which has still to be purchased. Let us show this by referring to the bookkeeping entries in the balance sheet of secondary banks (Table 1.3). Entry (1) refers to the monetisation of production of period p0, which creates 100 units of domestic income. Of these 100 units deposited with the secondary banks, 20 are then lent to clients C (2), who spend them on the purchase of part of p0 output (3), while the income generated by the monetisation of the new production (4) defines a new deposit of 50 units which secondary banks lend to firms. Thus banks benefit from deposits equal to 150 of which they lend 130 units to firms, and 20 units to C. As shown by the partial compensation of entries (1), (2) and (3), being spent by C on the final purchase of output, 20 units of these deposits are destroyed so that at the end banks still owe 130 units to income holders while firms owe the same amount to banks (entry (5)). Now, the danger of secondary banks being the cause of an inflationary increase in the money supply would be reduced to nil only if their two intermediations, monetary and financial, were rigorously kept separate. In the actual system of domestic payments this is not yet the case. Operating as financial intermediaries, secondary banks can therefore lend more than they get as deposits, the excess of credit being financed through monetary creation. Following Schmitt’s analysis (1984a) let us represent this possibility in Table 1.4.

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Table 1.3 Secondary banks liabilities (1) (2) (3) (4) (5)

Workers Clients Firms Workers Income holders

assets 100 20 20 50 130

Firms (output of p0) Workers Clients Firms (new output) Firms

100 20 20 50 130

As usual, the first entry corresponds to the monetisation of production. In our example, the payment of workers leads to the creation of 100 units of income and determines the amount of deposits the secondary bank can lend without generating any disequilibrium between money and current output. Now, if SBw were to grant a credit of 110 to its clients for the financing of their purchases, the transaction would take the form of entry (2). Even though SBw’s deposits are only equal to 100 units, through its intermediation economic agents would be able to exert a demand of 110, the increase in the quantity of money being the result of a monetary creation carried out by SBw. The equality between the two sides of SBw’s balance sheet is thus not enough to avoid the danger of overemission. From a double accounting point of view, everything seems to work correctly, yet the balance between assets and liabilities hides the fact that the supply of money has been increased through a simple creation of nominal money (and not through the monetisation of new production). If we have claimed that secondary banks usually respect the monetary equilibrium between money and current output it is because the mechanism represented in Table 1.4 can be considered as extremely marginal. Most of the time the excess of credit granted by a bank leads. to it becoming indebted to another bank, a situation which banks try to avoid as much as they can. By looking for their constant equilibrium, secondary banks are thus led to keep their credit to the effective amount of deposits they can dispose of. Moreover, even if banks were to ‘nourish’ part of their lending through monetary creation, the inflationary effect of this over-emission of money would not be too worrying since it would be compensated as soon as the clients benefiting from the initial credit started to pay it back. The money created in excess in period p0 would thus be destroyed at the moment credits are returned to the bank, and since in a complex system new credits are granted and old ones repaid in each period, it is clear that no serious inflationary disequilibrium can be generated through the mechanism of credit. At whatever level we consider the relationship between loans and deposits we can observe that

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Table 1.4 Secondary bank SBw liabilities (1) (2)

Workers Firms Workers Firms

assets 100 110 100 10

Firms Clients Clients

100 110 110

banks cannot be considered as a cause of cumulative inflation. Of course, as we have said, a single bank (or a group of banks) can grant credit too generously and, in some cases, get into serious trouble. Because of bad/ management banks can go bankrupt, yet this will not generate any empty money and will therefore not lead to inflation. Does this analysis also apply to Central Banks? Is it not true that the financing of government spending can entail an inflationary expansion of the money supply? If we start from the concept of effective demand and from the analysis developed by Keynes in his famous pamphlet How to Pay for the War, we are led to answer in the affirmative since an extraordinary rise in government spending (on arms, for example) seems effectively capable of generating an excess of aggregate expenditure. Let us suppose the economy to be in a full employment situation. If it is financed through monetary creation, an increase in government spending leads to an increase in demand which cannot be matched by an equivalent rise in production and which is therefore the cause of an inflationary decrease in the purchasing power of money. This particular explanation of inflation is perfectly in line with the quantity theory of money. When financed by monetary creation, the increase in public spending leads to a growth in the money supply which is the source of a numerical disequilibrium between total supply (real output) and total demand (the available quantity of money). The remedy proposed by the Keynesians is also entirely compatible with the Monetarist theory. By raising the general level of taxation and avoiding the recourse to printing money the government avoids being the cause of an injection of empty money into the system and its expenditures can no longer be considered as a source of inflation. The border line is thus represented by the way public deficits are financed. If governments ask their Central Banks to cover their deficits by printing money it is certain that their economies will suffer from an inflationary increase in the money supply. On the contrary, if public expenditures are financed through taxation and through the sale of Treasury bonds, total demand remains unchanged and money stable. Now, when Central Banks comply with the rules of modern banking, they act as intermediaries between the government and the public. Hence, if the government needs to increase its expenditures through the sale of bonds the Central Bank purchases them on behalf of the public. Its money creation is therefore only an advance

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which is immediately covered as soon as the Treasury bonds are bought by the public. The financing of state production is sometimes considered as another kind of government spending. Whether of public utility (roads, schools, hospitals) or not (arms), the production financed by the state increases total demand, since it adds new income which can be spent on the purchase of real output. If this increase were not matched by an equiva lent increase in total supply, the government’s intervention would be the cause of a pathological disequilibrium and would have to be stopped for purely economic reasons. It is clear to everybody, however, that public goods are part of domestic output and must be included in the measure of total supply. The fact that schools or arms are not usually bought directly by consumers is irrelevant here. Acting as a producer, the government is not essentially different from a private firm, and is therefore confronted with the necessity to sell its products in order to fulfil its financial engagements with the Central Bank. To the extent that public goods are sold directly or indirectly (through taxation) to householders, the state can cancel out its debt to the Central Bank, while for the remaining part of the debt it has to fall back on an explicit loan from the public (Table 1.5). As shown by the entries of the Central Bank’s balance sheet, from the start the government’s debt to the Central Bank is in reality a debt to the public (and, more precisely, to the producers of public goods), whose income is the object of the initial loan granted to the state (entry (1)). The irreversible transfer of income which the state can benefit from by selling its products and by raising taxes allows for the final cancellation of part of this debt (entry (2)). The remaining part can only be covered by a reversible transfer of income which the government obtains by selling Treasury bonds (entry (3)). Finally, the totality of public goods is paid for through the expenditure of an income equivalent to that generated by their own production. Once the costs of production of public goods have been covered, total demand is thus reduced to its previous level, even though the state is still explicitly indebted to the purchasers of public bonds. It is only if a government had the power to force the Central Bank to cover its public deficit by printing money that the economy would suffer from an inflationary increase in total demand. In most industrialised countries, governments either do not have this power or do not exert it so that we can easily conclude that in these countries government spending cannot be held responsible for any pathological disequilibrium between money and output. Let us now briefly consider the other main category of inflation. Table 1.5 Central bank liabilities (1) (2)

Producers State

assets 100 60

State Income holders

100 60

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Central bank liabilities (3)

State

assets 40

Income holders

40

Cost-push inflation Among leading economists the idea is still widely held that increases in costs of production are the principal cause of inflation. ‘Thus an increase in the money stock is necessary for a continuing process of inflation to persist. Monetary expansion is not, however, necessary for the initial generation of inflation, which may be due to supply shortages, e.g. of energy and raw materials, war demands, wage-push (as in the United Kingdom in 1969), etc.’ (Goodhart 1975:208). Thus, according to Goodhart, inflation is first caused by supply shortages and is then maintained through an increase in the money supply or checked through monetary contraction. Among the possible sources of cost-push inflation suggested by the economists sharing this point of view, by far the most important is represented by nominal wages rising more than the productivity of labour. Since wages are one of the main components of costs, and costs one of the main components of prices, their increase leads to a rise in prices, whose higher general level is thought to be a clear symptom of the inflationary disequilibrium introduced into the system. Let us first note that an increase in wages leads to an equivalent growth in the money supply which does not support Goodhart’s distinction between monetary and non-monetary causes of inflation. Having said that, we still have to establish whether this particular increase in the quantity of money is actually of an inflationary nature or not. The question we have to answer is in which way a rise in nominal wages affects the relationship between money and current output. It is not the fact that an increase in wages generates a rise in prices that is under discussion. If a chair produced in period p0 at a cost (in wage units) of 10 is successively produced, in period p1, at a cost of 12 its macroeconomic price passes from 10 to 12 and it is very likely that its microeconomic price (the selling price) will also rise proportionally. What we have to make clear, however, is the impact of this increase over the relationship between the chair and the quantity of money which conveys it. If we were to compare the chair produced in p0 with the money generated in p1 we would certainly find a numerical discrepancy between the value of the chair and the amount of money. Yet, this is not the right relationship to be investigated. Despite their physical appearance, the chair produced in p0 and that produced in p1 are two completely distinct outputs which can be monetised by two completely different amounts of domestic money. Of course, such a change of scale in the measurement of national output would only

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be a nuisance and it would be much more rational to avoid it, but this is not the point. According to the new version of the quantity of money, an inflationary gap arises when the money supply associated to a given output is increased relative to this same output. Production establishes a relationship between a certain amount of vehicular money (corresponding to nominal wages) and the output it must convey (and which defines its real content). If some pathological event leads to monetary expansion, that is, if a sum of empty money is added to that initially associated with production, inflation becomes unavoidable. In our example, inflation would thus result in chair p0 being finally conveyed by 12 units of domestic money (Figure 1.3). A change in nominal wages does not have this effect and can therefore not be considered as a cause of inflation. It remains true that the need for a change in the scale of wages is strictly related to the existence of inflation. It is because workers suffer from a reduction in their purchasing power that they ask for an increase in nominal wages. Were it not for the beneficial impact of technological progress, retail prices would rise far more because of inflation, and the adjustment of wages would have to be far greater than it is today. What has to be understood is that a rise in wages is not a cause of inflation but rather a reaction against its effects, and not a very efficacious reaction either, since, the true causes of inflation being unaffected by this change of scale, workers see their purchasing power decreasing immediately after having benefited from an increase in nominal wages. Let us now consider another argument traditionally put forward by the advocates of cost-push inflation. Unless imports are proportionally reduced —it is claimed—a rise in the price of imported goods (caused either by a decision taken by their producers or by a fall in the rate of exchange of domestic money) is the cause of what is called imported inflation. Since foreign goods (particularly energy and raw materials) are included in the basket of commodities used for the calculation of the general price index, an increase in their price entails a reduction in the quantity of goods consumers can purchase. Moreover, this reduction in purchasing power affects not only a particular category of consumers but also all the other residents, since a greater part of domestic income is sent abroad. Hence, a rise in the price of foreign goods seems to lead to a generalised increase in the cost of living caused by a decrease in the purchasing power available within the country. What is completely missing in this argument, however, is the fact that inflation is a disequilibrium affecting domestic money in its relationship with domestic output. A change in the price of foreign goods does not alter the purchasing power of domestic money, which can only be exerted over domestic output. The income available within a given country is created by the monetisation of its production and is destroyed only through its final purchase. This means that when it is spent on the purchase of foreign goods, domestic income is simply transferred from the buyer to the seller, who can then use it to purchase part of the country’s internal output. In the case of imports increasing in price, the country’s residents will have to transfer a

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Figure 1.3 Production cost, empty money and inflation

greater part of their income abroad and this will give foreigners greater power over domestic output. However, in the same way as the internal redistribution of income among residents does not alter its global amount, domestic income is not decreased by being partially transferred abroad. More precisely still, since payments are all carried out by banks, foreign sellers are paid through the transfer of a deposit certificate: they become the new owners of a sum of income deposited within the banking system of the importing country. The entire amount of domestic income is thus available within the country, where it is finally spent on the purchase of domestic output. The fact that part of this output is purchased by residents of another country is irrelevant as far as the purchasing power of domestic money is concerned. Whatever its distribution among residents or between residents and non-residents, domestic money maintains its purchasing power intact. Hence, although an increase in internal profits or in imported goods generates a growth in the price index and a new redistribution of income, neither of them is a true source of inflation. Friedman is therefore perfectly right when he claims that: If there are no unions, he (every businessman) will attribute it to some other force which is driving up wages—perhaps the world shortage of sugar, or the Arabs. But the truth of the matter is that the ultimate source of inflation is always that increase in demand which percolates through to him in this or some other form. Friedman 1975:35 Though demand-pull and cost-push theories of inflation represent the main contribution of traditional analysis to the understanding of the causes of this disequilibrium, another attempt deserves some attention, namely that of

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establishing a causal relationship between international payments and inflation. Let us consider it briefly. International payments and inflation Two arguments are advanced to prove that international payments can be the cause of inflation. According to the first, the use of the American dollar as the international unit of payment and the persistent balance of payments deficit of the United States are the source of an inflationary increase in the supply of money of net exporting countries. Since the dollar is the most readily acceptable currency in the western trading bloc, foreigners will be perfectly willing to accept payment for their exports (US imports) in terms of dollars. Nevertheless the impact on the rest of the world of the continual injection of dollars into their respective economies will be to provoke inflation. Trevithick 1980:110–11 According to the second, net American imports are considered an injection of effective demand in the exporting countries which generates an expansion in their domestic aggregate demand. If imports are regarded as a withdrawal from the level of effective demand (similar to savings) and exports are regarded as an injection (similar to investment), an increase in the flow of exports over imports resulting from the American balance of payments deficit will lead to a net injection of effective demand into the economies of the rest of the world. p. 111 The first argument is advanced by Monetarists and is based on the assumption that the dollars paid to the net exporting countries are added to their domestic currencies, thus increasing their internal supply of money. If the neoclassical homogeneity postulate held good, currencies of different countries could effectively form a unique collection of identical money units. However, monetary homogeneity is still a far cry from being more than a desideratum which only a few countries are really prepared to transform into reality. As the European countries know well, it is not enough to believe in the neoclassical postulate to enjoy the advantages that its existence would certainly entail (as, for example, exchange rate stability). The creation of a European Central Bank and of a European Clearing System are fundamental steps towards the realisation of a unique monetary area. While waiting for this project to become a reality, monetary heterogeneity is the rule and the analysis of international payments must conform to this. Thus, for example, the dollars paid to Great Britain are not added to the sum of pounds, so that the total money supply of Great Britain is

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not equal to the sum of pounds and dollars. As every top banker knows, the dollars earned by Great Britain through its net exports increase its official reserves and are invested in the Euromarket. But what about the pounds which are created by the Bank of England in exchange for the dollars accumulated in its reserves? Do they not increase English domestic money supply? And if so, is this increase a source of inflation? The answer is founded on two observations. The first is that the creation of pounds corresponds to the monetisation of the external gain realised by Great Britain and is thus necessary to avoid deflation (see Schmitt 1984b and Cencini 1994). The second is that the pounds thus created are necessarily recovered by the English banking system, so that any new monetisation can be carried out without having to resort to another creation (except for the amount which would exceed the one corresponding to the initial monetisation). Hence, the internal payment of English net exports is a perfectly sound operation which cannot be considered the cause of any cumulative inflationary process even from the Monetarist point of view. This result is not fundamentally modified when international payments are considered from the Keynesian point of view. Although it is true that exports increase the level of effective demand, the rise in prices is due to an external gain and not to an anomalous discrepancy between domestic money and current output. It is normal that because of a country’s net exports its domestic prices tend to increase, and it is likewise normal that the banking system is made to provide the otherwise missing domestic income through the monetisation of the country’s external gain. Once again the question which has to be asked is not whether international payments lead to a rise in domestic prices or not, but whether they are the cause of a pathological disequilibrium between money and output. As we have seen, prices can rise for several reasons which have nothing to do with inflation. The internalisation of external gains is another of these reasons, so that the hypothesis of a causal relationship between international payments and inflation appears to be based either on a false assumption (monetary homogeneity) or on a truncated analysis of prices. Let us conclude our short critical appraisal of the traditional analysis of inflation by reconsidering the case of government spending. As is well known, Monetarist’s objection to the Keynesian theory is that a policy of monetary expansion is a far more important cause of inflation than the size of a budget deficit. What Friedman has in mind when he claims that aggregate spending is mainly influenced by monetary policy is his theory of the natural rate of unemployment and his belief that unemployment can be maintained below this rate only through a government policy of (inflationary) monetary growth. Whereas we shall deal with this particular problem in the next two sections (concerned with the analysis of unemployment and stagflation), what we would like to stress here is simply that even from a Monetarist point of view the financing of government net expenditures by monetary creation is a source of expansion in the money supply. Both Monetarists and Keynesians agree that inflation is due to an increase in the money stock which cannot be matched by an

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equivalent increase in real output. The idea is that only through a pathological growth in the quantity of money can the relationship between money and current output be altered. Now, neither the Monetarists nor the Keynesians have been able to put forward a realistic explanation of how such a pathological growth can occur. The world famous example of the dispersal of newly printed money from helicopters is hardly more than a metaphor to illustrate the idea of a pathological increase, and can obviously not be considered a final answer to the problem. Despite the Monetarists’ failure to provide a sound explanation of the mechanism leading to an inflationary increase in the money supply, their idea that it must result from some incorrect working of the monetary system is not far from being right. Being a monetary anomaly which entails the decrease in the purchasing power of domestic money, inflation modifies the initial relationship between money and current output, and it is through a pathological mechanism that this can occur. UNEMPLOYMENT ‘If the market mechanism should work perfectly, with full information, there would be no undesired unemployment’ (Goodhart 1975:194). From this short but significative quotation we can derive two useful pieces of information, namely that unemployment is considered to be the consequence of uncertainty and that a distinction should be made between desired and undesired unemployment. Of course this is not the whole of the story. Keynesians, for example, do not share this point of view, claiming that even a free downward flexibility of wages and prices would not lead to full employment because of expectations working against the necessary reduction in interest rates. Nevertheless, Goodhart’s quotation is an interesting starting point since it emphasises the unavoidability of unemployment and the need to take behaviour into consideration to determine its source as well as its nature and extent. Let us start from the consideration that unemployment is, at least partially, an unavoidable consequence of our economic systems. According to a widely accepted classification, unemployment is said to be of a structural or a conjunctural origin. Structural unemployment is mainly related to technological progress and international competition, while conjunctural unemployment is essentially due to economic recession. Since competition and technological progress are a constitutive part of our systems, it would seem that we are bound to accept a certain level of unemployment as the price for a constant improvement in our standard of living. It is certainly true that, because of structural changes, production processes require a lesser amount of labour and that some products are replaced by others, their production transferred abroad or even suppressed. However, where it is due to technological progress, unemployment could well be given a positive meaning since, by reducing costs and prices, technological progress also provides the remedy against the disequilibrium it generates. With production increasing in terms of quantity and

INFLATION AND DEFLATION 35

quality, and prices decreasing proportionally with costs (a hypothetical situation which could occur only in the absence of inflation), nominal wages could be reduced without this leading to a corresponding reduction in the standard of living. Conditions would thus be created for a generalised reduction in working time. Whatever the technical solution adopted by a particular society (part time jobs over a given period of time, full time jobs over a shorter period, higher circulation of the working force with longer periods of rest, etc.), unemployment due to technological progress would be dealt with within a global project of socio-economic change. The same conclusion would apply to other kinds of structural unemployment as long as they are the effect of a general improvement in productivity. Frictional unemployment due to lack of information or to bad management is also listed in the category of structural unemployment and is also related to the workings of our economic systems. To a certain extent frictional unemployment is as unavoidable as that generated by technological progress although it cannot be given the same positive significance. It is clear, however, that if unemployment were to be caused by mismanagement or uncertainty alone, it would not have become one of our most serious problems. The case of conjunctural unemployment is more complex. To claim that unemployment will never be eliminated even if its cause were to be identified with economic recession amounts to maintaining that a shortage in total demand (deflation) is always potentially present, the search for equilibrium being constantly renewed in a system essentially marked by disequilibrium. This would be true, of course, if deflation were the result of economic agents’ behaviour. Let us analyse this hypothesis by referring to the laws of bank money. One of the causes of a shortage in demand which is usually proposed by mainstream economics is a change in the behaviour of consumers. The argument is the same as that used to explain inflation, though it runs the other way round. If for any particular reason consumers were to increase their propensity to save significantly, ceteris paribus this behavioural change would reduce total demand and induce firms to contract their production, thus increasing unemployment either directly (by laying off workers) or indirectly (by not replacing workers reaching the end of their working life). The whole argument rests on the assumption that saving has a deflationary effect since it reduces global demand. As we have already observed, however, this inference is not corroborated by modern monetary analysis. The income saved by consumers takes the form of a bank deposit, which means that every unit of income which is not spent by its holders is still entirely available within the banking system, where it is lent to other clients. When it is created, income implies a threefold relationship between the holder of the newly issued money, the banking system and the holders of real output. From a bookkeeping point of view, income holders have a net credit towards the banking system, which has a net credit to the holders of domestic output. In the emblematic case in which real output is held by a firm, income is owned by its producers under the form of a net bank deposit. Thus, income holders are the true owners of current output (which, being the object of the debt

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incurred by the firm, can obviously not be owned by it). Insofar as income holders spend their income on the purchase of the goods stocked by the firm, their positive deposits are cancelled out together with the negative deposits of the firm. Part of the income which is saved can then be lent to other consumers who spend it in their place. Another portion of bank deposits is thus destroyed by the consumers who borrow it, while income holders receive a right over their future income in exchange. The remaining positive deposits of income holders correspond to the part of current income which is saved; that is, which is not spent by consumers on the purchase of current output. The positive deposits still available within the banking system are thus matched by an equivalent amount of negative deposits whose content is precisely that part of current output which has not been sold by the firm. The matching of these two entries is the necessary consequence of the threefold nature of any bookkeeping relationship and shows that savings are immediately, though not finally, spent by the firm to cover its debt with the banking system. Acting as intermediaries, banks lend to firms what has been saved by income holders, so that their behaviour can have no influence on the amount of income globally available within the system. It is true that if consumers were never to buy part of current output, firms would have to cut their profits to refund the sum initially lent to them by income holders (through the intermediation of the banking system). And it is also true that firms whose products are not wanted by the public can be forced to close down, thus increasing the level of unemployment. However, this would not amount to an increase in unemployment due to deflation. Firms would not stop their production because of a lack of income but because of their failure to market their products correctly. Deflation is a very precise disequilibrium occurring when the amount of income available within a given economy is not sufficient to back the demand corresponding to the domestic supply of goods and services. Since savings do not affect the total amount of income, they cannot be seen as a possible cause of deflation, whose origin appears to be less evident than is usually implied by traditional analysis. Another argument put forward to explain conjunctural unemployment refers to the way savings and investment can be affected by official interest rate policy. The decision to push interest rates up, for example by raising the interest rate applied to secondary banks by the Central Bank, is said to encourage savings and discourage investment and is therefore considered as an anti-inflationary measure leading to a decrease in production. As far as saving is concerned, there is very little to add to what we have already observed. An increase in the propensity to save has no deflationary effect on total demand (since it does not affect income) and can only be the cause of unemployment if it drastically reduces the velocity of circulation of capital. If, because of a change in the behaviour of consumers, firms had to wait much longer before being able to sell the totality of their production, they could decide to decrease its intensity and employ some of their workers only part time. This decision would increase the level of unemployment, of course, but it would not be caused by a deflationary

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reduction in demand. The entire output can be purchased (and will be, though over a longer period of time) through the expenditure of the income generated by its production, so that total demand remains perfectly equal to total supply. It is not the length of the period required for the final purchase of current output that can modify effective demand. As economists know, the level of demand is neither determined by desire or necessity but by the amount of income available to finance it (demand which cannot be backed by corresponding income is bound to remain virtual, and virtual demand can exert no influence over the real world). Since savings do not reduce the amount of income, which is entirely deposited with the banking system, they cannot be the cause of a shortage in effective demand. Hence, an increase in interest rates cannot lead to deflation via its effect on savings. It still seems possible to claim, however, that a policy of high interest rates can have a deflationary influence by reducing firms’ incentive to produce. By increasing costs, a rise in interest rates reduces the margin of profits. Yet, unless this process can be related to the over-accumulation of capital, it is impossible to prove that it can lead to deflation. It is a fact that if firms were to produce less, unemployment would grow, but this reduction in production would not be caused by effective demand being insufficient relative to total supply. Whether firms produce for 100, 1,000 or 10,000, their activity (the activity of their workers) is the source of an income (measuring effective demand) which is perfectly equivalent to its real content (defining total supply). In other words, the equality between total supply and total demand is compatible with any level of production and, therefore, also with any level of employment. The point we would like to make clear here is that, even when it is the effect of a rise in interest rates, the reduction in the level of production cannot be imputed to a deflationary disequilibrium between supply and demand. We do not deny that because of higher interest rates firms could reduce their production, thus increasing unemployment. What we claim is that if the rise in interest rates is not analysed within a context of capital over-accumulation, it cannot be considered a cause of deflation. The determining factor is again provided by the modern analysis of money. It is through the monetisation of production that nominal money is given its real content. Being the result of the association between money and real output, income is determined as a drawing right over what has been produced by workers and stocked by firms. The simple observation of bookkeeping entries in banks’ balance sheets shows that there is a perfect correspondence between positive and negative deposits, where positive deposits stand for the amount of domestic income generated by production and negative deposits measure the debt incurred by firms and backed by domestic output. This correspondence is established independently of the subsequent redistribution of income and the level of production. Hence, neither the behaviour of consumers nor that of firms can introduce a discrepancy between real output (total supply) and income (total demand). By affecting the propensity to save and the decisions to invest, an increase in interest rates is said to provoke a rise in unemployment. However, if

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it is not supported by a rigorous analysis of capital accumulation and of the relationship existing between interest and capital, this claim can at most lead us to maintain that fluctuations in interest rates can be at the origin of some kind of frictional unemployment. A monetary policy based on the Central Bank’s intervention on interest rates can momentarily influence the activity of production, but since it does not introduce any positive gap between supply and demand, it cannot be considered a cause of positive or negative deflation. To provide further analytical evidence in support of the argument we have been developing so far, let us consider the impact of the real balance effect over deflation. As testified by economic literature, some authors believe that deflation can be partially matched by the real balance effect, i.e., an increase in real demand made possible by the increase in the value of monetary assets. Although this stimulating effect does not seem to be strong enough to lead to full employment (also because ‘a decline in prices may unleash other, possibly stronger, responses leading to further deflation’ (Goodhart 1975:203)), it is interesting to analyse whether the increase in monetary assets can be of any help in the fight against deflation. In other words, we must ask ourselves if domestic demand can be raised through an increase in the yields on government and/or foreign bonds. Let us suppose that a reduction in prices and wages leads to a rise in the value of public sector fixed-interest financial liabilities held by the private sector. As Goodhart points out, ‘the future interest payments on the bonds, which are now more valuable in real terms, have to be financed somehow’ (p. 203). Hence, if interest payments are financed out of direct or indirect taxation, the increase in the private sector income resulting from interest payments is entirely matched by an equivalent decrease due to the new transfer operated in favour of the public sector. On the whole the public is able to exert the same demand as before and no stimulating effect derives from the increase in the value of ‘outside’ assets. However, as suggested by Goodhart, it still seems possible to consider the real balance effect as a source of some induced expansion in demand if it is claimed that ‘an expectation of future higher tax charges (in real terms) to meet the interest payments is likely to offset some, but not all, of the expansion resulting from a higher present value of “outside” public-sector bonds’ (p. 204). But how is it possible for the public sector to pay interest without financing this payment through present taxation (or through the sale of new public bonds)? Having recourse to printing money is the easiest way, and it is certain that the state can rely on it on condition that the creation of money amounts to a simple advance and not to an inflationary increase in the money supply. This means that by paying today’s (period p0) interest, the state advances to the public the very amount that the public will later (period p1) have to pay back in taxes. Thus, taking both periods into account there are no reasons to believe that private demand can increase following an increase in the value of ‘outside’ financial claims. Moreover, since firms’ decisions about production are based on sustainable expected demand rather than on short term variation, the momentary increase in the private sector income is not bound to provoke any

INFLATION AND DEFLATION 39

reduction in unemployment. It is the amount of income available within a given economy which determines the amount of aggregate demand. If income is not increased, neither is demand, so that the true question we have to answer is whether a new distribution in wealth can modify domestic income. The simple observation that the transfer of income from an economic agent to another does not alter its global amount seems to lead to a negative answer. But what about the income paid as interest by the public sector? Since ‘the public sector does not have to worry about solvency when financing its deficits’ (p. 206) can the payment of its fixed interest debt increase income and thus have an antideflationary effect? This seems possible only if the public sector interest payments were financed through monetary creation. However, apart from advances (which do not modify the total amount of available income over time), if the state issued money to pay for its debt the result would be an inflationary growth of the money supply and not an increase in income. To fight one disequilibrium with another does not seem to be the right solution unless the two are complementary. Our next problem then will be that of verifying whether inflation and deflation are two opposed disequilibria which reciprocally cancel out. Before analysing this possibility, however, let us consider the attempt at classifying unemployment according to behavioural considerations. Goodhart, for example, distinguishes between desired and undesired unemployment, a classification which clearly refers to the way people behave concerning their working or non-working situation. Now, if this distinction is intended to define and calculate the level of unemployment, it is of little help from a purely economic point of view. Sociological considerations are an important part of this classification, which is not rigorous enough to provide a criterion capable of accounting for the various attitudes towards the problem of unemployment. Is a person aged 65 and still willing to work to be put in the category of undesired unemployment? And what if he is a self employed individual who can and does go on working? Does a pregnant woman who stops working for three years to look after her child and is not able to recover her job (or a similar one) after this period increase the number of unemployed? And do things change if she is offered a lesser job which she refuses? To these and other similar questions it is not possible to give a straight answer. Too many factors, economic, sociological, psychological, moral, etc., are implied in this classification to make it a reliable instrument to measure unemployment. A more interesting interpretation of the distinction between desired and undesired unemployment could be given by defining undesired unemployment as the consequence of economic agents’ behaviour. Thus, while desired unemployment would remain a loose concept related to the willingness to work under given conditions, undesired unemployment would be related to the microeconomic behaviour of consumers, firms, banks, government, and so on. The aim of the distinction would therefore be that of separating the unemployment caused by economic factors from that resulting from sociological or psychological factors in order to gain a deeper insight into both the sources of

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and the remedies against unemployment. As monetary analysis shows, however, the worst obstacle against this attempt is the fact that economic agents’ behaviour cannot be considered the cause of deflation. The main reason for pathological unemployment remains a mystery which cannot find its place in any of these two categories. Another analytical classification is proposed by Keynes, who distinguishes between voluntary and involuntary unemployment. If this distinction is seen as an attempt at classifying the various individual attitudes towards employment, it is obviously of no more interest than the one analysed before. As Goodhart observes, ‘in that sense virtually all unemployment is voluntary, since there are almost always some vacancies for jobs which the unemployed could accept’ (Goodhart 1975:197), and, conversely, all unemployment can be considered as involuntary since there would always be some jobs in the economy ‘which virtually any unemployed worker would take if offered’ (p. 197). However it seems possible to claim that what Keynes had in mind when distinguishing between voluntary and involuntary unemployment is something else. These two categories do not refer to the individual perception unemployed workers have of their situation, but to the different origins and characteristics of unemployment. A given level of unemployment is thus said to be voluntary if it is intrinsic to the choice of a particular economic system, and involuntary if it derives from the anomalous workings of this system. Let us explain this by starting from a quotation from Keynes’s The General Theory. Clearly we do not mean by ‘involuntary’ unemployment the mere existence of an unexhausted capacity to work. An eight-hour day does not constitute unemployment because it is not beyond human capacity to work ten hours. Nor should we regard as ‘involuntary’ unemployment the withdrawal of their labour by a body of workers because they do not choose to work for less than a certain real reward. Furthermore, it will be convenient to exclude ‘frictional’ unemployment from our definition of ‘involuntary’ unemployment. Keynes 1936/1973:15 Since frictional unemployment is defined by Keynes as the unemployment resulting from miscalculation, unforeseen changes and inconsistent decisions, and since he puts frictional unemployment, together with that caused by social and legal structures limiting free competition on the labour market, in the category of voluntary unemployment, it is clear that his conception of involuntary unemployment is not related to human behaviour. So, if we push this distinction a bit further and we include structural unemployment in the category of voluntary unemployment (which is consistent with Keynes’s analysis since structural changes result from managerial decisions), we arrive at the conclusion that involuntary unemployment can only be due to an anomaly in the economic system itself. In its pathological form, unemployment is generated by a perverse

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mechanism strictly related to the ‘structure’ of monetary payments. In this new formulation Keynes’s distinction seems thus able to capture the particularity of pathological unemployment, keeping it separate from that unemployment which is inherent in the behaviour of economic agents and technological progress. Together with inflation, involuntary unemployment thus becomes the disequilibrium which must be explained by monetary theory. STAGFLATION Let us start from the following quotation: ‘Once inflation has begun, for whatever reason, the authorities are then left with the unpleasant choice between accommodating the going rate of inflation by allowing monetary expansion, or of subjecting the economy to deflation and unemployment’ (Goodhart 1975:208). The idea implied in this quotation is that inflation can be controlled through a deflationary monetary policy and that, vice versa, deflation can be fought by inflation. As noted by Friedman (1975), the existence of an inverse relationship between inflation and unemployment was first suggested by Fisher in 1926. Fisher’s observations were later given further statistical support by Phillips (1958), who tried to establish an inverse correlation between the rate of unemployment and the rate of change in wages. It is not our intention to propose here another appraisal of the Phillips curve and its critical assessment by Friedman. In this respect let us simply observe that, according to the modern analysis of our monetary systems, inflation is not caused by variations in money wages, and that changes in real wages are perfectly consistent with the absence of inflation. Moreover, the rate of unemployment cannot be determined simply by counting the number of unemployed people period after period. Among the factors which can lead to unemployment, the one which monetary theory must effectively account for is the ‘structural’ anomaly which leads to a shortage in global demand. Hence, instead of using unreliable statistical data to build a hypothetical relationship between inflation and unemployment it seems far more interesting to re-examine Fisher’s correlation in the attempt to establish whether there is any theoretical foundation for a functional link between inflation and involuntary unemployment. Since the principal cause of pathological unemployment is deflation, let us start by considering its relationship with inflation. The first question to ask is whether inflation and deflation are two opposite and complementary disequilibria. If this were the case, one disequilibrium would compensate the other so that, globally, an economy could only suffer from one of the two at a time. Since inflation is defined as a situation in which total demand is greater (at least numerically) than total supply, and deflation as a state of affairs in which total supply is greater than total demand, it would seem obvious to match the excess demand with the excess supply. This is what happens in the traditional Keynesian analysis of income determination. As every student of economics knows, equilibrium is reached when production (total supply) equals total

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demand. If actual production exceeds the income corresponding to this point of equilibrium, the system suffers from deflation, current output being greater than total demand. On the contrary, if the level of production is not high enough to guarantee equality between total demand and total supply, the economy suffers from inflation. If we refer to the graphic representation of the simple Keynesian model of income determination we can easily observe that, outside equilibrium, the system can suffer either from an excess of total supply or an excess of total demand, but never from these two disequilibria at the same time. Either current income is greater than its level of equilibrium (Ye), and we are in the zone on the right of Ye, or it is smaller, in which case we are in the opposite zone, on the left of Ye. Under no circumstances can current income be simultaneously greater and smaller than Ye, or, in other words, can total demand be greater and smaller than total supply at the same time. If inflation and deflation were effectively opposite and complementary phenomena, then we would never have to worry about their simultaneous presence. In particular, a situation of inflation would guarantee the absence of deflation so that the term stagflation would lose most of its negative connotation. Inflation could not coexist with a high rate of unemployment and, what is even more important, an economy could never suffer simultaneously from inflation and involuntary unemployment. To be rigorous, the term stagflation should no longer be used, since it would not be possible for inflation and recession to hit a system at the same time. Recession is simply another word for deflation, and the complementarity of inflation and deflation would make the word stagflation practically meaningless. It is true that the Keynesian theory can account for the coexistence of inflation and unemployment. However, it is only voluntary unemployment which can be explained in this way. In a period of inflation firms benefit from extra profits, it is true, but this does not mean that a single firm could not get it all wrong and have to change its production or even close down. Analogously, the firms of a given sector could be pushed to restructure their production because of foreign competition, workers could be less willing to move from one job to another, information could circulate less efficiently, and so on. All these factors would cause an increase in structural or frictional unemployment, but none of them would lead to deflation. The impossibility of explaining stagflation is a serious shortcoming of all theories which, like the Keynesian one, assume the existence of an inverse relationship between inflation and deflation. This is also the case of the traditional Monetarist approach, which is essentially based on the neoclassical analysis of supply and demand. Friedman’s concept of the natural rate of unemployment does not modify the terms of the problem. The coexistence of inflation and of some positive level of structural and frictional unemployment (corresponding to the natural unemployment rate) is not enough to explain stagflation. Even Friedman’s rejection of a long run trade-off between inflation and unemployment does not provide a satisfactory answer, though it can be considered an interesting intuition of the possible coexistence between increasing

INFLATION AND DEFLATION 43

rates of inflation and unemployment. All the controversy about short- and longterm trade-off between inflation and unemployment is based on the wrong assumption that inflation can be identified with an increase in wages, and that, in a free market, unemployment tends towards its natural rate. Let us briefly sketch the Monetarist argument. Assuming that the natural rate of unemployment of a given economy is equal to 4 per cent, the government could be interested in reducing it through a policy of public spending. Because of the inflationary nature of this intervention, the reduction in the unemployment rate (say to 2 per cent) would be matched by an increase (for example to 6 per cent) in the rate of inflation and, therefore, by a rise in wages and prices. However, this initial tradeoff between inflation and unemployment would not last for long, since it depends on workers and firms interpreting the rise in wages and prices in the opposite way. If workers believe that real wages are increasing they are likely to be more willing to accept certain jobs, whereas firms are prepared to employ more workers if they believe that real wages are decreasing. It is only if workers and firms are the victims of opposite monetary illusions that circumstances are favourable for a trade-off. Of course, this particular state of affairs could only be temporary and both workers and firms would soon realise that they have no monetary reason to increase their supply of and demand for labour. The positive impact of public spending over the rate of unemployment would thus end, pushing the economy back towards the natural unemployment rate. Now, this time the trade-off between inflation and unemployment would not follow the same path as before. The increase in unemployment would not be matched by a corresponding decrease in inflation, since in the meantime workers and firms would have adjusted their expectations towards the new rate of inflation generated by the government’s intervention. Hence, ‘since equilibrium in the labour market is defined with respect to the anticipated real wage rate, that is the real wage rate that workers estimate they will be able to command and employers estimate they will have to pay, an expected rate of change of wages and prices will be perpetuated in the new equilibrium’ (Trevithick 1980:67). This means that while unemployment would rise from 2 per cent to 4 per cent, inflation would settle at around 6 per cent, a rate which would even increase if the government were to persist in its intervention against unemployment. Developed with the explicit intention of discouraging public intervention, this analysis seems to be able to explain, at least partially, the coexistence of unemployment with an increasing rate of inflation. Of course, this is far from being satisfactory, since the analysis leaves the problem of stagflation entirely unexplained. It is the increasing rate of involuntary unemployment which must be accounted for, and not only that ‘associated with structural rigidities in the labour market and with the frictional unemployment produced by workers changing jobs and registering as unemployed while looking for another job’ (Trevithick 1980:62). The worst problem industrialised economies are facing today (1995) is certainly represented by the growing number of unemployed people. Despite frequent inadequacy of statistical coverage, it is increasingly

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evident that the situation is particularly worrying because unemployment is not merely the side effect of technological progress and structural change but is mostly due to a general economic recession. The Monetarist analysis of shortand long-term trade-off relations fails to provide a theory of deflation organically linked with that of inflation, and this is undoubtedly its major shortcoming. Moreover, even the arguments put forward to prove that the fight against unemployment can lead to an increased. rate of inflation are not entirely correct. As we have seen in point (2), unless it is financed by printing money (which is not the case in our monetary systems), government spending does not provoke an inflationary increase in the money supply. If Central Banks comply with the rules of double entry bookkeeping and respect the principle according to which ‘deposits make loans’, government transactions are always financed by current income, so that they will never give rise to an emission of empty money. The assumption that government spending leads to an inflationary growth in the money supply does not take into account that, when acting as bank of the state, the Central Bank is an intermediary between the public and the state. Thus, a government can increase its expenditures only insofar as it can raise new taxes or if the public is willing to lend it the amount of income necessary to finance them. In both cases the state spends what is saved by the public, so that global demand is not inflated because of the government’s intervention. It is only if the state were not able to sell its products through taxation or cover its deficit through the sale of Treasury bonds, that its intervention could give the impression of leading to inflation. Let us suppose that, to fight unemployment, the state pays half of the unemployed workers to dig a hole and half to fill it up again. As a result of this useless job, the amount of money increases, leaving real output unaltered. Is this not proof that because of public intervention the system suffers from an increase in demand which, not being matched by an equivalent increase in supply, is the mark of an unavoidable inflationary gap? Yet, if it is certain that the digging and filling of holes increases the amount of income available within the system, it is only apparently true that it does not simultaneously modify real output. Apart from the obvious fact that filled up holes do not increase physical wealth, they are an integral part of current output. So much so that the state must sell them to finance their production, that is to cover its debt to the Central Bank. Were it not able to obtain from the public the necessary amount of income, the state would remain indebted to the Bank, which means that, through the intermediation of the banking system, the public would nevertheless be lending part of its income to the state. Finally, it would be the state itself which, waiting for the opportunity to increase its receipts, would purchase the holes. Despite the particular nature of the output we have assumed to be financed by the state, its production will not lead to a rise in the price of other goods, and cannot be considered to be inflationary. The starting point of the Monetarist analysis concerning the relationship between inflation and unemployment rests therefore on a somehow superficial assumption which is totally disproved by modern monetary analysis.

INFLATION AND DEFLATION 45

Let us now consider the second step of Friedman’s argument: the rise in prices and wages caused by government spending and its effect on inflationary expectations. First it must be observed that an intervention by the state to increase public production in order to decrease unemployment does not modify the level of the wage rate. The amount of total wages will increase because of the new production, but the workers who were already employed before will not benefit from any increase in wages, either nominal or real. Similarly, if the state is able to finance its production (which is usually the case in our economies, where treasury bonds are easily sub scribed to by the public), prices will not vary, since the public will still exert the same demand over current output. Only in the extreme example of digging and filling holes being financed by printing money, would prices rise. In this case, firms would benefit from a rise in profit and could be encouraged to increase their production. However, this positive effect on unemployment would effectively occur only if firms were to believe in a longterm increase in effective demand. Other factors would have to be taken into account, such as the process of capital accumulation and over-accumulation or the capacity of workers to adjust their nominal wages to the new level of prices. If monetary wages were to be increased following the increase in prices, nothing would be fundamentally modified in the long run. The effect on the initial production would only be a change in the scale of measurement of income and it would be equally wrong to claim that the intervention of the state can have a lasting impact on unemployment or that it leads to a persistent increase in inflation. In reality, the true cause of pathological unemployment is deflation, and this disequilibrium cannot be disposed of by increasing production (public or private) since, precisely because of deflation, current output is already in excess relative to the amount of income available. To fight against unemployment would it not be better to ask the state to increase the money supply by financing expenditure instead of new production? Obviously, if this amounted to financing the public deficit through money creation, its impact would merely be a growth in inflation. It is not through an increase in nominal or empty money that deflation can be fought. It is a lack in total demand which is the mark of deflation, and demand is determined by the amount of income which can finance it. By increasing the quantity of nominal money, the government would not increase total demand, and its intervention would have no lasting effect on unemployment. As we have already observed, profits would grow because of the inflationary increase in the money supply, but this would not be enough to reduce unemployment since deflation would go on exerting its depressing pressure on total demand. The economy would not be fooled by the ‘monetary illusion’ generated by inflation and the problem of unemployment would still be as worrying as before. If the intervention of the state did not amount to financing public expenditures through money creation then inflation would be avoided. However, this would allow neither for an increase in the quantity of money nor in total demand, so that neither inflation nor deflation would even be partially modified by public expenditures.

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In conclusion, the Monetarist attempt at explaining stagflation is not much more successful than the Keynesian one, since they both lack a satisfactory analysis of deflation. Unfortunately this is a widely diffused shortcoming of traditional monetary theory. Even Kaldor (1976) and his followers, for example, have not succeeded in overcoming it. In their analysis, the coexistence of inflation and deflation is accounted for by distinguishing among the structures of prices of the different economic sectors or even by distinguishing between firms of the same sector and claiming that an increase in prices of essential inputs can lead, through a difference in profit rates, to sectorial disequilibria of the opposite sign between supply and demand. The problem is that a rise in the price of foreign commodities (such as that of the price of oil in the 1970s) cannot be considered as an effective cause of inflation. It increases the price of the commodity basket and of the cost-of-living index, it is true, but it does not lead to a reduction in the purchasing power of domestic money (which is determined by the relationship between national money and domestic output). Moreover, the increase in unemployment which can be induced by a rise in the costs of production (and by the subsequent reduction in profits) would not be due to deflation, and would therefore not affect involuntary unemployment. Even though national producers have to pay a greater amount of income for the purchase of primary goods, their expenditures do not lead to a reduction in total demand. If primary goods are imported from abroad, the domestic income spent on their purchase remains entirely deposited within the national banking system. Foreign banks become the owners of domestic deposits, of course, but the amount of these deposits is not decreased because of the transfer of claims between residents and non-residents which domestic banks carry out for their clients. Hence, since the payment of primary goods takes place in the currency of the exporting country (Table 1.6), the level of domestic demand of the importing country remains unchanged whatever the price of these goods. As is shown by the bookkeeping entries of Table 1.6, the nature of bank money is such that the payment of imports does not decrease the deposits of domestic income available within the importing Table 1.6 Domestic banking system of country A (DBS of A) liabilities

assets

Importers 20 MA FBS 20 MA FBS 20 MA Foreign banking system (FBS) liabilities Exporters 20 NM

Residents Importers Residents

20 MA 20 MA 20 MA

assets DBS of A

20 MA

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country. Deflation can therefore not be imputed to the increase in the prices of primary goods, whose negative effect on unemployment, if any, is of a frictional kind. The critical analysis of traditional theory we have been developing so far has partially clarified the terms of the problem of stagflation. The true nature of this double disequilibrium is still mysterious. In particular, it is not clear how, being entirely deposited with the banking system, income can be smaller than current output, and how it is possible for total demand to be simultaneously greater (inflation) and smaller (deflation) than total supply. To provide the elements for a new monetary approach to these questions, let us briefly show how inflation and deflation are both related to the same ‘structural’ pathology. INFLATION AND DEFLATION AS THE CONSEQUENCES OF THE SAME ANOMALY Our banking systems are the result of a long lasting process of development of our understanding of the way a monetary economy can work in compliance with the nature of money. Through their activity, bankers have constantly improved the consistency of the system with regard to the role banks play as financial and monetary intermediaries. Interbank clearing, for example, is an extremely powerful instrument for guaranteeing monetary equilibrium, and a thorough analysis of the various transactions carried out by secondary and Central Banks of most highly developed countries shows that they are never the cause of either inflation or deflation. Yet these two disequilibria are certainly monetary, so that their origin must necessarily be found within the banking system. This means that, despite the high level of development reached by our monetary systems, there is still room for a partial discrepancy between the structure of banks’ bookkeeping and the laws of money. Let us show this by starting from a situation in which theory and practice are perfectly matched (Table 1.7). Table 1 .7 Banking system liabilities (1) (2) (3) (4) (5) (6)

Workers State Income holders Income holders Firms Workers

assets 100 30 70 30 100 20

Firms Workers Workers State Income holders Firms

100 30 70 30 100 20

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The first transaction (entry (1)) refers to the monetisation of production. It is carried out by banks on behalf of firms and leads to the creation of a positive amount of income whose real content is current output. Entries (2), (3) and (4) correspond to a simple transfer of the income created through the payment of (direct and indirect) wages and allow for its redistribution among the various economic agents (firms included, insofar as they realise a profit which is then redistributed as rent, interests and dividends). Entry (5) shows how income is definitively destroyed when it is spent by its final holders on the purchase of current output. New production (entry (6)) can thus be financed only through a new payment of wages, which gives workers (or, after redistribution, income holders) a purchasing power over the newly produced real output. Now, what would happen if, instead of being carried out by banks as represented in Table 1.6, the new payment of wages was itself financed by a corresponding income held by firms? Let us show this by assuming that production takes place under the supervision of two firms, F1 and F2, and that, having realised a profit of 20, F1 asks its bank to carry out a new payment of 20 to the benefit of its workers (Table 1.8). The first two entries correspond to the monetisation of the initial production of 120 units. Entry (3) is the result of the decision taken by workers to spend their income on purchasing from F1 only, while entry (4) represents a new payment of wages carried out by the banking system on F1’s request. After compensation, bookkeeping entries in the banks’ balance sheet show that F2 is still indebted for 20 units and that workers own a positive deposit of the same amount (entry (5)). Globally, production is equal to 140 units, of which 120 are or will be bought by workers and 20 are appropriated by F1. Apparently there are no substantial differences between Table 1.7 and Table 1.8 as far as the relationship between money and output is concerned. In both cases 20 units of bank deposits are finally confronted with 20 units of real output and it seems that there is no reason to believe that, financed out of a positive profit, the payment of wages can introduce a monetary Table 1.8 Banking system liabilities (1) (2) (3) (4) (5)

Workers Workers F1 Workers Workers

assets 100 20 120 20 20

F1 F2 Workers F1 F2

100 20 120 20 20

anomaly into the system. However, a closer investigation shows that things are completely different according to whether wages are paid out of nominal money or out of a positive income. In the first case, money is associated with real output

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and the transaction leads to the creation of a new amount of income of which workers are the initial owners. In the second case, an income is spent within the payment of wages, which means that, instead of being the real content of the sum of money credited to workers, current output is definitively purchased by F1 so that workers are effectively credited with a sum of ‘empty’ money. It is true that this empty money is not yet the mark of an inflationary gap between money and output since it gives workers a claim over the product of F2, but this must not hide the fact that, as a result of the final purchase carried out by F1 on the labour market, part of F1’S real output is transformed into a pathological fixed capital; that is, into capital owned by the firm itself and not by its holders. As clearly stated by Bernard Schmitt, firms get hold of the product of their workers through the net investment of profit. Their final purchase ‘leaves money wages unaltered but decreases their real content. The product subtracted from money is definitively appropriated by a ‘non-person’, the set of the country’s disembodied firms’ (Schmitt 1984a:208). As a result of the net investment of profit an excess demand on the commodity market is exerted through the payment of wages. In our numerical example the final expenditure of workers is equal to 120+20 =140 units, while F1 exerts a final demand of 20 units through its purchase of capital goods (taking place on the labour market). The excess demand of 20 units is thus due to the investment of profit; that is, to the payment of wages carried out by F1 through the expenditure of its profit. The sum of expenditures on the commodity market being greater than that on the labour market, the excess demand is financed by empty money. The formation of fixed capital is thus pathological because instead of being financed through saving, investment is financed through an emission of empty money. Let us represent side by side the correct and the anomalous payment of wages together with the expenditure of the income generated by production (Figure 1.4). When the payment of wages is carried out with nominal money, as in (a), workers are credited with a positive purchasing power over current output. Their income corresponds to a positive amount of full money, so that they are the initial holders of the physical product stored by firms. Once the various transfers among economic agents have been taken into account, income is owned by those we have called the final income holders. The subsequent expenditure of income allows income holders to purchase the totality of the goods and services produced. On the contrary, when the payment of wages corresponds to a net investment of profit, it leads to the formation of a pathological fixed capital. Being carried out through the expenditure of a positive income, the payment of wages gives rise to the purchase of current output by firms. As is shown by the double arrow in Figure 1.4, transaction (b) is of a dual nature, since the purchase of the product takes place simultaneously with the payment of wages. Workers are thus deprived of the real content of their wages, which is definitively appropriated by firms. The troublesome effect of this transaction is that the goods corresponding to the net investment of profit are no longer in the

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Figure 1.4 Correct and anomalous payments of wages, and the expenditure of income generated by production

economic possession of income holders. Fixed capital becomes the property of the country’s depersonalised firms, and its pathological nature, which is marked by the presence of empty money, has its most serious consequences over monetary equilibrium when it is amortised. The analysis of fixed capital amortisation having already been developed by Bernard Schmitt (1984a and this volume), we shall here merely recall its main results. Because of the existence of disembodied firms, amortisation of pathological fixed capital leads to the formation of an extra profit whose investment is the cause of an equivalent emission of empty money. The process is analogous to the one we have been examining in relation to the formation of fixed capital. However, this time workers producing profit goods are paid with an empty money which can no longer represent a claim over the production of other goods and services. The emission of empty money is thus entirely pathological and involves the creation of an irreversible inflationary gap. Moreover, the over-accumulation of fixed capital is also the principal source of

INFLATION AND DEFLATION 51

involuntary unemployment. The argument runs as follows. Because of overaccumulation, fixed capital grows larger and larger, which makes its remuneration increasingly difficult. Firms start having problems in finding the amount of profit necessary to ‘nourish’ their capital and can thus be induced to reduce their investment in capital goods. For example, firms could decide to reinvest only 80 units of their profits (equal to 100 units) on the production of new capital goods, lending the rest on the financial market. In this case, capital over-accumulation would lead to unemployment, thus confirming the existence of a strict link between this disequilibrium and inflation. Firms could also decide to reinvest the whole amount of their profits, partially in the production of new capital goods and partially in the production of consumption goods. This decision would imply the final purchase by firms of new capital and consumption goods (for example of 80 and 20 units respectively). However, while the 80 units of capital goods would be definitively appropriated by firms, the remaining 20 units of consumption goods would be offered on the commodity market. Having the form of consumption goods, part of the real output purchased by firms since the payment of wages would thus increase the total amount of goods for sale on the market. The subsequent increase in total supply is evident. Yet, would this increase not be matched by an equivalent rise in the amount of income available within the system? If wages were paid out of nominal money this would effectively be the case. The new production of consumption goods would simultaneously and equivalently increase both the amount of total supply and that of total demand and would not be the cause of either an inflationary rise in total demand or a deflationary increase in total supply. Since wages are paid out of a positive income, however, the production of the 20 units of consumption goods would involve their purchase by firms. The expenditure of profit on the labour market leads to the purchase of the newly produced goods and services. Hence, if firms financed the production of 20 units of consumption goods out of their profits, they would become the owners of the real output which would define the real content of the wages paid out to their workers. In other words, workers would be paid with an empty money; that is, with a money with no purchasing power over current output. Now, the selling on the commodity market of the consumption goods which firms have already purchased on the labour market, has the effect of increasing total supply even though their production does not entail the creation of a new equivalent income. The payment of wages out of a profit increases the total supply of money, it is true, but money itself cannot finance a positive demand unless it is endowed with a positive purchasing power. It is the amount of income which determines total demand, and in our example the new production of 20 units of consumption goods would simply lead to an emission of empty money and not to an increase in income. Thus, the increase in total supply would not be balanced by a corresponding increase in total demand, which is the rigorous description of a situation known as deflation.

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The over-accumulation of capital is a process which can go on for quite a while without generating involuntary unemployment. In the periods when industrialisation is at its beginning, capital over-accumulation contributes to accelerating economic expansion and the inflationary fluctuations it provokes are often underestimated. The loss of purchasing power suffered by money seems to be generously compensated by the increase in the quantity of goods which can be bought by nominal income. The fact that, without inflation, this quantity would be greater and we would all be able to enjoy the entire benefit of the increase in physical productivity derived from technological progress is seen as a minor shortcoming, a price we must and can pay for economic development. However, when capitalism reaches its present level of evolution things change. Technological progress alone is no longer capable of avoiding the inflationary decrease in money’s purchasing power to lead to a (relative) decrease in the quantity of goods which can be purchased out of a given nominal income. Moreover, capital accumulation is made increasingly difficult by the necessity to remunerate it out of a profit whose rate is tendentially decreasing. Without favourable external conditions which could allow for another period of economic expansion, our systems can no longer provide for the profitable investment of inflationary profits in the production of new capital goods. The level of overaccumulation is such that these profits can no longer guarantee a satisfactory remuneration of capital. In these circumstances firms cannot go on investing their profits in the production of new capital goods, and are thus led to increase unemployment. As we have seen, two possibilities are open to them. They can stop or reduce the over-accumulation of capital simply by investing their profits on the financial market or by investing them in the production of new consumption goods. In the first case unemployment would be a direct consequence of the reduction in productive investment, in the second it would result from the pathological increase in total supply (deflation). Finally, the overaccumulation of capital (due to fixed capital amortisation) is the unique, objective cause of any increase in what we have called involuntary unemployment since the impossibility of realising enough profit to remunerate their capital forces firms to reduce their production. Stagflation can be explained only if the analysis of bank money is pushed so far as to emphasise its dual nature. The classical distinction between nominal and real money is to be understood with respect to bank money and to the monetary and financial intermediations carried out by banks. By analysing banks’ bookentries it is possible to establish that money acquires a positive purchasing power through its association with real output and that this results from a single monetary operation: the payment of wages. Hence, through the payment of wages, money (the ‘numerical vehicle’ of the economy) is associated with its real content (current output) and transformed into income. Now, if this logical distinction between money and income is adequately accounted for by the practical workings of our banking systems, then no monetary disequilibrium will ever derive from it. On the contrary, if money and income are erroneously

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intermingled, inflation and unemployment are the unavoidable consequences of the unfortunate inconsistency between the nature of money and the monetary structure of banks. In particular, if the realisation of profits and the payment of wages are entered on a single department (which results in their being entered on the same balance sheet, see Table 1.7), this leads to their reciprocal compensation, that is, to wages being paid out of profits. Thus, an operation which should entail the creation of a new income through the association of money to current output, becomes a double transaction in which the goods produced are bought within the payment of wages. Inflation derives precisely from this anomalous purchase which, instead of taking place on the commodity market takes place on the labour market. Their product having already been purchased by firms, workers are paid in a money deprived of its real content, an empty money with no purchasing power which pathologically increases the money supply. Derived from the net investment of profit, empty money marks the birth of fixed capital, a capital whose amortisation is the source of an inflationary increase in the quantity of money and of a process of overaccumulation. As we have seen, when accumulation reaches a critical level, the investment of inflationary profit can be diverted from capital to consumption goods, thus provoking an increase in total real supply with no corresponding increase in income. The possible coexistence of inflation and deflation is therefore definitively established by their common origin, both being the effect of the imperfect correlation between the laws of money and their practical implementation. To conclude, let us briefly show how our banking system can be made to work in compliance with the nature of money. Since the pathological payment of wages comes from the fact that wages are imputed on profits, the solution consists in avoiding their direct compensation. Following Schmitt’s example (Schmitt 1984a) let us introduce a distinction between the financial department, where all the transactions entered relate to the creation of income (payment of wages), to its transfer (redistribution) and to its final expenditure on the commodity market, and the fixed capital department. In this second department, banks enter the income which has been positively earned by firms and that, being saved, is transformed into monetary capital. Hence, at the end of the day (period of reference for the calculation and payment of interest) the balance of firms in the first department is transferred to the second, where the capital remains recorded unless it is re-transformed into income and definitively destroyed in the final purchase of real output. Applied to the problem we are investigating, this means that the profit realised by any given firm is transferred from the financial to the capital department. Were the firm to ask its bank for the payment of new wages (that is, for the monetisation of new production), this transaction would be entered in the bank’s financial department, leaving the amount of profit entered as capital in the second department unaltered. The payment of wages would thus not be financed out of the firm’s profit. The firm would not exert the purchasing

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power of its profit on the labour market, and workers would not be paid in an empty money. Let us refer to the example of Table 1.8 and show how the same transactions would be entered in the financial and fixed capital departments of the banking system (Table 1.9). The first two entries refer to the payment Table 1.9 Financial department (1) (2) (3) (4) (5) (6)

(4)

liabilities

assets

Workers 100 Workers 20 F1 120 F1 20 Capital dep. 20 Capital dep. 20 Workers 20 F2 20 Capital dep. 20 Fixed capital department liabilities F1 20

F1 F2 Workers F2 F1 F2 F1 Workers F1

100 20 120 20 20 20 20 20 20

assets Financial department

20

of wages carried out by banks on behalf of F1 and F2 and which leads to the creation of 100 and 20 units of income respectively. As in Table 1.8, entry (3) illustrates the expenditure by workers of the whole amount of their income on the purchase of the goods produced by F1. This time, however, the profit of F1 is transferred to the fixed capital department, entry (4), where it is entered as a debt to F1. When the firm asks the banking system to carry out another payment of wages, entry (5), the operation is entered in the financial department as a debt to workers and a credit towards F1. Since F1’s debt and credit are not entered in the same department, they do not cancel out: profit no longer finances the payment of wages and the entire system works without leading to the anomalous emission of empty money. Finally, workers spend their new income on the purchase of the consumption goods produced by F2: the transformation of wage goods into capital goods is thus achieved together with the transformation of monetary profits into monetary capital. Of course, this example should be developed further to show all the implications of the change in the monetary structures of the banking system required to avoid pathological disequilibrium. For the time being let us simply observe that the distinction between financial and capital departments, and the rule governing their relationship are enough to achieve monetary stability. The problem within the actual structure of domestic payments is that the formation of

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fixed capital does not lead to the capitalisation of profits. Having been invested in fixed capital, part of domestic income is definitively transformed into saving and should therefore not be still available on the financial market. Without a monetary structure allowing for the capitalisation of monetary profits (through their transfer to the department of capital), they are invested in the payment of wages. Instead of being definitively saved by the community, profits are spent by firms on the labour market, a pathological operation which leads to the emission of empty money and to the appropriation of fixed capital by ‘disembodied’ firms. The choice between order and disorder is therefore between a system in which fixed capital is owned by people and a system in which it is owned by depersonalised firms. Disorder leads to the duplication (under the form of empty money) of profits invested in the production of capital goods, and is thus the cause of inflation and unemployment. Order avoids this duplication by taking profits (those which have been invested) definitively out of the financial market. Hence, what is needed is a monetary reform allowing for investment to be financed out of saving, and not out of an empty money, since it is only in the first case that income holders can finally become the economic owners of fixed capital, and inflation and deflation can definitively be defeated. Through the introduction of the two departments monetary stability is achieved whatever the behaviour of firms, consumers and banks, in accordance with the claim that stagflation can neither be due to the existence of profits, to the decision to produce capital goods or to an increase in the propensity to save. The anomaly of our monetary systems consists in a bookkeeping mechanism allowing for production to be financed through the expenditure of profit on the labour market. It is because of the overlapping of labour and commodity markets that firms acquire an autonomous existence as depersonalised entities, and not because they realise a profit or decide to invest in the production of new capital goods. If depersonalised firms did not exist, capital would be entirely owned by individuals, and its accumulation would benefit the whole population. On the contrary, if the investment of profit gives rise to pathological fixed capital, the presence of depersonalised firms sets out a process of over-accumulation which leads to inflation (through the emission of empty money) and to (involuntary) unemployment (because of the increasing cost represented by the remuneration of fixed capital). In this context, the intervention of monetary authorities can have very little effect (a policy of low interest rates can momentarily increase the production of new capital goods by making it more profitable, but its positive effect on deflation would not last long, and the growth in inflation due to the over-accumulation in capital would soon lead to an increase in interest rates which would cancel out the initial decrease). The remedy is to tackle the problem at its source, and since the source is placed at the level of the structure of monetary double entry bookkeeping, it is this structure which must be modified to take into account the analytical distinction between money, income and capital. It is following this path that a new research programme in monetary

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analysis has to be conceived to bring about a reform capable of achieving monetary order.

2 STRUCTURAL CHANGE, ECONOMIC GROWTH AND UNEMPLOYMENT IN A VERTICALLY INTEGRATED MODEL Mauro Baranzini

INTRODUCTION In this chapter we shall briefly consider a number of analytical aspects of the inter-relationship between structural change, economic growth, employment and the dynamics of the price system in the model of growth, distribution and accumulation recently put forward by Pasinetti (1965, 1981 and 1993), with special reference to technological unemployment and labour mobility as a consequence of technical progress. Pasinetti’s earlier contributions to the economic literature include a well-known critique of the use of aggregate production functions to evaluate technical progress. In this work Pasinetti suggests a new procedure for evaluating technical change, which precisely avoids the use of the traditional production function, and presents its own estimates for the US private sector between 1929 and 1950, as well as for the automobile industry from 1939 to 1947 (on this point see Pasinetti 1959, and the comment by Robert M.Solow, as well as an unpublished paper by Richard Stone). More recently Pasinetti has put forward a revised theoretical treatment of the problems of maintaining full employment in a multisector economic system with a growing population and different rates of technical progress in different sectors of the economy. The conditions for full employment and full capacity utilisation are examined when prices are stable and also when there is inflation. Normally such analyses are carried out, as is customary in multi-sector models, in terms of input-output relations; here on the contrary they are treated in terms of vertically integrated models. This makes it possible to consider the economic process in terms of the structural dynamics of production, of prices and of employment of the factors of production. It must be said that according to this framework of analysis both demand- and supply-sides play an important, and often cumulative, role in the determination of structural changes. First the demand-side: as productivity increases, per capita income also rises and the increments (or decrements in the case of inferior goods or services) ‘will cluster in succession around different goods’ (Pasinetti 1981: 223). Therefore the rate of change of demand for each commodity will be

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continually changing over time and will normally be different from the rate of change of demand for any other commodity. The actual production of each sector, as Pasinetti points out, will follow a growth path of its own, at a nonsteady rate of change. But one may go further, or rather deeper (see again, Pasinetti 1981:223). A process of structural change of production imposes a very specific type of difficulty, and therefore of decision to take, on any administrative unit in which production is organised. Clearly, a pattern of growth requiring unsteady rates of change for the production of each commodity is not the best one from a purely organisational standpoint. Especially if we imagine production organised into large enterprises— which is a pattern that technology very often imposes—it is quite easy to realise how the financial means at the disposal of each enterprise, the possibilities of training new personnel, the outflow of new ideas, the abilities of the managers to face new situations, etc., take the shape of rather steady flows over time. Within each period of time, these possibilities have a definite upper limit (or at least an upward rapidly stiffening limit). And on the other hand, most of them, if not utilised within the time period, can hardly be reversed for the following one; they simply go to waste. This means that an efficient way, from a purely organisational point of view, of pushing for a long-run expansion of plants, technical and administrative structures, trained personnel, etc., is that of gearing up expansion to a rate of growth which is roughly steady or at least not too unsteady. Now, if the pattern of expansion of demand, on the other hand, is necessarily non steady, a great deal of organisational difficulties and inefficiencies may arise. When demand overcomes the steady rate to which the enterprise is geared up, at least a part of it will remain unsatisfied, and when it falls below that steady rate, the enterprise will remain with idle productive capacities or with unexploited organisational or research possibilities. Pasinetti 1981:223 To conclude, the core of the problem lies in the gap between the potentialities of efficient growth of the single organisational units of production and the highly unsteady as well as uneven nature of the expansion of demand for all commodities. And in a world where technical progress becomes increasingly relevant this contrast is bound to become a crucial factor of disequilibrium. TWO FRAMEWORKS OF ANALYSIS: THE CIRCULAR MODEL AND THE VERTICALLY INTEGRATED MODEL As has been argued in Baranzini and Scazzieri (1990:273–5), a complex process of economic dynamics may be reduced to a number of fundamental components

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such as trends, transition paths (i.e. traverses) and ruptures. The way in which these components may be combined so as to generate definite patterns of change depends on the description of economic structure. In particular it is important to recall the distinction between ‘horizontal’ and Vertical’ schemes of structural specification. As a matter of fact it is possible to show that the patterns of economic dynamics that may be considered are different depending on the particular scheme of structural specification adopted. An immediate implication of the above distinction is linked to the analysis of the structural rigidities to which the economic systems are bound. When the economic structure is identified with a set of vertically integrated sectors the production system appears as a sequence of successive processes by means of which a number of original inputs (such as labour and land) are transformed into final consumption goods. On the other hand, when the economic structure is identified with a set of interdependent and horizontally integrated sectors, the production system may be represented as a network of sectorial interdependencies in which circularity of production comes to the fore. Different types of bottle-necks are associated with this distinction: first, the focus on transformation of original inputs into consumption goods draws attention to the bottle-neck relating to the endowment of original factors or the level of final demand. Second, the focus on circularity and accumulation draws attention to relative scarcities internal to the production system (this may be due to the inadequate supply of a given sector with respect to the other complementary factors). As already said the above distinction between ‘horizontal’ and ‘vertical’ schemes of structural specification may be used to analyse the three fundamental components of economic dynamics (trends, transition paths and ruptures) and the way in which their combinations bring about definite patterns of economic dynamics; within these two different contexts such pathologies as inflationary and deflationary pressures may also be considered. In order to throw some additional light on these issues it is worth expounding such frameworks a little more by first considering the ‘generation’ of trends. We may recall that trend is meant to be a pattern of approximately continuous variation of certain economic magnitudes in which it is possible to identify a constant direction of change. In this way any given trend may be connected with a cumulative and self-propelling movement. In the vertically integrated scheme attention is focused on synthetic indicators such as total capital, labour supply and employment, national income and population as well as ratios like capital per capita, output per capita and saving propensities. A particularly important implication concerns the treatment of technical progress, which is often linked to the so-called ‘factor augmenting’ bias. This is due to the fact that the analysis of a process of cumulative change tends to exclude the consideration of structural breaks, so that technical change is often associated with increased effectiveness of factor utilisation. The use of a restricted number of synthetic indicators makes the identification of the trend

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component of economic dynamics easier and provides a direct link with the macroeconomic conditions (among which are included the dynamics of employment and prices). The horizontally integrated scheme, which is based on the concept of circularity and reproducibility, draws attention away from the fairly simple trendgenerating mechanism of the vertical scheme, by bringing to the fore the endogenous nature of the process by means of which commodities are produced, distributed and accumulated within a dynamic economic system. In this way a process of cumulative change may no longer be described as the outcome of externally generated movements of a cumulative case, such as capital accumulation, population increase and technical progress (an issue which is considered in Baranzini and Scazzieri 1996), since the basic determinants of economic movements (including the degree of factor utilisation and the dynamics of the price system) are not to be found outside the system. The analysis of dynamic processes thus becomes much more complex: on the one hand emphasis is placed upon elementary economic movements of a more disaggregated nature than in the vertical model; on the other hand a complete analysis of dynamic paths becomes difficult in the absence of a comprehensive theory of causation mechanisms. From the above considerations it emerges quite clearly that the problem of unemployment (as well as that of inflation) may be approached from a fundamentally different angle according to the representation of the economic structure that is chosen. Let us, for the moment, retain the classical distinction of unemployment as caused by (a) lack of effective demand; (b) technological change; (c) frictions in the labour market; and (d) structural changes (i.e. concerning the relative weight of the various sectors or industries in the whole economy). In general terms the horizontal representation of the economic system will allow for an exhaustive consideration of the issues connected with the reproduction of the economic system, the possible generation of a surplus, and the whole process of accumulation; in such a framework it is easier to consider problems associated with the lack of effective demand and structural change, the latter being associated with changes in the composition of demand of families in particular. The process of accumulation might also allow us to consider in detail the mechanisms which lead to a definite accumulation and the forces which account for class creation, strength and dispersion. The above elements also refer to the institutional settings of society and may allow for more insights into the relevance of frictional unemployment. On the other hand the vertically integrated scheme allows for a thorough analysis of the role of technical progress in determining structural changes and the system of prices. As pointed out by Pasinetti (1993) within a multi-sector vertically integrated framework it is possible to examine the structural dynamics of prices, production and employment (as they are associated with differentiated rates of productivity growth, expansion of demand and diffusion of human knowledge). (In addition this approach might help in considering a number of

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institutional problems, where institutional and social learning, know-how and the diffusion of any kind of information emerge as determinant factors accounting for the overall performance of modern industrial societies.) Obviously the main advantage of this approach is that it allows for a better understanding of the mechanisms which are the basis of the formation or reduction of technological unemployment and of the dynamics of prices; in other words one could say that it is nearly a microeconomic framework which goes a long way beyond, say, the fixed-coefficient input-output analysis model. In the next section we shall consider the main implications of technological unemployment in a vertically integrated model, such as the one proposed by Pasinetti, as well as the various endogenous and exogenous mechanisms which are bound to aggravate or soften this process. TECHNOLOGICAL UNEMPLOYMENT IN THE VERTICALLY INTEGRATED MODEL According to Pasinetti, in a vertically integrated model where each productive sector is characterised by a different capital/output ratio, a different rate of technical progress and a different rate of demand expansion: Overall full-employment will be maintained, only if the economic system is able to carry out successfully a continuous process of structural redistribution of employment from one sector to the other, in accordance with the pattern shaped by the structural dynamics of technology and demand. It should be stressed that this is an unavoidable process. It cannot be stopped, unless technical progress itself is stopped. Therefore, over time, half of the production processes, on average and in relative terms (i.e. as a percentage of total employment), will be pushing out redundant labour and the other half will have to absorb it, if total over-all employment is to be successfully kept. Pasinetti 1981:227 This statement (which is rigorously proved by the Anglo-Italian economist, heir of the post-Keynesian Cambridge School) makes it possible to discern a number of features concerning the characteristics of our modern economic systems and the difficulties that have to be overcome in order to absorb part of the negative implications of these structural changes. First, the difficulties connected with such changes are explained by the author as follows: A structural process of this type evidently poses innumerable problems, owing to the fact that labour is inseparable from people and division of labour and specialisation are inseparable from technical progress. The structural dynamics of employment therefore pose grave problems both to the firm and to individuals. If a man is to be transferred from one job to

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another, most of his previous training is lost, potential efficiency is wasted and fresh training, i.e. supplementary capital funds and time, are required. For individuals there are all the psychological and social difficulties of readaptation, especially strong when structural redistribution of employment also implies geographical redistribution of population. Pasinetti 1981:227–8 The point is that as productivity increases per capita income also rises and the increments in demand will be unequally distributed around different goods according to Engel’s Law. This means that the rate of change of demand for each commodity will be continually changing over time and will normally be different from the rate of change of demand for any other commodity. Additionally there is no particular reason for which each sector will have to follow a steady-state path; generally speaking this means that in a number of sectors there will be a given level of under-utilisation of resources, while in the remaining sectors there might be an over-utilisation of resources, but such deviations will not be automatically compensated. This will also imply, in the absence of perfectly symmetrical behaviour, a particular dynamics of prices. Going back to the issue of structural unemployment Pasinetti mentions four factors which may counteract the dis-equilibrating implications of the uneven technical progress: 1 Working population continually renews itself through the process of retirement and that of the entrance of new generations into the working force. Pasinetti (1981:228) underlines that ‘by taking advantage of this natural process, it is possible to direct the young to jobs which are different from those the old performed’. The point is that this phenomenon may not always work in such a way, and that a number of rigidities may even aggravate the situation. In fact geographical, social, historical as well as economic phenomena may hinder the process of renewal from improving the situation. The new generation may well be less inclined than the old one to accept low-paid manual jobs, or to move from one region to another for a number of (well-motivated in certain cases) reasons. Add to this that the variation in consumption composition may be accelerated by the arrival of new generations or immigration waves. The result is that the system would require a much higher level of labour force adaptation than previously needed. Finally, it might also be pointed out that: (a) the tendency of most industrialised countries to increase the retiring age for both sexes represents an additional element of rigidity of the labour market, and that, (b) the progressive lengthening of the formation period of younger generations slows down the process of renewal of the working force. On the whole such a renewal may turn out to represent an additional factor of rigidity of our modern industrial societies. 2 The second point raised by Pasinetti concerns the growth of population: ‘Population is normally growing, and the higher the rate of population

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growth, the easier it is to operate a relative redistribution without actually transferring people from one job to another. A growing population means both a higher proportion of inflow of young people into the working population, and a proportional expansion of demand in all sectors’ (Pasinetti 1981:228). Such a factor may of course be reinforced by an increase in the rate of female occupation, as it is the case of a number of industrialised and less industrialised countries. But it may turn out to be irrelevant, or even negative, in the case in which population is not growing or declining, as in the case of numerous European countries. Immigration may however counterbalance such a tendency. 3 A third factor put forward by Pasinetti concerns the presence of multiproduct enterprises. This factor is quite distinct from the previous two, because it can be built up by the economic system itself, and therefore represents yet another aspect of the responses of the production organisation to the requirements of ‘natural’ structural dynamics. The multi-product enterprises, by turning the same organisational unit into the production of a continually changing range of products, are able to provide a remarkable stability of employment. By a continuous change in the composition of their production, they may carry on efficiently (because they are able to choose their new branches according to their experience and know-how) and inside their own organisation, that process of structural change of employment which would otherwise cause so many difficulties to the economic system as a whole. Pasinetti 1981:228 As the author further points out, this is an important aspect of structural dynamics that has been so far underestimated in the economic literature. This is certainly true, but a number of elements which have emerged in the last years have come to hinder the efficiency of such a device, that is: (a) The progressive replacement of the labour force with advanced machinery in order to respond to the competitive threat of emerging countries; (b) The transfer of highly as well as low paid jobs outside the so-called industrialised world where wages are lower and the quality of the labour force often competitive. In this way multi-product firms are not an element of absorption of unemployment, but often an additional cause of unemployment in most advanced countries. The point is that even in the less developed coun tries sooner or later the process of job creation will come to an end and more capital intensive production techniques will be introduced.

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4 A fourth stabilising factor, always according to Pasinetti, ‘is represented by the extent to which single or multi-product firms succeed, through a successful export policy, in substituting foreign demand for a declining internal demand’ (Pasinetti 1981:228–9). This is surely an important factor, as long as new markets and hence new demand is created; but if this is the case changes in the composition of demand (we refer to Engel’s Law) will accelerate, and in the medium and long term the unemployment issue, at a planetary level, may turn out to be even more severe. If, on the other hand, no new markets are associated with this export-led growth, jobs in the importing countries will immediately be at risk, and unemployment will be just exported. Such outcomes will of course become a cumulative process if technical progress is uneven between national and international industries, and also if the rate of change in the composition of demand differs among countries engaged in international trade. The way in which technical progress plays a central role within a multi-sector framework is examined by Pasinetti in a more recent work (1993); in particular he studies the structural dynamics of prices, production and employment (implied by differentiated rates of productivity growth and expansion of demand) against a background of ‘natural’ (i.e. institution-free) relations. In this work Pasinetti also considers a number of institutional issues: institutional and social learning, know-how, and the diffusion of information emerge as the crucial factors accounting for the success and failure of industrial societies; and where among the economic variables the level of employment is taken into account. It is within this context that the international mobility of labour and of information and technical knowledge is considered. INTERNATIONAL MOBILITY OF LABOUR, INFORMATION AND TECHNICAL KNOWLEDGE As pointed out by Pasinetti (1993) we may say that there are two distinct channels through which each country may obtain benefits from international trade: A first channel is that of specialization in the productive branches in which the country is enjoying comparative cost advantages. This is the traditionally explored channel, which emerges as relevant for all countries (…). A second, and distinct, channel is that of learning new techniques in those production branches that cannot rely (or could only partially rely) on internal demand (mainly because of low incomes), but that can find demand abroad. This second channel, which has been ignored by traditional economic theory, is of paramount importance especially for those countries which are economically less developed. For these countries, it may well surge to a position of far greater relevance than the first

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(traditionally more explored) channel, with which it may in any case jointly operate. Pasinetti 1993:163–4 But there is much more to be gained from the vertically integrated investigation of Pasinetti on the influence of human learning on the development through time of a ‘pure labour’ economy. In fact in an open model, non-mobility of labour, ‘when associated with differentiated levels of technical knowledge, and thus of productivity, inevitably brings about international disparities of wage rates (and thus of per capita income), which may well reach enormous proportions, and which are at the roots of inevitable international “unequal” exchanges in terms of labour’ (Pasinetti 1993:165). It is hence clear that international trade cannot be a substitute for the international mobility of labour. International mobility of labour is not immaterial—it matters a lot. But it is not possible to rely on international mobility of labour to eliminate the economic disparities among the various nations. Precisely the opposite seems to be the case. It seems that it would first be necessary to eliminate the international economic disparities, before we may be able to bring about the favourable conditions for a completely free international mobility of labour. Pasinetti 1993:172 So it would seem that the inter-regional mobility of labour will not necessarily be an important element for ensuring a higher degree of utilisation of given resources, since a strong prerequisite is given concerning the ‘international economic disparities’. From this point of view a parallel may be drawn with the thesis put forward by the monetary School of Dijon and Fribourg (see the contributions in this collection by Alvaro Cencini and Bernard Schmitt in particular); in fact the main disequilibria of our economic systems are connected with the incorrect functioning of the monetary aggregates and may not be easily corrected by international flows or transfers: a sort of asymmetry is to be found as in many other fields of economics. SUMMING UP The factors that are supposed to check the process of job destruction in an industrialised country characterised by an uneven rate of productivity growth clearly require a reassessment that takes into account the functional representation of the economic system. Such a representation must not only distinguish between cyclical and structural components, but also take into consideration (a) the role of supply and demand, (b) a minimum level of disaggregation in order to allow for the incorporation of changes in the composition of demand and also in order to incorporate different rates of

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technical progress for different productive sectors and (c) the causal relationship between the most important variables of the system (simultaneity as in the case of most marginalist models, or chains of causal links coupled with sub-systems characterised by simultaneity as in post-Keynesian and neo-Ricardian models). In the present chapter we have focused on, and investigated, the role of different rates of technical progress and of uneven dynamics of the composition of demand in defining, for the medium and long run, the structure and significance of possible under-utilisation of resources. Our analysis has allowed us to expound a number of mechanisms and situations which may play a positive role in reducing the discrepancies caused by such uneven dynamics of demand and technical progress. We have also been able to report on a number of asymmetries which seem to come into play, with particular reference to the international flows of factors. It must be finally said that our analysis has drawn extensively from Pasinetti’s works (1965, 1981 and 1993) on structural change and economic growth where he presents an original theoretical treatment of the problems of maintaining (or approaching) full employment of economic resources in a multisector economic system with a growing population and different rates of technical progress in different sectors. Pasinetti, as already pointed out, considers a wide range of issues, in particular the conditions for full employment and full capacity utilisation when prices are stable and when there is inflation. His entirely new approach is carried out not in the framework of an input-output model, but in terms of vertically integrated productive sectors. According to him, remarkable implications are drawn for a suprisingly large number of theoretical problems: from price theory to the theory of the rates of profit and the rates of interest; from production theory to the theories of fluctuating growth, ever-changing composition of output, choice of technique and even international trade. In the most simple case of a closed economy characterised by different rates of technical progress in different productive sectors, Pasinetti’s analysis proves that in a normal situation the number of firms dismissing workers would be no less than half (on average) of the total number of firms. But the presence of the mechanisms mentioned in the preceding sections should help to check such a disequilibrium process. Always according to Pasinetti in the case of unevenly expanding technical progress: We shall find, in practice, that half the sectors are expanding both in relative and absolute terms and are therefore absorbing new workers. The other half will inevitably have decreasing possibilities of providing employment, in relative terms, but not necessarily in absolute terms. In fact some sectors, although reducing the percentage of the total labour force which they employ, may still be increasing the number of their workers. Some other sectors will be decreasing the number of jobs they can offer, although still expanding the physical amount of production. And,

ASPECTS OF A VERTICALLY INTEGRATED MODEL 67

finally, some sectors may even be compelled to reduce the absolute amount of production (and a fortiori the number of workers) over time. Pasinetti 1981:229 It is worth recalling that the level of under-utilisation of resources is mainly caused by (a) the more or less rapid change in the composition of demand of consumers and by (b) differentiated rates of productivity growth of the various industries of the economy. It is hence clear that these two (separate) elements may, by a fluke, develop in such a way as to guarantee full employment in all sectors of the economy for long periods of time; but it is more likely that, at least in the medium and long run, there exist a number of sectorial discrepancies which give rise to local disequilibria. We might also consider, in this context, the rate of growth of population, and the impact that demography will have on the availability of labour. Finally we might also consider the conditions under which institutions might become endogenous and themselves become an element of divergence or convergence of the economic system under consideration. A number of these issues are skilfully summarised by Pasinetti as follows: The growth of an economic system with technical progress is normally, though not inevitably, bound to take place by an alternating succession of expansion waves and pauses. I say ‘pauses’ because this is what comes out of our analysis so far. These ‘pauses’ are periods in which the rate of growth of effective demand tends to fall short of the rate of growth of the production potential. They are not necessarily depressions (i.e. sharp falls of demand and of employment). Whether they will develop into large scale depressions or not depends on further factors, mainly on the existing type of institutional arrangements (…). It is rather important to realise for the moment that the alternating leaps and pauses are inseparably and inevitably linked with the structural dynamics of the economic system; they are—in other words—an effect of technical progress. In a hypothetical stationary economic system, or in an economic system expanding only as a result of population growth, with constant coefficients, there would be no difficulty of this sort. No fluctuation of demand, and employment, would arise! The only exception would be represented by external events, entirely outside the process of economic production (such as military, or economic, wars, natural calamities, etc.). It is also interesting to note that when economic growth is, as in normal circumstances, the product of both technical progress and population growth, the likelihood and the hardship of the difficulties discussed above will be the stronger the higher is the proportion of technical progress with respect to population in determining the over-all rate of economic growth. Technical progress and economic growth emerge, therefore, as influencing the fluctuating character of economic growth in opposite directions. The former inevitably carries with it all the

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difficulties mentioned above. The latter makes it easier for the economic system to overcome them. Pasinetti 1981:235–6

Part II INFLATION AND DEFLATION AS MONETARY PATHOLOGIES

3 UNEMPLOYMENT Is there a principal cause? Bernard Schmitt

INTRODUCTION All our arguments are developed with respect to a given country (or nation) and a given period of time which we shall refer to simply by the expressions ‘the nation’ (or ‘the economy’) and ‘the period’, p. In this chapter the bancor is the unit of money of the nation. The chosen unit may be a million ‘bancors’, or a thousand million bancors, or any other amount of bancors, as the reader chooses. By convention, one bancor corresponds to one unit of value. We shall reason in the context of a closed economy. Therefore, the title of our chapter should read: is there a principal domestic cause explaining the amount of unemployment which obtains in the economy? Let us at once answer in the affirmative. A single ‘cause’ is indeed at work within the economy, a precise factor which accounts for the main bulk of unemployed people. The purpose of the present chapter is to substantiate, as far as possible in so short a space, this proposition. We shall argue that the positive amount of unemployment which is imposed on the nation is due to the occurence of a positive difference between total supply and total demand. In other words, total demand is ‘insufficient’. By demand we do not mean ‘effective’ demand, a notion which has never achieved a reliable degree of precision in the literature. As all economists know, effective demand is defined at the point of intersection between a given demand and the corresponding supply. Effective demand could therefore equally be called effective supply. In this article, supply and demand are considered as separate entities or ‘forces’. Accordingly, to say that, at the level of full employment (production of 200 value units), demand is ‘insufficient’ means that the sum of all demands remains inferior to 200 value units. By total supply we shall mean the value of the goods of any kind newly produced in the period. Total demand, in our sense, is measured by the ‘purchasing power’, in units of value, which accrues in period p to households and enterprises.

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Employment and unemployment are defined with respect to the labour force, irrespective of the ‘employment’ of machines, whether or not they are used to capacity. If, full employment being at the level of E200, the value of employment is in fact merely E160, then unemployment stands at the level of 20 per cent of the labour force and, therefore, of the national economy. By unemployment we invariably mean involuntary unemployment. Furthermore, we set aside any unemployment which is merely frictional. The main source of inspiration leading to the arguments we shall expound here is the work of Maynard Keynes, towards whom our intellectual debt is unlimited. Yet, we shall not refrain from pointing a number of hard criticisms at the Keynesian analysis, which holds the promise of a science yet to come and not, by far, the tenets of an already accomplished and unassailable body of thought. Qui bene amat bene castigat. We shall briefly develop the following points: 1 In an economy where all incomes belong to households, global demand necessarily equals total supply; therefore, no positive margin of unemployment can possibly occur in such an economy. The same ‘impossibility theorem’ applies when invested profits are positive in the economy, provided all its incomes are formed in the production of consumer goods, C, or else in the production of investment goods, I. It would seem that no other final goods are turned out by the production of the economy. If that were the case, unemployment would needs remain inexplicable. But after a new conception of money is introduced, it becomes clear that the economy produces another category of final goods, in addition to consumer goods and investment goods. 2 We shall attempt briefly to explain a new way of looking at money and at money income. If it were true to say that money is a commodity, analysis of the national economy could not go beyond the generally accepted definition, Y=C+I. In fact, though, amounts of money are pure sums of ‘concrete numbers’. The current national product of any period is ‘integrated’ in a sum of pure numbers. If follows that money as such is devoid of all purchasing power, whether ‘intrinsic’ or ‘extrinsic’. The theoretical consequences of this fact are rather far-reaching; they have, in particular, a direct bearing on the question at hand; unemployment can only be explained in terms of the correct definition of the national income which is based on the fact that the only purchasing power ‘inherent’ in money units is nothing but the exchange value of the real goods which the process of national production deposits within the sums of money that firms pay out for the remuneration of the ‘factors of production’. 3 In the light of the new conception of money, the problem posed by the existence of profits, particularly with respect to the logical possibility of a positive measure of unemployment, can be tackled again, starting from the Keynesian insights. The relevant conclusion will then definitively

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be reached: in no way can profits be held responsible for unemployment. We then reach the gist of our argument, founded on the new conception of money. Every year the national economy produces a considerable number of goods which, notwithstanding the fact that they too are integrated into money units, belong neither in the category of consumer goods nor in the category of investment goods. In conformity with the novel distinction— or the new conception of that already well-known distinction—between money and money income, the complete definition of the national income is not Y=C +I, as economists generally believe, but Y=C +I+U, where U stands for the value of ‘replacement goods’. In each period, fixed capital sheds some of its value, which must be replaced or reproduced before net profits emerge. Two distinct factors account for this loss suffered by fixed capital, namely ‘user cost’ proper or wear, and technical progress which tends to make equipments of all kinds obsolete. For the sake of simplicity we shall include the effect of obsolescence in ‘user cost’. In each period total user cost determines the value of U. Just like the production of consumption and of investment goods, the production of ‘replacement goods’ adds, in each period, a new value to the national dividend, commensurate with the cost of production of these goods. It is therefore a logical mistake—a very serious flaw as we shall see —to suppress, or even simply to omit, U from the definition of national income. In fact, the production of the goods which replace the fraction of fixed capital that is lost in the period yields goods that are final and not merely, as is generally thought, intermediate. As we chall see, ‘replacement goods’ exist in two distinct forms or definitions; this amounts to saying, curiously enough, that these goods belong simultaneously in the separate categories of intermediate and final goods. If we are correct on this point, it must be true to say that the production of the goods which replace the fixed capital ‘used up’ in the current activity of the economy as a whole —to the value of, say, 20 bancors—yields two different sets of commodities, namely an amount of additional consumer goods, whose value is 20 bancors, and, furthermore, the current ‘replacement goods’, or ‘R-commodities’, the value of which is 20 bancors again. The first of these two sets consists in final goods while the second set relates to intermediate goods. 4 We have already pointed out the fact that no difference between total supply and total demand can possibly occur in the economy as far as consumer goods and investment goods are concerned. This explains, in our view, the reason why no theorist has yet come up with a satisfactory explanation of unemployment. The foundations of analysis are changed when the production of replacement goods is taken into account, as it must be, in the definition of national income. The terms of the following relation,

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are not necessarily equal. In other words, the above equation is not an equivalence, for the equality of total supply (Y) and total demand (C+I +U) is not given by any law. True, if U were equal to zero, more exactly if U were necessarily or logically nil, then, but only then, equation Y=C+I +U would be an equivalence or an equality enforced by an economic law, namely Say’s Law. But U is a positive magnitude in any period. Thus, once U is added to the generally accepted definition of the national income, Say’s Law no longer applies—indeed, it is no longer a law at all— for, then, total demand can logically (or conceivably) remain inferior to the corresponding total supply. Thus, at full employment, E200, the creation of national income (Y) can in some precise circumstances, which we shall briefly analyse, be greater than the corresponding demand, granted that U is included, as it undoubtedly should be, in the definition of Y. It may well happen, for example, that the value of C+I+U amounts to only 160 units. We shall attempt to discover the prinicipal cause which explains the fact that, in the real world and for a considerable number of years, total demand has systematically fallen short of total supply in many national economies. The cause of this discrepancy lies with the demand for replacement goods. To be more precise: in this chapter it will be established that the production of replacement goods to the extent of value x elicits a total demand equal to 2x. For full employment to be sustained, the whole amount of these 2x units of income must necessarily be spent on the market for goods in a requisite proportion, namely x units for the purchase (by households) of consumption goods and x units again for the purchase (by enterprises) of investment goods. Now, households invariably spend ‘the sum total of their incomes, whether directly or via the financial market, for the purchase of final goods. But on the other hand, enterprises can forcibly be led, due to the economic circumstances caused by the blind exercise of the two mechanisms by which fixed capital is being accumulated and replaced, to spend x units out of the other half of the 2x units of income (x <x) in purchasing goods destined to be resold to households, i.e. consumption goods instead of investment goods. As a consequence, a positive measure of unemployment, equal to x , will then unavoidably occur in the economy. By way of conclusion, we shall propose an outline of a possible solution to the problem of unemployment. Only a monetary reform is equal to the task. The purpose is to establish, within the banking system, a control or a ‘sifting’ of monetary flows, such as to make it impossible for the net incomes which are formed to the benefit of enterprises as a ‘by-product’ of the replacement of fixed captial, R, to be spent for the purchase of consumption goods. After the required monetary reform is implemented, Say’s Law will invariably hold, making it mechanically, and therefore logically, impossible henceforth for total demand to fall short of total supply, even at the level of full employment. The principal cause or aetiology of unemployment will thus be uprooted and the main malfunction of the economy cured.

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NO POSITIVE MEASURE OF UNEMPLOYMENT CAN OCCUR IN AN ECONOMY WHERE THE DEFINITION OF THE NATIONAL INCOME REDUCES TO C+I We are not pretending that such an economy exists in the real world. As a matter of fact, this state of affairs, where the national income is equal to C +I, could only exist if a national economy produced goods without the help of any fixed capital, or, at least, if no user cost were incurred in a given period by an economy. Clearly, such an economy cannot be found in the world as anyone can observe it, unless the chosen period is unduly, not to say ludicrously, short. Suppose that labour is fully employed in period p, the corresponding national income amounting to 200 value units, or 200 units of money, given that 1 unit of money is endowed with one unit of value. We assume first that households own in its entirety the net national income created in period p. Second, we shall introduce net profits. Before proceeding with the argument, let us state again the general purpose which we are pursuing: we intend to prove that all incomes, and nothing but these incomes, which are formed in the production of consumer goods and investment goods are necessarily spent in the final purchase of the given total output. As a consequence, so long as C+I is the correct and complete measure of the national income, total demand cannot possibly —for logic will not allow it— lag behind total supply. It is certain, then, that no amount of unemployment can occur. We shall first consider the simplest case where households own the sum total of all incomes formed in the national economy. Then we shall introduce positive profits and investments. Finally, we shall attempt to propose a general proof of the necessary equality, holding in all circumstances—under the only proviso that U be equal to zero—of savings and investments or, identically, of incomes spent and incomes formed. Following the criterion, which we deem to be correct, of an insufficient global demand, unemployment thus remains inexplicable, unless the replacement of fixed capital is integrated in the analysis. Households own the total income formed in the period A preliminary remark must be made here. Households can lend incomes to firms, which invest them. By acting in this fashion, households forsake the present ownership of the corresponding part of their incomes. For that reason, the only credits granted by households which fit into this section are extended to other households. The only category of income which we set aside for the time being consists of profits proper, namely incomes which enterprises derive, for investment, from their sales on the commodity market and on the financial market. We have just argued that even profits which households advance to firms are alien to the present section.

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Under the given circumstances, full employment income is defined by consumption only; Y=C, where C represents both the production of consumer goods, Cp, and their final purchase, Cf. But what proof can we offer to the effect that magnitudes Cp and Cf are necessarily equal to one another? One would fall head-on into extremely bad logic by ascribing the equivalence of Cp and Cf simply to the fact that each of these magnitudes is the definiens of national income: Y=Cp, Y=Cf, therefore Cp=Cf. Let us call ‘sector 1’ or ‘first sector’ the part of the economy which produces goods for consumption. According to our assumption, in period p the total output of the economy is the result of the production taking place in sector 1. The sums of money paid out by enterprises, or, on their behalf, by banks, to households define the formation of various incomes in sector 1. These incomes comprise wages, interest, rents and dividends which, from the point of view of the firms, are the costs incurred by the total production of consumer goods, and in the present case, the sum total of all costs of production pertaining to period p. It is obvious that incomes can only be spent once they are formed. Therefore, the formation or production of incomes in sector 1, Cp, must be given priority, in analysis, over the expenditure of incomes for the final purchase of consumption goods, Cf. Suppose that the total production of goods in the first (and only) sector amounts to 100 units of value: Cp= 100. It is certainly true that households can spend no more than their disposable incomes; thus, Cf cannot exceed 100 units of value. But, unless proof is offered to the contrary, households are in no way obligated to spend the totality of their incomes in acquiring (consumer) goods, or, for that matter, in purchasing any commodities or assets offered in the market. Prima facie, there is no reason whatever to think that it is obligatory for households to spend all of their incomes, to the last penny. It would seem, therefore, that as a rule households are in a position to save a positive part of their incomes, so that Cf is smaller than Cp. If households display a propensity to save equal to 20 per cent of their total incomes, Cf is equal to 80 while Cp is equal to 100, in value units. If it is indeed logically possible for the expenditure of income, Cf to remain inferior to the corresponding income formation, Cp, then two consequences must follow. First, Cp and Cf cannot both be the definition of the national income. Second, saving is greater than investment whenever Cp is greater than Cf. Now, in a considerable number of publications, various authors propound the view that saving and investment are the terms of an equivalence, that is to say of an equality commanded by logic. Accordingly, in the present case, investment being nil, the amount of income saved by households must be nil too. No less than thirty-four pages of Keynes’s The General Theory (1973) are devoted to the proof of the equivalence holding between saving and investment, or, identically, between Cp and Cf. True, in the corresponding chapters, investment is assumed to be a positive magnitude. But this fact is not germane to the present matter. Whether I is positive or nil, saving and investment are equal magnitudes if, and

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only if, the formation of income in sector 1, Cp, is equal to the sum of incomes spent in that sector, Cf. Indeed, it has never been argued that a difference between saving and investment could occur in sector 2, in which investment goods are being produced. This fact provides a considerable simplification of the savinginvestment conundrum, that is, a loss of complexity which is all the more welcome since, as we have already stated, it will be established, in the end, that Ip (incomes formed in the production of investment goods) and If (incomes spent on investment) are the terms of an equivalence, or of an equality which stands whatever the circumstances. So, is the equality of Cp and Cf an absolute necessity? If not, equation Cp =Cf is, at most, a conditional equality. Answering this question cannot be all that easy considering the fact that Keynes expounds two contradictory theories on the subject. Having explained, at considerable length, in chapters 6 and 7, that no difference between saving and investment can ever occur, the author of The General Theory proceeds, in chapter 16, to explain, in vivid terms, that households are free to save incomes which nobody spends. An act of individual saving means—so to speak—a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Keynes 1973:210 In this passage, Keynes twice errs. In the first place, when an individual saves, there may well be another party who simultaneously overspends his or her income, so that the net effect of the collective behaviour of agents is not known, at this stage of the argument, with any degree of certitude. But, even more pungently, it is a mistake to leave the financial market out of an analysis purporting to depict an act of saving and its (alleged) dire consequence on the level of employment. Dinners, boots, and such like are all goods. But what about bonds and equities? If households, taken as a whole, spent the whole amount of their incomes in the market for commodities, how could enterprises possibly make any investment? Admittedly, the argument which we have just advanced is inconclusive and, even more seriously, it reaches beyond the present scope of the enquiry. So, let us postpone until the next section the examination of the possible balancing of savings by positive investments. It may be difficult to prove for certain, in a few words, that Cf and Cp cannot possibly differ but that is precisely the case, all the same. The simplest proof of the fact that Cp and Cf are the terms of an equivalence, Cp=Cf, is to be found in the rules governing the working of commercial banks. Nothing can prevent households saving, if they so wish, a positive fraction, say 20 units, out of the 100 units of their current incomes. It is very tempting, then, to jump to the conclusion that (Cp—Cf) is equal to 20 value units, far from being nil as

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equivalence Cp=Cf would require at all times. But an important question remains to be answered, namely, what happens to the amount of money, 20 units, which households decide to save? The correct answer is to say that saved incomes are deposited with banks. As a consequence, incomes which households refrain from spending increase the amount of ‘loanable funds’ that are at the banks’ disposal. Now, it is the very business of banks to lend the sums of money which are deposited with them. If we arbitrarily leave out incomes which are saved by some households but that other households borrow from deposit banks, it obviously follows that a positive amount of national income, Y, is missing or ‘lacking’ in the market where the new products are offered by enterprises. As a result, the market cannot be cleared so that the act of saving is rightly judged to be counterproductive. If 20 units of income are saved out of a total income of 100, firms can sell only 80 per cent of their current output. In the following period, provided their anticipations are governed by their past experience, enterprises will scale down production and employment, from 100 to 80 units, in the expectation that the diminished product will sell in its entirety. This claim of reasoning is incomplete. Agents who are eager to exercise a positive amount of excess demand for commodities need to borrow the incomes which banks are willing to lend in order to earn the difference between interest they charge on borrowers and interest they owe to depositors. It is hardly conceivable that borrowed deposits should be saved again. At any rate, the ‘last’ borrower will spend the income (20 units) which was initially saved by households. And from the macro-theoretical point of view it matters very little whether incomes are spent by their original owners or by some borrowers; in either case, total demand (100) is exactly equal to total supply (100). Up to this point in analysis, we can hardly claim to know anything yet about the real cause of unemployment. The set of all households necessarily spends the whole amount of wages, interest, rents and dividends; as a result, the market is cleared of all produced commodities irrespective of the level of employment. But the following objection might be raised: if relation Cf=Cp really is an equivalence, there can be no moment in time when it is not true to say that the amount of deposits which banks have lent out to the public is exactly equal to the amount of deposits entrusted to them. But, clearly, this is asking for too much. Even if it were true that each and every deposit is the object of a credit granted by banks, there is no way by which it could be ascertained that all incomes, without any exception, ‘leave’ the banks at the very instant they ‘enter’ into their accounts. A positive time interval can elapse between instant t, when an income is deposited with a bank, and instant t+, when the public (including firms) recoups the very same income as a result of a credit transaction. It suffices, then, for the theorist to measure Cp and Cf in such an interval of time, in order to become aware of the fact that these magnitudes are definitely not the terms of a strict equivalence. Let us introduce investments, but of zero value. Regarding the comparative measure of saving and investment or, which comes to the same thing, between the

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formation (Cp) and the corresponding expenditure (Cf) of the national income, clarity of thought is reached provided that the following propositions are upheld: the whole sum of existing incomes is spent in purchasing commodities, in part by the initial holders of the incomes flowing from current production and, for the rest, by the sellers of assets, old or new; new assets denote an equivalent amount of additional investments; under the present assumption the sale of new assets is nil in the period; final purchases financed by profits also define new investments; again profits and, therefore, invested profits, are assumed to be nil; finally, the community as a whole can only save the precise part of the national income which is invested; investment being nil; it logically follows that the set of households can constitute no savings at all. Taken together, these propositions result in a single truth: in each month (or in any other period), the community’s money income, issuing from current production, is entirely spent. Collective savings can nevertheless be positive due to the fact that incomes are spent either for consumption or for investment; by definition, incomes which are invested are not consumed; such incomes are therefore indubitably saved. Consideration of this fact leads us to the next section. But before pushing analysis one step further, let us again state our purpose. According to accepted analysis, full employment cannot be reached when total demand falls short of total supply. We fully endorse this view. Furthermore, in accordance with traditional theory, we define net savings as the positive difference between total supply and total demand. The only thing we deny is that net savings, i.e. savings that are not invested but hoarded, can possibly occur in the national economy considered as a whole. We have just established that logic requires all savings to be invested in the case where all incomes, formed by the production of commodities and services, are in the final possession of households. We now proceed to prove that savings are invested all the same when incomes are split between households and enterprises. Households and enterprises own the sum total of all net incomes created in the set of successive periods, year after year It seems convenient to found analysis, again, on the genius of Keynes, who uncovered the saving-investment identity. But science is more likely to progress if a critical attitude is adopted, even towards the teachings of the ‘founding fathers’. Keynes most emphatically denies the validity of what he calls a fallacy, or a specious and even absurd argument, namely that when people save they

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perform or elicit an equivalent and countervailing act of investment, so that total demand remains unaffected. It is of this fallacy that it is most difficult to disabuse men’s minds. It comes from believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield. Now, prospective yield wholly depends on the expectation of future effective demand in relation to future conditions of supply. If, therefore, an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment. Keynes 1973:212 The preceding argument, as advanced by Keynes, is seriously flawed. Even if the reason for buying an asset is the future yield which may be expected from it, a fact which no economist ever ventured to deny, it is still true to say that, whatever the motives lying behind the transaction, an act of saving invariably defines the effective purchase of a financial asset. Is the purchase of a commodity, say a car, any less a real demand for the reason that the buyer expects to derive a satisfaction from using it over a number of years? It could well be argued that it is not the car as such which is desired by its purchaser, but the prospective yield of the car, for instance by way of the mileage which it will cover. The moment the theorist defines saving as an act, or an action (transaction), as Keynes explicitly does, it cannot make any difference, so far as total demand is concerned, whether incomes are spent or saved. Under all conceivable circumstances, the sellers of the assets which are bought by the savers receive from them the equivalent amounts of unspent incomes, since incomes can only be spent—or finally spent—for the purchase of the newly produced commodities. Logically, an act of saving can be construed only as an act of deferred expenditure. True, the person who saves part of an income by, say, abstaining from having dinner today, is not sure to dine twice tomorrow. But that is beside the point. The purchaser of a financial asset may hold it indefinitely together with the rest of his wealth. But it is the other party that one should consider: the saved income, in its entirety, is now in the hands of the person who sold the said financial asset. And sellers of assets either buy commodities or other assets. Even if one imagines the existence of a whole chain of sellers in the financial market, all of these transactions, forwarding the initial savings to ever new owners, occur in the very short run, so that there is literally no time for total demand to flag. The incomes saved by some agents are simply spent by other parties, a fact which can have no adverse effect whatever on the value of total demand. Savers have no hand in unemployment. Keynes very nearly admitted that much, in his teachings in chapters 6 and 7 of The General Theory. ‘The mere act of saving by one individual, being two-sided as we have shown above, forces some other individual to transfer to him some

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article of wealth old or new’ (Keynes 1973:212). In other words, when an individual saves 20 units of income, some other person ‘must be dis-saving an equal amount’ (Keynes 1973:82) of income. As a result, the amount of saving, so far as it is an outcome of the collective behaviour of individual consumers, could not possibly be a positive magnitude, if it were not for the fact that investments are savings. Let us now suggest a general proof to the effect that saving and investment are always, at any point in time, equal to one another. A revision of the concept of money, nothing less, is necessary to that end. THE COMPLETE DEMONSTRATION OF THE EQUIVALENCE OF SAVING AND INVESTMENT MUST BE FOUNDED ON A REVISION OF THE CONCEPT OF MONEY So far, we have paid insufficient attention to the length of time which may elapse between the moment an income is formed and the point in time when it is actually spent. Even if it is true that all incomes, created by present production, will be spent eventually, at some indeterminate date in the near or distant future, how can we be sure that the level of employment will not be adversely affected by such a protracted ‘waiting’ of uncertain length? The time has now come when it is expedient to place the equivalence, that is deemed to hold between saving and investment, on a firmer footing. This can be achieved only if analysis fully succeeds in proving that the aforementioned equivalence is absolutely timeless. Up to now we have assumed that income holders exert a positive demand provided they decide to purchase at least one newly produced commodity, if, for whatever reason, they decide instead to increase their money savings, is it not obvious then that they refrain from demanding any real goods (aside from financial assets)? Certainly most economists would think so. But this is paralogical. In the real world, money and products are by no means dichotomous magnitudes. In reality, output and income are the terms of an identity. To illustrate this fact, consider the national economy as a whole. Could it correctly be argued that Y, the national income, is a ‘monetary entity’ comprising 3x units of a special commodity, called money? If that were the case, it would be true to say that the national product, P, and the national income, Y, are two distinct, if possibly equal, magnitudes. This conclusion, however, would neglect the fact that bank monies, or mere book-entries, are the very anti-thesis of commodities. The truth of the matter is that the national output is the substance, or tenor, of the sum of bank deposits which are formed by production; in that sense, which perfectly befits the modern state of money, Y is like a bottle filled with P. Money, especially bank money, is the empty, numerical form into which outputs are integrated. If the current product, P, of a period is deposited in the sum of 3x units of money, acting as ‘repository’, the national income, Y, of

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the given period is the complex ‘form—content’ defined by 3x units of money containing P. Therefore, at the very moment or ‘instant’ when households earn an income, they are already in full possession of the real goods, or products, contained in the sum of money which they perceive. This fact appears most clearly for the income of the nation defined as the set of its residents. In each period, say every month, the sum of all incomes formed by the employed ‘factors’, contains the whole range of the new goods flowing from production. In order to make sure that the domestic output is really being demanded, there is thus no need to wait until incomes are spent. The formation of incomes defines, at once, an already fully accomplished demand, to the value of the whole national product. The so-called propensity to consume can be of interest for certain specified purposes; but it has no influence on the value of total demand. Households who hold the current income also hold, ipso facto, the current output, irrespective of their wish to consume or to lend the products which constitute the kernel, which is real, of their monetary income. How can we tell if a commodity is the object of a positive demand? In this respect, the only valid criterion runs as follows: if an agent puts his hand on the given commodity, then it may rightly be said that he subjects it to one of his demands. Accordingly, the current output is positively demanded at the precise moment when it is converted, or injected, into a sum of money. It is important that money and money-income should be distinguished into two separate entities. Money-income denotes the national output, and is therefore a real commodity, while a sum of money, taken as such, is a purely numerical and immaterial form. Transactions which inject the real output into a monetary form are the only source of money-incomes. If the factors of production were paid in sums of pure money, the value of the corresponding demand would still be an open question. But since, far from receiving mere sums of money, the factors of production earn money-incomes, they positively demand the corresponding output without any delay, from the exact moment when they are paid. This fact could not be disputed unless it were assumed that income holders refrain, at least in part, from holding on to their incomes, which seems to imply nothing short of a contradiction in terms. Keynes’ theoretical construction of unemployment is utterly mistaken. Whatever the level of employment, even at full employment, the national output measures the total supply while the national income measures the total demand; and in no conceivable circumstances could there arise, however fleetingly, even the slightest discrepancy between the sum of outputs (supplies) and the sum of incomes (demands). Before incomes are formed, at the moment when firms proceed to remunerate their factors of production, the real product is not yet demanded (no incomes are disposable to this effect), but neither is it supplied yet. The only factor which lends cohesion and homogeneity to inchoate physical products is the intermediation of money. Furthermore, money comes into the picture by one channel only, namely when the factors of production are being

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paid in money units instead of taking immediate possession of their physical products. In period p, the national output, considered in its entirety, is introduced into the proper field of economics by the remuneration of the factors of production for their activity during that period; at the precise moment, for instance at the end of p, when households receive their new incomes, the total current output of the society is injected into the sums of money making up the nominal income; global supply and global demand then jump into existence at one and the same time, and their mutual equality is just as certain as the equivalence of the volume of air and the volume of the room where it is enclosed. That being said, a conundrum seems to linger on. How could money be used to connumerate the vast diversity of real goods if it were true that money is itself a real commodity in a sort? At this point, what could be named a discovery comes fully to bear: just as Leon Walras, founder of the Neoclassical school of thought had surmised, a sum of money is nothing but a sum of concrete numbers. ‘Hence there is no such thing as the rareté or the value of a half-decagram of silver 0–900 fine and the word franc is the name of a thing which does not exist […]’ (Walras 1954:188). Walras clearly recognised the fact that money proper does not belong in the category of commodities like, say, ‘green cheese’. The fundamental reason why Keynes failed to come up with an even remotely correct diagnosis of unemployment, which he had set out to combat and to vanquish, must be ascribed to his flawed conception of money. After more than half a century has elapsed from the date of publication of A Treatise on Money, it may now be confidently affirmed that Keynes was mistaken from the start when he defined the relation that holds between money and money-of-account ‘by saying that the money-of-account is the description or title and the money is the thing which answers to the description’ (Keynes 1971b:3). To sum up, according to Walras money is a thing which does not exist. Keynes’ view is quite the opposite: money is the thing which is described by money-of-account. The truth of the matter is quite simply that money-of-account and money proper are both defined by pure numbers. In actual fact, the two concepts must still be carefully distinguished. Money-of-account provides a means of assessing the numerical value of claims and debts, whether financial or commercial. On the other hand, any sum of money which exists at any time somewhere in the national economy, in the hands of entrepreneurs, in the possession of households, or at the disposal of the nation-state, is endowed with a positive purchasing power over newly-produced commodities (and, indirectly, over second-hand goods and assets). Therefore, money cannot be distinguished from money income, while money-of-account merely constitutes a system of reckoning. As soon as the true definition of money or, identically, of money income, is arrived at, it becomes clear that money is a flow. Traditional theory (the so-called quantitative theory of money) has it that money flows. That is not so. It is by no

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means true that money flows, for money is a flow. Surely, flows cannot flow. Money and payments are one and the same thing. No money, if correctly defined, exists either before or after a given payment. The result of a payment which has been made is a sum of monetary capital, which, as the case may be, is either created or destroyed in the relevant flow. We have just established the fact that all incomes are spent at the very moment, or ‘instant’, when they are created. It would be foolish to construe the foregoing proposition as if it meant that, no sooner do they come into existence, than incomes are necessarily spent on the market for commodities. That would amount to pure nonsense. Quite the opposite is true; incomes cannot possibly be spent until a positive space of time has elapsed from the moment when they were created. If incomes were created and spent—that is, destroyed—all at once, no incomes could ever exist. Notwithstanding this obvious fact, it still is an immutable truth that no income can live beyond the moment when it is created. In other words, no incomes can be held; in actual fact, income holders have nothing but financial titles or assets in their hands; the object they are holding is not an income proper but a sum of money capital, held in a current, or open, account with a bank. The sequence of events which can be observed in the real world heeds the following pattern: at instant t a sum of money is formed into a sum of incomes (this happens when firms remunerate their factors of production); at the same time, the sum of incomes which has just been created is transformed into an equivalent sum of monetary capital, or money deposits. There can be no economist left on this earth who still believes that a sum of money deposited in a bank account remains there for a positive duration. To deposit incomes means to destroy them; such incomes are spent by their holders; how else could they possibly acquire a deposit? Now that we are cognisant of the fatal and instantaneous demise of all incomes accruing to households, we can assure ourselves that so far as wages, interest, dividends and rents are concerned, no discrepancy between incomes formed and incomes spent can ever arise in the real world. Identity saving=investment is now perfectly clear; it reflects the following identity: formation of incomes (FI)=expenditure of incomes (EI). Both these identities or, more exactly, identity FI=EI and its copy, identity saving =investment (or, likewise, identities Cp=Cf and Ip=If), are strictly timeless. As a consequence, global demand is identically equal to global supply, at all moments of time, irrespective of the level of employment. But it is equally certain, at least inductively, that in the present state of many national economies, the full employment of available human resources is quite unable to elicit a global demand at the requisite level; instead, total demand fails to clear the market unless the production of commodities is restrained. So, are profits to blame? This is very likely after all, considering the fact that incomes earned by households strictly abide by the rule establishing the necessary equality of supply and demand.

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PROFITS ARE DEFINITIVELY NOT TO BLAME FOR ANY MEASURE OF POSITIVE UNEMPLOYMENT The title of this section could be misleading. So far as net profits are concerned, as they emerge after replacement costs of fixed capital are met, profits cannot be held responsible for any fraction of unemployment which besets the economy. But so far as gross profits are concerned, we rest our case. As a matter of fact, we shall attempt to show in the section beginning on p. 96 below that replacement costs, as regards fixed capital, can only be effectively covered provided households pay for them twice. Let us first expound a brief theory of net profits, reaching beyond Keynes, and then offer an outline of the double nature of replacement goods. A startling view: net incomes earned by enterprises, i.e. net profits, constitute an extraneous magnitude with respect to the national income Suppose that profits amount to 20 units of money. Should profits be added to the national income or are they an integral part of it? In his book, A Treatise on Money, vol. 1. The Pure Theory of Money, Keynes developed a truly strange theory of profits defined as incomes which are not really incomes at all; ‘we reserve the term profits for the difference between the cost of production of the current output and its actual sale-proceeds, so that profits are not part of the community’s income as thus defined’ (Keynes 1971b:111). Admittedly, definitions are not ruled by logic, provided they can be consistently adhered to. Nevertheless, if the 20 units of profits are added to the national income of 100 units of money, then the question inevitably arises as to where these profits come from. The only relevant answer which Keynes provides is even stranger than his definition of profits; purporting to divest profits from the category comprising the whole range of incomes issuing from production, Keynes boldly asserts that profits are not only in a category apart from all (other) incomes—a proposition one can readily accept—but in a category which is void of all conceivable incomes—a conclusion which amounts to nothing less than a pure contradiction. Yet, despite its inherent shortcoming, something can be said in favour of Keynes’s theory of profits, for it provides analysis with an elegant means towards explaining inflation and unemployment, all at the same time, by one and the same argument. Consider first the expenditure of 20 units of profits, in the purchase of new commodities whose cost of production amounts to 100 units of money. If all incomes are spent, the proceeds of entrepreneurs then reach the sum of 120 units of money; as a result, an inflationary pressure exerts itself on the price level which finds its new equilibrium at a premium of 20 per cent. Unemployment disequilibrium can be explained along the same lines, albeit only if entrepreneurs now refrain from spending their profits; consequently, the

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newly produced investment goods cannot be sold. Only when profits are nil can it confidently be said that the national economy is at an equilibrium. These Profits (whether positive or negative) are made up of two elements, …, Q1.…, which is the profit on the output of consumption-goods, and Q2. …, which is the profit on the output of investment-goods. Now equilibrium requires that Q1, Q2 and Q should all be zero. Keynes 1971b:136 At least we are assured that Q is indeed zero if both of its only component parts, Q1 and Q2, are nil. The remaining difficulty relates to the source of profits: where can they possibly flow from? We are certainly at a loss for an answer if profits do not originate in production. After 1931, even Keynes had to admit that production is the only source of all incomes, including profits. The correct explanation seems to go like this: enterprises taken as a whole can state for their output a price, Pr, which lies above its value, V, as measured by its total cost of production comprising wages, interest, rents, and dividends. The positive difference between Pr and V is the measure of profits. Now, due to simple logic, the expenditures of non-wage incomes cannot possibly restore the profits which are thus spent. It follows, therefore, that incomes belonging to households are the only fund whence profits are retrieved. Let us give an example, in terms of wages. The production in a given period involves a cost in wages alone amounting to 100 units of money; the currently produced wage goods are supplied at a price of 200 money units; when wage owners spend their incomes, they are unable to purchase all the available wage goods; instead, their purchasing power encompasses no more than half of the newly produced wage goods; taken together, these assumptions amount to the answer we are looking for: by spending their wages, 100 units, households secure only half of their money’s worth, that is the purchase of merely 50 per cent of the newly produced wage goods, the other half of their wages, still intact or unspent, defines the profits accruing to the firms that supply the current output of the economy. A question now arises which goes right to the heart of our investigation: when enterprises refrain from spending their profits in view of acquiring newly produced capital goods, surely total demand then really falls short of total supply; or does it not? It would seem that the main cause of unemployment is to be found in unspent profits, or at least, in profits which are spent only on the financial market, thus failing to reach the only relevant market, where the new outputs are supplied, waiting to be purchased either by households or by enterprises. Most theorists, purporting to explain the origins of economic slumps, stress that in periods of depression investment expenditures are at a low pitch, a fact which is clearly evidenced by statistical data. Total expenditures are the sum of

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consumption and investment expenditures; now, when profits are formed, households cannot help but curtail their consumption expenditures; finally, if enterprises choose to put their profits into some financial assets instead of acquiring new investment goods, full employment cannot be sustained. But how is the fall in investments to be explained? It is due to the fact, at least so we are told in The General Theory, that the marginal efficiency of capital is a rate which, as years go by, tends to become inferior to the current rate of interest. Now, there is no need to go any further into the study of unspent profits for they simply cannot exist under any conceivable circumstances. As so often happens in recent literature, here again we are confronted with an obvious confusion between micro- and macro-theoretical concepts. In microeconomics, each entrepreneur is free to refrain from spending any positive part of his profits on the market where newly-produced commodities are offered, in order to purchase some financial assets instead. But no such choice exists in the field of macroeconomics where any profits which are spent in the financial market persistently define an undiminished real income (that merely changes hands any number of times) which continues to exist until it is at last spent in the purchase of new outputs. At the end of the day, all existing profits will have been converted into an equivalent part of the current output of real goods. The only logical conclusion resulting from these arguments is that unemployment remains unexplained, or is even inexplicable, in all cases that we have been considering, whether the national income is entirely in the hands of households or shared by households and firms. The new conception of money, briefly set out in the third section above, overthrows the analytical dichotomy which theorists usually draw between money on one side and real goods on the other. In reality, all incomes which flow out of the production process are created to the sole benefit of the factors of production and all such factors are households. If positive profits are formed in the national economy, for example to the value of 20 bancors in period p, it still remains correct, indeed necessary, to say that the sum total of incomes produced in period p, 200 units of value, belongs to households; formal logic provides and requires the following resolution of this apparent paradox: households who transfer 20 units of income, out of their income of 200 units in period p, pay 20 units of profits into the hands of entrepreneurs, who can spend these profits in only one way, namely by paying out, in a subsequent period, 20 units of wages for the remuneration of the factors who produce investment goods. Thus, it is an incontrovertible fact that, the existence of positive net profits notwithstanding, total demand is exactly equal to total supply, for, under all conceivable circumstances, households spend, directly or by the intermediation of the financial market, to their own benefit or in favour of firms, the whole amount of their disposable incomes. We are now in a position to uncover the deep meaning of identity Ip=If. At the precise moment when households transfer a part of their income to the profit of enterprises, they elicit an equivalent investment in wage goods; at a later date, households recoup their transferred incomes in payment for their production of

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capital goods. The original investment in wage goods is thus transmogrified into its final state of an investment in capital goods. In this manner, identity Ip=If obtains first for the investment in wage goods and again for subsequent investment in capital goods. At both ends, profits can no sooner be formed than they are spent. In short, if Y=C+I is the correct definition of the national income, total supply, Y, and total demand, C+I, namely the sum of expenditures, for consumption and investment, are the terms of an equivalence, that is to say an equality which is logically necessary under any conditions which may obtain in the national economies. In the economy we are considering and in period p, if firms give full employment to the labour force, the corresponding income yielded by the national production being 200 value units, it is absolutely certain, in the final analysis, that the value of the global demand exerted by households and firms amounts exactly to 200 units; there is no conceivable reason, therefore, why full employment could not be sustained indefinitely. But this is not the end of the story, for the correct definition of the national income logically includes a category of expenditure which has gone unnoticed by all schools of thought, Keynesian or otherwise. R-commodities are endowed with a double nature: they belong (obviously) in the category of intermediate goods but also (less evidently) in the category of final goods Let us at once name these expenditures: they consist in the costs incurred by firms in view of maintaining the value of their fixed capital. Following Keynes, it is convenient to refer to these expenditures as the sums of incomes that are absorbed by the payments of user costs, U. There is no need to dwell on the proposition stating that R-commodities are intermediate goods. But it is altogether another matter to claim that Rcommodities are also final goods. We suggest that the only correct definition of the domestic income of any nation is Y=C+I+U. It must be admitted that no analysis has yet been worked out purporting to uncover any causal relationship which the expenditures of type U may entertain with unemployment. But before we attempt somewhat to prove this matter, it is our duty to establish that ‘R-expenditures’ are indeed, together with consumption-expenditures and investment-expenditures, an integral part of the flow which, in each production period, defines the formation of the national income. Consider a quotation from The General Theory, ‘Appendix on user cost’, chapter 6. ‘Some part of the maintenance of the equipment must necessarily take place pari passu with the act of using it (e.g. oiling the machines). The expense of this (apart from outside purchases) is included in the factor cost’ (Keynes 1973:69). Factor costs are the amounts which the entrepreneur ‘pays out to the

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factors of production’ (p. 23). It should be noted, however, that Keynes refers to individual entrepreneurs, not to the set of all entrepreneurs. ‘In a given state of technique, resources and costs, the employment of a given volume of labour by an entrepreneur […]’ (p. 23). The same is true regarding the appendix on user cost. ‘For in deciding his scale of production an entrepreneur has to exercise a choice between using up his equipment now and preserving it to be used later on’ (pp. 69– 70). Now, available equipments are always used, although not necessarily at full capacity. What Keynes means, we may presume, is that in a given period individual entrepreneurs can freely decide either to maintain the full value of their previously invested profits or to ‘disinvest’ part of their fixed capital. But it is quite obvious that no such choice is open to the set of all enterprises for, in a given period of time, there is no way of determining, for the community as a whole, the net value of the newly produced commodities, unless the value of all the new capital goods (e.g. the oil used to maintain a machine) which merely replace the pre-existing equipment is precisely known and deducted from the gross value of the sum of correct outputs. Inasmuch as macroeconomic magnitudes are considered, investments in fixed capital can only be either positive or nil in any period of production. It is a matter of simple observation that the fixed capital owned by the community as a whole actually increases by a positive amount each year. Even in periods of economic depression, the rate of net investments remains positive, if low. For the sake of greater clarity in exposition, we divide the national economy into three separate sectors. Consumption goods are produced in sector 1; sector 2 produces investment goods; finally replacement goods, which replenish the value of fixed capital diminished by user cost, are produced in sector 3. The value of R, to wit, the value of capital goods which merely replace the exact value which is currently shed by fixed capital due to wear and to obsolescence, is equal to the user cost: R=U. Asssume that the work-force is employed in equal parts in each of the three sectors. If no labour were necessary in order to produce replacement goods, or goods R, the payments of user costs could not correctly be said to belong in the category of final purchases. In each period a ‘Brownian movement’ of intermediary payments occurs in the national economy, the only final purchases consisting of the two symmetrical sets of payments that, in turn, monetise and demonetise the newly produced commodities, namely the payment of the sum of all costs of production followed by the final retrieval of the current output of consumption and investment goods. But how could anyone dispute the fact that ‘gross investment goods’ cannot, any more than ‘net investment goods’, be obtained for nothing? Let x be the wages earned in each sector. If we measure the new output in wage units, its total value is 3x. Thus, fully a third of the value of the current output is attached to the newly produced replacement goods. It follows that the national income is the sum of incomes formed in the three sectors of the economy: Y=C (production of sector 1)+I (production of sector 2)+R (production of sector 3).

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Leaving the production of sector 3 out of account inevitably leads to an overvaluation of the new investment goods. The net value of new investments is equal to the total production of capital goods (2x) minus the value of R (x). If we left out the value of R, net investments would erroneously appear to be of value 2x; their true value is only x because it is simply illogical to construe replacement goods, or ‘R-commodities’, as a positive addition to accumulated capital goods. There must be some good reason why theorists in general do not consider the production of replacement capital as belonging in the category of net productions. How can we explain the fact that, according to the scientific community, the production of R-commodities, unlike the production of consumer goods and capital goods, educes no positive addition whatever to the net product of the nation? There is no need to embark on any lengthy argumentation in order to unsnarl the reason why R-commodities are not generally considered to be final goods. The ‘justification’ for putting Rcommodities aside when final goods are to be defined is quite simple: economists are somehow deluded into believing that the value which the previously accumulated fixed capital sheds in the current period is an impartable magnitude, for it enhances, so they believe, the value of the consumption goods which are produced with the assistance of machinery. The only raison d’être of fixed capital undoubtedly being to increase the production of consumer goods, it is only natural, so it is argued, that all the value which capital loses in the process of its utilisation be recovered by the goods issuing from it. On further thought, it becomes visible that the whole idea of a sum of value ‘jumping’ from capital goods on to or into consumer goods is metaphysical, derogatively. Genes may jump but not so with value. In the real world, the value of any commodity is absolutely inseparable from precisely the commodity of which it is the value. It is quite true, of course, that fixed capitals progressively lose their value in a process known as amortisation. It is nonetheless inconceivable that the value of a capital good should survive in any sense, or in any commodity, after the relevant equipment is dead or discarded. Capital goods and their value vanish together, all at once, in the same process and at the same time. Replacement capital must be newly produced in each period; there is no difference in this respect between R-commodities and the other final goods, produced for consumption and investment. Taking full cognisance of this fact is all the more difficult since payments of user costs no doubt pertain to the category of intermediate purchases. The quandary theorists are thus confronted with is the awesome task of reconciling two findings which must surely stand in an outright contradiction to one another; on the one hand, R-commodities must logically be added to the other categories of final goods; but on the other hand, by paying for the cost of production of R-commodities, households purchase no final goods whatever; instead, they merely provide enterprises with the means to cover user costs.

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This dilemma can indeed be solved but only on the condition that a new theory purporting to explain the link holding between money and real goods is established. We have already suggested a sketch of the requisite theory. REAL MONEY, NOMINAL MONEY AND THE PRINCIPAL CAUSE OF UNEMPLOYMENT A reminder of the new conception of money Established theories (Classical, Neoclassical, Keynesian) predicate that monetary and real magnitudes are the terms of a dichotomy; accordingly, sums of money and stocks of commodities are seen as facing each other, so that their respective flows are deemed to go in opposite directions. When agent A purchases a commodity from B, to the value of x units of money, theorists postulate—for this ‘obvious fact’ seems to be in no need of proof— that x units of money flow from A to B while a, presumably equivalent, commodity flows the other way, from B to A. In actual fact, however, each monetary flow and the corresponding real flow are the two components of one and the same ‘motion’. Consider the flow of wage payments, enterprise E paying out 200 money units to its factor of production, T. If accepted theories were correct, it would be true to say that 200 units of money flow out of a capital previously held by E, while an equal value of newly produced real goods is set in motion in the opposite direction, from T to E. It is no longer possible to hold this simple view of monetary versus real flows; the modern supremacy of bank money has rendered such a ‘theory’ obsolete. When money was made of pure gold, it was permissible, or it is at least forgivable, that economists should have considered money as being, in its own right, an asset, if not the asset par excellence, susceptible of being exchanged against any kind or real asset, or in payment for the purchase of foreign currencies. When two distinct commodities, namely a sum of ‘commodity money’ and some other commodity, are exchanged for one another, it is indisputable that they are made to move in two opposite directions, each party relinquishing a commodity for the sake of acquiring another commodity, surrendered by the other party. Strangely enough, in 1930 Keynes still considers the existence of Commodity Money, which he places in the midst of a truly entangled classification (of his own making), of distinct monies (fiat money, representative money, state money, money proper, and so forth). Thankfully, things are much clearer in the world as it exists nowadays, the only form of money which is still in currency being bank money. The principal characteristic of all monies issued by secondary or Central Banks is that they are devoid of any ‘intrinsic’ value. As the phrase goes, the only value of bank money is its purchasing power. The sums of money issued by Central Banks, in the form of notes or mere ‘book entries’, are no exception; the time is long past when it

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was true to say that the money issued by Central banks was linked to gold by a legal definition. Today, money is as valueless as the paper which it is made of. Provided we go merely one step further, we are ready to aknowledge the fact, which is so startling that it deserves to be stated once again, that a sum of money is nothing but a sum of ‘concrete numbers’ (Walras). The ‘value’ of a bank note is the number of money units which is inscribed on it, for a 10 dollar bill and a 100 dollar bill have exactly the same, albeit negligible, paper-value. We may now draw a crucially important inference; a sum of concrete numbers, already devoid of any intrinsic value, cannot possibly have any ‘external’ value either; i.e., its purchasing power is necessarily nil. Therefore, any monetary theorist who pays some attention to logic must be reconciled to the truth that, at least in its modern form, money is not an exchangeable commodity, for there cannot be a single person who would accept to exchange real goods for a sum of mere numbers. Sector 1 and sector 2 of the economy create units of real money but sector 3 creates units of nominal money Each new production or, identically, the production of each new period, elicits the creation of an equivalent sum of money. Real productions and nominal creations merge into a single transaction whose outcome in any period p is the current national output of p, Op, deposited in the sum of 3x units of money which is created for the payment of the factors (producers) of Op. The national income of period p, Yp is thus equivalent to the net product of the nation in the same period: Yp=Op. If Ym=3x is the sum of money which forms, for the production in period p, the remuneration of the producers, we may observe that Op is contained within Ym; it is precisely the identity form-content which is constituted by the numerical or nominal form Ym and its real kernel Op, which defines the national income, Yp. It is now possible to propose the correct definition of real money versus nominal money. Output, Op, is the collection of all the commodities which are newly produced in period p; Op is therefore a real magnitude; as a necessary consequence, magnitude Yp is a sum of real money; it would be a mistake to define Yp as a sum of purchasing power over commodities; in fact, Yp is a collection of commodities, namely the collection Op; the only difference between Yp and Op is that Op is a collection of heterogeneous physical quantities whole Yp defines exactly the same collection but in a new and measurable form; in short, Yp is the monetary measure of Op. Measuring a purely physical output in terms of money presents no difficulty given that a sum of money is nothing but a sum of numbers. It is precisely because a sum of money is a sum of numbers that national accountancy provides a true (scientific) measure of the national output. The magnitudes that we have defined so far are all real, since the national income denotes the national output at the precise moment when it is contained in a sum of money. How, then, are we to define a purely nominal magnitude?

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The first analytical step towards the correct definition of a nominal magnitude is effected as soon as the theorist becomes aware of the fact that Ym is such a magnitude. But the main difficulty in this matter still lies ahead. Is it at all conceivable that Ym could exist on its own, that is in a complete separation from any output? As yet we have been unable to push analysis beyond the point where we have established that Op is integrated into Ym; as a result of this integration, Ym reduces to the numerical aspect of Yp. If analysis could not progress any further, it would appear that all incomes which exist in the economy are real. Now we venture to say that if that were true, any positive amount of unemployment would remain—as indeed it does in all theories which are known today—beyond the boundaries of any conceivable reality. It is quite fortunate, therefore, that analysis can be advanced to the point where the concrete existence of purely nominal incomes can clearly be conceived. In fact, all the incomes springing out of the third sector of the national economy are purely nominal magnitudes, for they are utterly devoid of any output whatever. Sector 2 of the economy produces real incomes. If the same were true so far as sector 3 is concerned, it could never happen that global demand should fall short of global supply; in other words, unemployment would, in all circumstances, be identically equal to zero. Now, it so happens in the real world that all incomes which are born in sector 3 of the economy can only nourish a zero demand, due to the fact, precisely, that these incomes are purely nominal magnitudes. The value of the global output in period p being 3x, equally divided between the three sectors of the national economy, unemployment can theoretically develop until it engulfs one third of the labour force. At this extremity, global supply extends to the output of all three sectors whilst demand is confined to the measure of incomes produced in sector 1 and in sector 2 of the economy. The incomplete definition of the national income, as it is generally proposed by the profession, Y=C+I, comprises only real magnitudes; as a logical consequence, unemployment is then utterly inconceivable. The completed definition, Y=C+I+U, entails a purely nominal magnitude, equal to U; the production of R-commodities (=U) elicits a purely nominal income which, by its very nature, can support no positive demand. It follows that Y, a magnitude which is totally real, is met by a demand which is partly nominal: U is thus the measure of the only unemployment ‘disequilibrium’ which is at all conceivable. Final proof of the state of affairs by which incomes created in sector 3 are purely nominal A few very simple diagrams may help the reader to the immediate perception, ‘at a glance’, of the required proof. The first highly significant event is the induction, exercised by the production in sector 3, of an equivalent production, in both physical and value terms, added in sector 1 (Figure 3.1).

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Figure 3.1

At the moment when the new output, produced in period p, is measured in monetary units, by its integration into a purely numerical form (3x units of money), it can be counted in units of physical goods, one such unit being the exact output which is deposited in one unit of money. It is quite logical, therefore, to assume that in period p thirty goods are produced in each of the three sectors of the economy. The production (of investment goods) taking place in sector 2 is irrelevant to our present purpose. In the two other sectors, the current outputs of the national economy amount to—or so it seems—sixty goods. We can even offer proof to that effect: 3x units of money, or bancors, are the measure of ninety goods; thirty goods, to the value of x units of money are produced in sector 2 (which we leave out of analysis); ergo, sixty goods are produced in sectors 1 and 3, accounting for a total value of 2x money units. Straightforward as it is, this line of thought is seriously deficient for the obvious reason that it fails to take into account the most important factor in the present context, namely the productivity of fixed capital. Interest is of no relevance here. But the costs incurred in maintaining fixed capital are at the heart of the problem of unemployment. By what means can firms recoup the production costs of R-commodities? There is only one way leading to this goal: the cost of R-commodities is included in the selling price of consumption goods. So, is the theorist invited to jump to the conclusion that the goods produced in sector 1 are sold at a price which exceeds their value (by the cost of production of R-commodities)? Certainly not. All positive differences which we might be tempted systematically to draw between the price and the value of any set of given commodities, are nothing short of a figment of the imagination, which it would be more proper to lay at the door of metaphysicians. In the real world, the value of commodities is equal to the sum of their prices (or costs of production). Hence, it is necessary to proceed just one analytical step further in order to reach an important finding. The fact that the value of R-commodities is invariably added to the value of consumption goods has the following precise

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meaning: due to the replacement costs of fixed capital, an additional sum of consumption goods, defined in physical terms, is elicited within the production process; thus, as a direct consequence of the economic activity which is being deployed in sector 3, the output of sector 1 is automatically increased, by, to repeat, a number of physical goods, up to the exact point where the value of this increment equals the production costs of the current output in R-commodities. Figure 3.1 is a simple numerical example of this curious, but unassailable, fact of ‘duplication’. Due to the production of thirty R-commodities, the production in sector 1 is increased by thirty physical goods (measure of the physical productivity of fixed capital in period p, in addition to interest), so that the total production of sector 1 in period p amounts to sixty (consumer) goods. The proposition which we have just stated seems very strange indeed. It is hardly conceivable that a greater number of goods should be produced in sector 1 as a consequence of the production taking place in sector 3 of the economy. But a proposition which is odd may yet be true; as a matter of fact, the case in point clearly shows, on deeper thought, that the number of goods which are being produced in sector 1 is contingent on the two following states of affairs: first, it depends on the total value of the currently produced consumer goods and, second, it reflects the fact that the number of newly produced consumption goods increases by the same factor as their value. In the nineteenth century, classical economists used to think that a given physical output can be subjected to a change, namely an increase, in value. We are somewhat wiser today for we positively know that the value, in any positive (non-metaphysical) sense, of a collection of commodities is nothing but its numerical measure; more precisely, the value of goods is their monetary measure. Furthermore, we are now fully aware of the fact that the monetary measure of commodities is unequivocally given by their cost of production. In this respect, Maynard Keynes was perfectly correct, in The General Theory, when he posited that the wage-unit (i.e. the unit of money which enters nominal take-home and indirect wages) is the only and universal yardstick in economics and in the concrete national economy. Money wages measure the production of labour, likewise, together with the money interest due on fixed capital, the replacement costs of fixed capital, assessed in money terms, measure the production due to capital. If we leave interest aside, it can safely be confirmed that, in period p, sixty homogeneous physical commodities are produced in sector 1, as shown in Figure 3.1. We can now proceed to represent the expenditure of the sum total of real incomes, Yp1+3, earned by households in sector 1 and in sector 3; all of these incomes are spent in the final purchase of the sixty consumer goods produced in sector 1 (Figure 3.2). Figure 3.2 makes it clear that households spend all their incomes, earned in sector 1 and in sector 3, for the purchase of the sixty goods produced in sector 1 alone. Hence, three most interesting inferences follow:

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Figure 3.2

Inference 1 By spending 60 bancors for the purchase of the sixty consumer goods whose cost of production is 30 bancors, households cover the cost of the production of R-commodities. In this respect, R-commodities are intermediate goods, since they are paid for in the purchase of consumer goods. Inference 2 The whole real output produced in sector 3, to the value of 30 bancors, flows directly into the hands of entrepreneurs at a zero cost (of production). In this additional capacity, R-commodities are final goods, since, in the end, an equivalent output of net capital goods is produced in sector 3. Let us refer to these supplementary capital goods as ‘dual capital’. By virtue of the fact that R-commodities are paid for (in the form of additional consumer goods) by households, dual capital goods, which are equivalent, in each period, to the current output of R-commodities, are automatically added to the capital goods produced in sector 2. Inference 3 The incomes which households earn in sector 3 are purely nominal; the only instance where the national production yields a measure of purely nominal incomes is thus uncovered; incomes formed in sector 1 and in sector 2 are all real but there can be no doubt at all that monetary incomes formed in sector 3 are purely nominal magnitudes for they contain absolutely no real products, the whole output of sector 3 is immediately divested of its monetary form to be appropriated by firms, for nothing, in the form of dual physical capital. The meaning of this last inference can also be educed in a slightly different way. In sector 1, thirty commodities are purchased by households who spend the real incomes, 30 bancors, which they earn in remuneration for their production of consumer goods. In sector 2 firms spend a real income, amounting to 30 bancors, which they derive from households who relinquish, to the profit of entrepreneurs, the real incomes which they form in the production of investment goods. Now, in sector 3 events are altogether different. The real incomes produced in sector 3, earned by the factors of production (households) who are employed in that sector, are by no means spent in purchasing the commodities produced in sector 3; instead, households spend in sector 1 the 30 real bancors produced in sector 3. So far as commodities produced at a positive cost are concerned, households who are employed in sector 1 together with households who work in sector 3 receive a total remuneration which is limited, in real terms, to the sole output of the factors of production who are employed in sector 1. The

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Figure 3.3

thirty additional consumer goods which are included in the purchasing power of households have a zero cost of production. The gist of the matter can now be expressed in the following cursory statement: the factors of production employed in sector 3 perceive for their work x purely nominal bancors which, from the moment they are handed out by firms, are completely empty of all purchasing power, that is, devoid of any output. The way by which the wage units (30 bancors) shared out by firms in the third sector are ‘emptied’ of their purchasing power is absolutely clear: the set of all enterprises—for what we observe here is a strictly macroeconomic phenomenon—automatically comes, at a zero cost, into the possession of the net output realised in sector 3 by virtue of the fact that the set of all factors of production derives no positive amount of real remunerations from the activity in sector 3 (Figure 3.3). The dual physical capital, measured by x bancors, is the definition of Rcommodities, in so far as these goods are final commodities—as is inevitably the case. We are already aware of the fact that the thirty consumer goods produced at a zero cost (in sector 1) are the alter idem of the R-commodities with respect to the other definition which necessarily and simultaneously applies to them, for R-commodities are indubitably intermediate goods. The reader is thus reminded of the double nature of R-commodities, reflecting the state of affairs which characterises positive (in contradistinction to metaphysical) economics: in the real world, the value of replacement goods can by no means be imparted to the consumer goods which are produced by labour with the help of fixed capital; more generally, no positive theory will allow even a single unit of value to be detached, to the benefit of other goods, from the commodity of which it is a numerical measure. The nominal income created in sector 3 and the corresponding dual capital produced in the same sector (see Figure 3.3) are the two key magnitudes governing the incidence and the volume of unemployment.

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The creation of purely nominal incomes is the principal cause of unemployment Once we have conquered the new concept of purely nominal incomes, we are on the other side of a mountain of problems and the essence of unemployment lies clearly before our eyes. Then, only a few words are necessary in order to describe the main cause of unemployment disequilibrium. In definition Y=C+I+U, C contains the R-commodities in their quality of intermediate goods and U is the measure of R-commodities in their capacity of final goods. Now C (including the goods produced by fixed capital) and I are the only components of global demand, assessed in real terms; U is definitely not a component of demand. It is quite certain, on the other hand, that global supply extends to all the newly produced commodities. If the national production is measured in period p by the sum of 3x units of money, the value of the supply in each of the three sectors being x bancors, the measure of Yp is 3x bancors. The corresponding measure of total demand, Dp is 2x. Here we have, for the first time, a positive discrepancy between supply and demand, equal to x units of money. The formation of the discrepancy between total supply and total demand is the cause of unemployment. It follows that the production of R-commodities, as final goods, is the principal cause of unemployment. All other ‘causes’ of unemployment exercise their effects within the frame of the equality between supply and demand. If, in period p, Y200 is the level of full employment in the economy, Y2/3.200 may well be the level of employment enterprises are able to sustain, in the socalled industrial sector, irrespective of the level of the real wage bill, including indirect (or social) wages. No wonder that the economists who constitute ‘the profession’, still unaware of the presence of R-commodities in the category of final goods, are at a loss when asked to explain the existence of a positive discrepancy between supply and demand. To their eyes, the main bulk of unemployment, however large, can only be traced to the free will of potential employees, who find current real or monetary wages insufficiently attractive or, then, quite to the contrary, the same economists are content to point their finger accusingly at what they judge to be the excessive weight of the wage bill for enterprises. So, is the wage bill too low or is it too high? This question logically belongs in the field of microeconomics or else it is a matter (admittedly of great importance) concerning distribution, not production. The profound truth of the matter lies in a completely unexpected direction, namely in the creation, within the production process, of a positive measure of purely nominal incomes, a phenomenon which pertains strictly to the field of the still new discipline of macroeconomics.

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The measure of unemployment is not necessarily equal to the whole value of the production taking place in sector 3 In the scope of a chapter we cannot probe this matter in any depth. It may be sufficient here to rehabilitate the theory of unemploymet propounded by Maynard Keynes albeit in the light of the production taking place in sector 3 of the economy. If all incomes which ensue from production were endowed with a positive share of the newly produced real output, the marginal efficiency of fixed capital could never fall beneath the current rate of interest. As we have stated before, the production of purely nominal incomes is the real cause of unemployment. In sector 1 firms can only produce consumer goods, to be sold to households. In sector 2, enterprises produce investment goods. The rule—a true law—governing the production in these two sectors of the national economy is the equivalence between the sum of incomes which are formed and the sum of incomes which are spent. Therefore, if no production took place in sector 3, no positive measure of unemployment could logically occur; then, the productivity of fixed capital, as expected by firms, that is the efficiency of capital, including new (or ‘marginal’) investments, could not possibly fall below the rate of interest. Prima facie, the income— expenditure relationship is exactly the same in sector 3 as in the two other sectors of the economy. In fact, however, the production taking place in sector 3 is subject to a degree of freedom. The value, in period p, of the output in sector 3 is x bancors. As a consequence, x units of money are the measure of the dual physical capital which accrues in period p to the set of all firms. Now, no doubt can be cast on the state of affairs which obtains in sector 3 as it does in the other sectors of the economy; in all three sectors, the newly produced output absorbs exactly, neither more nor less, the real incomes which the production of these goods has given birth to. If analysis could not be pushed any further, no discrepancy could arise, in theory, between global supply and global demand. Theory and fact are at last reconciled at the moment when research uncovers the existence of sector 3. In sectors 1 and 2 real incomes are first produced in order to be spent later. But in sector 3, real incomes are already spent at the ‘instant’ when households perceive their wages; so, research is being narrowed down to the recognition that in sector 3, the remuneration of the factors of production are, as we have carefully shown, a sum of purely nominal incomes from the moment they are formed. Hence, only two possibilities remain: if the dual physical capital is made of investment goods, no harm is done to the level of employment; but if the dual capital is a collection of consumer goods, within the national economy, absolutely no real incomes are available which could be spent (by households) for the purchase of these goods. We have no space, here, to go beyond the diagnosis laid down by Keynes; unemployment occurs when the marginal efficiency of capital is equal to or lower than the corresponding rate of interest; when that is the case, firms have no choice but to accumulate the dual physical capital in the form of consumer goods. Production in sector 3 amounting to x units of value in period p, (x—x ) is the

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measure of the dual capital that consists in new investment goods; consequently, x is the measure, in period p, of the newly produced dual capital which firms decide to accumulate in the form of consumer goods. When (in industry) unemployment is at its limit, x is equal to x. Fortunately, many other values of x , between zero and x, can obtain in the economy. Sometime in the (hopefully none too distant) future, a monetary reform, devised along Ricardian lines, will extirpate the main cause of unemployment How could we possibly give, in but a few words, even a mere outline of the necessary reform? It must suffice here to state the precise aim which should be pursued. A computer program can be devised and established whose theoretical goal and practical effect is, when applied by the banking system of the nation, to eradicate all positive creations of purely nominal incomes. In his theory, David Ricardo divided the banks into two departments, monetary and financial (a reform which was adopted some twenty years after his death by the Bank of England). The required reform is the institution of a third department in all deposit banks, which will manage all income-expenditure flows relating to profits, in such a way that, henceforth, all remunerations handed out by enterprises to the factors of production will be real incomes. No longer will it be possible, then, for global demand to fall short of global supply.

4 FROM KEYNES’S TO THE MODERN ANALYSIS OF INFLATION Xavier Bradley, Jean-Jacques Friboulet and Claude Gnos

Considering all the writings of Keynes, one is struck by the recurring theme of inflation. It is the leading feature from the Tract to the Treatise. It plays an important role in The General Theory (hereinafter also GT) where Keynes considers the transmission mechanisms of the quantity of money on prices. It is the main theme of the writings on a war economy such as How to pay for the war. Although Keynes kept on analysing the question of inflation, he did not seem to use the same definition all the time: his point of view was totally modified in 1925. He broke with the quantitative theory and went on to develop a very original analysis of the credit cycle. Of course, in the Tract, Keynes clearly distanced himself from the most orthodox expressions of the quantitative theory, but he remained convinced that the old theory was still sound. At the beginning of chapter 3, he writes: ‘This theory is fundamental; its correspondence with fact is not open to question’ (Keynes 1971a:61). What is the true meaning of the break taking place in the Treatise? What are the reasons for it and what are its consequences for today’s analysis of inflation? The post-Keynesian tradition has not taken a great deal of interest in this problem because it considers the Treatise as a work of transition between the Tract and The General Theory. For opposite reasons, the Monetarists have also minimised the theoretical significance of the Treatise. It actually contains a conception of inflation which denies any relevance to the monetary policy. To understand the novelty of the Treatise, one has to go back to Keynes’s writings of the 1920s and to the lectures given during this period. Analysing the events of the time and developing his own reflections from the works of Marshall and Withers, Keynes was led to a kind of Copernican revolution in the areas of monetary theory and value theory. According to him, inflation was no longer to be defined simply in reference to prices; inflation is an excess of aggregate demand over aggregate supply. Strangely enough, the widening of the scope of the Keynesian revolution, in the GT, led to the new conception of inflation being set aside. What were the reasons for this? The criticisms from the Cambridge economists against the static character of the analysis in the Treatise played a significant role: in the GT, Keynes had to elaborate a dynamic analysis and, for that purpose, he had to take

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into consideration the evolution of prices through time. This is also the result of the emphasis on the identity of aggregate supply and demand: how then could an inflationary gap be conceived of as an excess of demand over supply? We shall make reference to the writings of Keynes from the Tract to the Treatise and then from the GT to the later writings. First of all, we shall consider the new theory of the value of money and the analysis of inflation as exposed in the Treatise. Then we shall demonstrate how, in the GT, the identity between aggregate supply and demand has shrouded the new analysis of inflation; finally we shall have a fresh look at the intuition of the Treatise: the profit inflation. INFLATION FROM THE TRACT TO THE TREATISE The lessons from the Tract What can we learn from the Tract on the question of inflation? For a full understanding of chapter 3, which expounds the core of the thesis, one has previously to consider the first part of the book which analyses the economic and social consequences of inflation. Two points are featured in the argument. The first one is that inflation has different effects on the savings of the rentiers and on the investments made by entrepreneurs. It is detrimental to this kind of savings to the point of being considered as a tax on capital but it stimulates investment by creating windfall profits; it has no positive nor negative consequences for wage earners as long as they are able to protect themselves through wage indexation. The question of the relation between saving and investment became a prominent part of Keynes’s later works. The second point is that governments can create a special kind of inflation through the issue of fiat money. This disequilibrium is called inflation of cash. It is the consequence of the inability of governments to find alternative resources. Its particular relevance during the 1920s was the consequence of the increase in the public debt following the First World War. The inflation of cash is a kind of taxation. These two results are used again in chapter 3 when Keynes showed that basically inflation does not originate in the activities of the banks. It is true that the inflation of cash can be associated with an inflation of credit defined by a decrease in the liquidity ratio of the banks (r). But the inflation of credit can be suppressed through the control of (r) and the inflation of cash can be eliminated through an adequate taxation policy. Keynes emphasised that these two kinds of disequilibrium no longer existed in England. The basic source of inflation must be found in the behaviour of the public willing to keep a certain amount of real balances in the form of money. In the so-called balances equation, n=p (k+rk ) where: n=amount of cash, p=price of the consumption unit,

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k=number of consumption units that the public is willing to keep in notes and coins, k =number of consumption units that the public is willing to keep in bank deposits, r=bank liquidity ratio, the variables (k) and (k ) are independent and (p) is the determined variable. The role of the monetary authorities is to deal with (n) and (r) so as to reach a certain price level (p) taking into account the desires of the public expressed through (k) and (k ). These authorities must manage (n) and (r) through the variations of the discount rate in order to face the demand of consumption units (k) and (k ). At first glance, the Tract seems to follow a strict quantitative line. But this judgement has to be qualified because of the emphasis laid on the real variables (k) and (k ). Keynes thinks that the relation between (n) and (r) is disturbed by the variations of (k) and (k ) during the credit cycle. He writes: ‘the characteristic of the credit cycle consists in a tendency of (k) and (k ) to diminish during the boom and increase during the depression, irrespective of changes in (n) and (r)’ (Keynes 1971a:67). In other words, the decisions of consumers are more important than the variations in the money stock for the successive stages of the cycle. The variable (n) is in a relation of interdependence with the demand for money determined by the wealth of the public and its spending habits. In this respect, the thesis presented by Keynes in the Tract is typically Marshallian. The genuine monetary phenomena are determined by real and institutional variables. On the real side, we find the consumption by the households; on the institutional side, we find the budget policy and the exchange rate system. A government has not the ability to control both the price level and the exchange rate at the same time. Thus Keynes is against any return to the gold convertibility of the pound sterling. The idea proposed in the Tract is interesting on two accounts. Setting limits to the monetary policy, Keynes has a balanced view of the role of the monetary authorities, quite opposed to the orthodox quantitative point of view. The means to obtain a stable price level cannot be established once and for all. They must be adapted to the political and institutional context. The Central Banks are not, according to Keynes, an independent entity with a fixed doctrine. They must act as regulators balancing the needs of the economic system and the stability of society. The theory of the Tract has another strong point. It adds the bank deposits to the notes and coins in the cash demand of economic agents. Adding the deposits might be seen as quite secondary. Actually it is important both on a symbolic and a theoretical level. Through it, Keynes severs any link with the ‘Currency School’ tradition which considered the bank deposits as a way of increasing the velocity of the circulation of the metallic money. But more important, he is taking the first step into the analysis of the difficult problem of scriptural money and sets forth the conclusions brought up in the Treatise.

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This evolution was noted by Cannan (1924) who disapproved of it in an article published in the Economic Journal. Keynes’s rejoinder emphasised what was at stake from a theoretical point of view: Professor Cannan is unsympathetic with nearly everything worth reading— as it seems to me—which has been written on monetary theory in the last ten years—yet the almost evolutionary improvements in our understanding of the mechanism of money and credit and of the analysis of the trade cycle, recently affected by the united efforts of many thinkers, may prove to be one of the most important advances in economic thought ever made. The ideas are new. They are only just beginning to be capable of complete or clear expression. Keynes 1983:419 This text constitutes a sketch of the analysis expounded in the Treatise. Before elaborating on this, we must point out two shortcomings in the Tract which Keynes was fully aware of and which he tried to overcome as early as 1925. These are the insufficient treatment of investment in this scheme and the questions related to the consumption unit. We have already insisted on the emphasis that Keynes has put on the inflation of real balances. According to him, this kind of inflation stems from a change in the behaviour of the public which is not accompanied by a sufficient variation in cash. The relation between saving and investment is not brought into the picture. This is quite surprising as Keynes was fully aware of the Marshallian so-called indirect transmission mechanism. Marshall, followed by Wicksell, worked out the idea of an influence of the quantity of money on the price level through the rates of interest and forced saving. But this idea does not appear in the Tract. The reason why Keynes discarded it is obvious when we consider the letters written by Keynes after the publication of the Tract. He did not agree with the classical theory of interest. He labelled the ‘old view’, the determination of the rate of interest by the simultaneous influence of saving and investment. Thus one of the main purposes of the Treatise was to use saving and investment as direct determinants of the price level and no longer as indirect determinants through the increase of the money stock. To liken real balances with consumption units raises a problem of coherence that Keynes himself underlined in his analysis of the quantitative equations in chapter 14 of the Treatise. The equality n=p(k+rk ) related the money stock to the units of consumption multiplied by their prices. But, by definition, the money stock can be used for other purposes than consumption. It is used in financial transactions and as a fund by the firms. Thus (n), (k) and (k ) are not related to the same object. Their ratio necessarily differs from (p), the price of the unit of consumption, hence the use of (r). This logical error is so obvious that Keynes could not fail to see it. But Keynes chose to express his ideas in this way rather than in the form of the traditional Cambridge equation to emphasise that inflation

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is more than anything a change in the purchasing power of the public on the consumption goods; this was to be supplemented in the Treatise. He also distanced himself from the Pigovian conception of real balances because he thought it inadequate on two accounts. Pigou dichotomised between physical variables and monetary variables whereas Keynes was looking for an integrated measure of the national income and the national product. Pigou referred to a general price level whereas Keynes thought it impracticable and preferred the consumption goods price level. The abandonment of the gold standard and the creation of deposits In 1924, at a turning point in his career and personal life, Keynes embarked on the ambitious project of a new book on the credit cycle. His professional perspective had grown more definite. He once thought he could quickly go back to the governmental sphere after the ‘reparations’ episode. In 1924 he could no longer contemplate this possibility so he decided to devote his time to his business activities, his academic work and his articles for reviews and newspapers. This new equilibrium gave him more time for research and more liberty vis-à-vis the monetary orthodoxy represented by the Bank of England. His personal life was affected by two events. He was deeply moved by the death of his mentor A.Marshall to whom he owed his interest in economics and his conception of political economy as a branch of ethics. In 1941, he wrote to the Archbishop of York: ‘Along one line of origin, at least, economics more properly politico-economy is a side of ethics. Marshall used always to insist that it was through ethics that he arrived at political economy, and I would claim myself in this, as in other respects, to be a pupil of his’ (quoted by Hession 1984, chapter 13:326). The loss of Marshall marked for Keynes the end of a scientific era whose fruitfulness he recalled in his Essays in Biography (1972). The years of 1924–5 were also marked by his marriage with Lydia Lopokova and his disaffection with the Bloomsbury Group. He turned a page in his life and was able to find the intellectual and moral resources for the great scientific adventure of the Treatise. This project gathered momentum in 1925 when Keynes definitely dropped the initial draft based on the quantitative equation and conceived a new project centred on the study of bank money. More than the fundamental equations appearing in the third part of the book, the first two parts on the nature and value of money do constitute the heart of the argument. As he would do later in The General Theory, Keynes put the core of his message at the beginning of the book. He tried to convince his reader right from the start of the novelty of his propositions. The thesis put forward in the book was radically new. The deposits in the banks are the main object of the analysis whereas the money from the Central Bank only plays the role of money for interbank payments. The deposit is no

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longer considered a substitute to fiat money as in the Tract. Keynes’s objective was the understanding of the innovation brought in by the deposit in relation with the history of monetary economy; he also wanted to analyse the consequences of this innovation on the economic equilibrium and the stability of the price level. The lectures given at Cambridge during those key years are typical of Keynes’s interests. He viewed the history of money through the history of money of account. The money of account is a number which enables the expression of debts and assets; its very existence marks the difference between barter economy and exchange economy. But the money of account is not an economic value. This number is created by the banking system and this creation takes different forms depending on the technological and institutional context. Keynes makes a distinction between a nominal money which is a pure number and a real money which appears in the liabilities of the banks in the public’s deposits. Here one point must be emphasised. The author of the Treatise makes a distinction between the value of money and the legal tender. The legal tender is the result of a political decision, the value is the consequence of an economic operation. If Keynes insisted on the intervention of the state to validate money, he did not consider that the bank deposits were produced by the state. These deposits are created by the banks in the payments which determine their value. The conception of the real money presented in the Treatise is not a purely institutional one. It links the institutional intervention to the determination of a purchasing power which is the result of the economic activity. Identifying real money to the deposits, Keynes contributed to a scientific revolution which was stressed by Schumpeter in his History of Economic Analysis. Endorsing Withers’s thesis, he showed that money is not the result of a transformation of assets or a substitution of assets but the result of a creation. He puts to the fore the primeval function of the banks in an economy of production. The banks not only assist in the use of savings but they also have a purely monetary activity which consists in creating means of payments for the firms and the public. They create deposits whose value does not derive from that of the cash they hold. Using the famous Withers expression ‘loans make deposits’, Keynes showed his pragmatic turn of mind. In practice, commercial banks do not limit their loans to the amount of cash received in a previous operation. But more than anything, the author of the Treatise wanted to take into account the overdraft operations. By definition the overdraft means a loan without any pre-existing deposit brought by the borrower. Here the monetisation of assets is ruined. Relinquishing the fiction of the deposit representing a metallic money, Keynes reconciled the monetary theory and the practice of his times. But he was quite aware that the idea of the creation of deposits questions the conception of the value of money which was propounded by the Cambridge school of thought. According to Marshall and the Currency School tradition, the metallic money had a unitary value defined by the conditions of its production. The economy, on its part, determines the amount of real balances which are needed. The equilibrium

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quantity of money is defined by the ratio between the value of the real balances and the unitary value of money. In contrast, the bank deposit has a near zero cost of production. It is not created through an entrepreneurial activity like the coins or the notes which are then sold to the commercial banks. Thus the distinction between the production of money and its introduction into the economic system is no longer relevant.1 The unitary value of money can no longer be taken as the guideline for monetary policy. The equilibrium quantity of money is indeterminate. In 1925, ruling out any theoretical link between the banking deposit and the metallic money, Keynes lost an essential component in the definition of the value of money. The years 1925–8 were dedicated, among other things, to the reconstruction of such a component. The genius of Keynes was here in full bloom. He succeeded in conceiving an objective measure of the value of money without any reference to the gold standard. Thus the monetary equilibrium could be defined anew and the monetary policy was fitted with a precise reference to the range of options opened to it. INCOME AND THE DEFINITION OF THE INFLATIONARY GAP In the first place, we shall examine the conception of the value of money presented in the Treatise. From it, Keynes deduced a measure of the purchasing power totally different from the usual measure through a price index. We shall end our presentation with the analysis of the consequences of the new measure in order to understand inflation. The value of money In chapters 2 and 3 of the Treatise, Keynes developed a theory of deposits. These are created by the banks through their lending operations. But Keynes had still to explain the economic value of these deposits. Withers had set aside the problem in the introduction of his book: ‘The meaning of money is not a question of economic theory’ (Withers 1909, chapter 1:1). Keynes had too acute an awareness of the real features of the banking system to follow Withers on the same way of thinking. He knew that the value of the debts of the banking system towards the public is not simply a question of trust in the issuing institutions. The value is not just a symbol; it is a real phenomenon. In other words, to be used in payments, the deposits must have an object. They cannot only be numbers certified by the banking system. What is then the object of the deposits? The quantitative theory considers that it is the reserves in Central Bank money recorded in the assets of the banks. Keynes rejected this point of view. The net creation of deposits implies by definition that there is no money asset which could fund the liabilities. When issuing the money of account, the banks do not rely on a pre-existing monetary object because that would imply only the transmission to the depositors of the money previously held as an asset; they

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would not be themselves involved in any liability. The hypothesis of a preexisting monetary object being in contradiction with the observed facts, we are left with the possibility of a real counterpart. This is what Keynes upheld in the Treatise. The banks create money in lending operations or overdraft in counterpart of real deposits. What is then the nature of these real deposits? It is the new product, the production of which is then financed by the banking system. When the banks create a sum of money for the firms, they monetise an equivalent part of the production. In so doing, they receive in deposit an equivalent product waiting for sale. In the Treatise perspective, the commercial papers and the loans appearing in the assets of the banking institutions are not just promises from the debtors to pay back. They are the actual form of the new product created by the producing services during this period. They constitute real claims and not just personal commitments. The money appearing in the liabilities has a counterpart in the product deposited in the banks on the assets side. That is the meaning of the emphasis put by Keynes on the concept of national income at the beginning of chapter 10: I propose therefore, to breakaway from the traditional method of setting out from the total quantity of money irrespective of the purposes on which it is employed and to start instead with the flow of the community’s earnings or money income and with its twofold division (a) into the parts which have been earned by the production of consumption goods and of investment goods respectively and (b) into the parts which are expanded on consumption goods and on savings respectively. Keynes 1971b:121 Keynes linked the creation of the deposits to the formation of income because the operations of income formation are the only operations that connect the issue of new money to the formation of a real deposit in the bank accounts. Keynes only considered the stock of money in relation with the national income; this does not mean that he was not aware of the deposits resulting from the financial operations but, according to him, the formation of income is the only source of creation of new bank deposits. These deposits are not based on a pre-existing asset; their object is the real product formed in the operation of money creation. The question of a money creation is at the heart of the Treatise. This needs to be detailed. In chapter 2, Keynes recalled that the banks issue new money in exchange for real values or promises of repayment, and he added: ‘There is no difference between the two except in the nature of the inducement offered to the bank to create the deposit’ (Keynes 1971b: 21). This statement seems quite puzzling because of the profound difference between the two kinds of operation. On the assets side, there are pre-existing economic values, on the other side, there are simple commitments to repay. The puzzle can only be solved if we link this statement to chapters 9 and 10. The advances considered by Keynes in chapter 2 are lent to production and they result in the income deposits. They are

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realised through the purchases of the firms to the producing services. They cannot be disconnected from a real payment from the seller to the buyer, the former giving up his product against a reward. In consequence the creations of money only differ as to their motives. In fact, they always result in the deposit of a real value on the assets side of the banks’ balance sheets whether it existed previously as in the case of the discount of commercial papers or it is newly formed in the operation as in the case of a loan to production. Linking money creation and production, Keynes realised the synthesis of the monetary thoughts of Withers and Marshall. He kept the Withers ex nihilo money creation: the new deposits are not based on any pre-existing monetary object. But he supplemented it with the real deposits concept. Following Marshall, he considered that the banks cannot create any economic value. The value comes from the producing services through production. The banks act as a catalyst. Issuing the money of account, they monetise the new product created in the firms, outside the banks. The deposits written on their liabilities sheet constitute the income of the community. The counterparts appearing on the assets side are not simple commitments to repay by the firms. The banks would be uncovered if they had lent real values against promises. These counterparts are real assets. They are the form of the new product deposited in the banks at the moment of the money creation. Having defined the net creation of money through the formation of national income, Keynes deduced from it that the excess of aggregate demand on aggregate supply cannot originate from the activity of the banking system. The banks have not the ability to issue a greater amount of money than the amount of product that they have received because the latter is precisely defined economically by the former. The source of inflation must be found in the spending of the firms or the public. To make this point more explicit, we must examine the consequences of the definition of income on the measurement of inflation. Considering that the income is the exact equivalent of the national product, Keynes determined in every period the amount of aggregate supply to which the aggregate demand must be adjusted. From it, he deduced that the excess of demand is equivalent to a difference between spending and income. Let aggregate supply be: where E=the sum of the payments to the factors of production, D = the income formed in the production of consumption goods, I = the income formed in the production of investment goods. Aggregate demand is expressed in the following way: Eqn 4.1 where P=the price of the whole product, O=the volume of the national product,

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D=the spending on consumption goods, I=the spending on investment goods. The definition of saving as the difference between national income and the households consumption allows a new expression of the equality 4.1: Eqn 4.2 The excess of the aggregate demand (D+I) on the aggregate supply (D +I ) results, in the Treatise, in a difference between the price (P.O) and the cost E of the national product. This difference is equal to the difference between I and S: If we split up the expression (I−S), we can observe, with Keynes, that this difference is equal to the sum of two profits: where Q1=I −S=profit realised on the sale of the consumption goods, and Q2=I−I =profit realised on the sale of the investment goods. Q1 and Q2 respectively define profit inflation and capital inflation. This distinction is fundamental for today’s theory. Before developing it, it will be useful to have a closer look at equality 4.2: As an expression of the global inflation during the period, equality 4.2 is interesting on two accounts. First of all, it indicates that the reduction in the purchasing power of money has a twofold link with investment, through the difference between the cost of the production goods and voluntary saving on one hand, through the difference between the price and the cost of these goods on the other hand. In comparison with the Tract, there has been an obvious work of clarification. The increase in the price of the product, including consumption goods, is mainly due to the difference between investment and saving. The equality 4.2 then does not define inflation by an increase of the general price level from one period to another, but by the difference (I−S). The latter determines an excess of the price of the aggregate demand (P.O) on the price of the aggregate supply (E) during the current period. In the Treatise Keynes did not fall into the trap of measuring inflation with price indexes variable through time. Following Marshall’s intuition, he showed that any price index reflects many different phenomena. In a closed economy, one can identify the variations of productivity, the variation of the unitary costs of production, the variations in the taxes and the social contributions and the consequences of the excess of the demand of consumption goods and investment goods. But only the demand in excess can directly affect the purchasing power of money. The variations of productivity as well as the variations of cost give rise to a price variation but with no consequence to the purchasing power of money because the public will always receive in the aggregate amount of income the power to purchase the entire product. The same can be said of price increases resulting from fiscal and social contributions; they cause transfers of wealth within the public but do not lead to any decrease in the purchasing power of the public as a whole.

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The distinction between increases in price indexes and a decrease in the purchasing power of money is fundamental for the understanding of the Treatise. Keynes formulated the distinction for the first time in 1926 while reviewing Robertson’s book Banking policy and the price level2 and he used it for the analysis of the economic situation in the USA in 1928. It enabled him to reject the usually acknowledged thesis of a monetary origin to inflation. One can find a renewed interest for it to analyse today’s coexistence of price increases and unemployment. If we follow the Treatise on this point, only over-investment (I −S) can run into conflict with the development of a macro-economic unemployment. An increase of price indexes, whether resulting from an increase of the costs (income inflation) or from the speculation on capital goods (capital inflation), is not a forced saving. It is therefore consonant with an excess of aggregate supply on aggregate demand. Capital inflation and profit inflation Keynes makes a distinction between (I−I ), the difference between the price and the cost of investment, and (I −S), the difference between the cost of investment and saving. The distinction between (I) and (I ), in other words the possibility of a capital inflation, in itself establishes the originality of the theory proposed in the Treatise compared with the theory of Wicksell. Following the classical tradition, Wicksell likened (I) and (S). Every supply in saving constitutes a demand for investment. Consequently inflation is defined as a difference (I −S) between the production of investment goods (I ) and the supply in saving. For Wicksell the distinction between capital inflation and profit inflation has no logical meaning. The opposition between these two authors deserves a closer look; it stems from the role of the interest rate. For Wicksell, the production is an exchange the equilibrium price of which is a remuneration of the factors of production. The author of Interest and Prices assumes that capital and labour come into an exchange relation with a price corresponding to their marginal productivity. On the capital market, the marginal productivity defines the ‘natural’ rate of interest (in). The conception of production as an exchange implies that the determination of the prices of investment and saving is that of an equilibrium price. The variables (I ) and (S) are both functions of the natural rate of interest (in). The banking system can upset the relation between (I ) and (S) through the determination of a money rate of interest (im) lower than (in). This in turn gives rise to an excess of the supply of investment goods (I ) on voluntary saving (S) and thus a forced saving (I −S). This thesis is not to be found in the Treatise. Keynes does not see production as an exchange of value but as a creation of income. Consequently the marginal productivity of capital does not come into the picture of the determination of (I ) and (S). In every period, the firms determine the amount of production (I ) depending on the anticipations of the future profitability of the investment. In the same way, the marginal productivity of capital does not appear in the saving

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function (S) which depends on the level of consumption being that part of the income which is not consumed. In the Treatise, the rate of interest is a purely financial variable which exerts an influence on the distribution of the savings between deposits and securities but has no effect on the global amount of macroeconomic saving. In relation with the current rate of interest, the independence between (I ) and (S) has two consequences: the definition of a profit inflation which does not originate from monetary phenomena, the possibility of a difference between the price (I) and the cost (I ) of investment. Let us consider first the second aspect. The demand for investment (I) is not determined by the current income like (S). It is a demand for capital determined by the capitalisation of interest. It could concern an old capital whose price is in competition with that of a new capital. Thus the demand for capital (I) depends on the current rate of interest. ‘The actual price level of investment is the resulting of the sentiment of the public and the behaviour of the banking system’ (Keynes 1971b:128). A difference can occur between (I ) which is determined by the current production of the firms and (I) which is the price of capital determined on the financial market; Keynes called this difference capital inflation. In the economic literature, it has often been likened to the Wicksellian forced saving, but this leads to a confusion because it implies leaving aside the major theoretical breakthrough of the Treatise: the independence of (I ) and (S) in relation with the current rate of interest. Distinguishing between the demand for investment (I) and the supply of saving (S), Keynes established a precise limit to the responsibility of the banking system in the inflationary process. Through their rates of interest, the banks can influence and feed the demand for capital (I). In so doing, they play a part in the creation of a difference between (I) and (I ). They do not have the possibility to influence directly the aggregate volume of saving and investment, and, consequently, to give rise to a forced saving (I −S). Forced saving is defined in relation to the real economy, not with the financial system. It is a profit inflation and not a capital inflation. Here we must stress that profit inflation is not logically linked with capital inflation. There is no transmission mechanism between the (I− I ) profit and the (I −S) profit. Keynes disconnects the speculative bubbles which characterise the financial markets and the over-investment process which is at the heart of the credit cycle. The former do not necessarily cause the latter and that was precisely the case in the speculations during the years 1986–90. Once again the theoretical tools of the Treatise are very useful for economic policy to distinguish between the different kinds of price increases. Capital inflation does not in itself involve a fall in the purchasing power of the public which basically results from an excess of production of investment goods (I ) over saving (S).

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Together with the definition of income, Keynes considered the concept of profit inflation as the most important contribution of his book. In chapter 19, he described the normal course of the credit cycle: ‘Something happens—of a nonmonetary character—to increase the attractions of investment. It may be a new invention, or the development of a new country, or a war, or a return of “business confidence” as the result of many small influences tending the same way’ (p. 271). The new inducement to invest is the consequence of the increase in anticipated profits. It causes an increase in the production of instrumental goods which is not financed through voluntary saving from the public. The workers hired for this production spend their wages on consumption goods and services. A difference then appears between the price and the cost of the consumption goods indicating a fall in the purchasing power of money. In case of profit inflation, the credit cycle has three sequences: an impulse in the instrumental goods sector; a new production (I ) in response to this impulse; an increase in the price of the consumption goods which defines a profit (I −S). These sequences lead to two observations: 1 Keynes develops the idea that the level of capital accumulation depends on the anticipated profits. Over-investment (I −S), contrary to the difference (I −I) does not originate in the banking activity. Through the interest rate, the banks influence the prices of the securities and the price of investment. They cannot influence directly the level of production (I ) which depends on the anticipations of the firms. 2 This statement is supported by the conditions of the financing of (I − S). Over-investment is not paid through a money in excess. The Q1 profit in the Treatise is neither a sum of money nor an income. It is a capital. To the amount of Q1, the producing services of the investment goods are paid in securities. ‘The profits must be regarded, not as part of the earnings of the community (any more than an increment in the value of existing capital is a part of current income), but as increasing (or if negative, as diminishing) the value of the accumulated wealth of the entrepreneurs’ (p. 112). The remunerations (I −S) determine the constitution of a capital for the firms. This assertion introduced in the Treatise is quite puzzling. It led to a series of debates within the ‘Cambridge Circus’ especially in relation with the widow’s cruse. Is the exclusion of inflation’s profits a pure convention imagined by Keynes? If it were so, Keynes would simply regain through the spending what was not taken into account in the aggregate supply. Profit inflation would then simply be a delusion. This interpretation is supported by the fact that, in The General Theory, Keynes restored profit as a component of the national income;

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but, for two different reasons, we shall not adopt it. The first reason is that Keynes had pondered over the concept of profit inflation during the whole period of preparation of the Treatise as we can see in his first drafts. He considered it as one of the main contributions of the book. Is it really likely that he could invest so much scientific expectation on a simple accounting device? A second reason reinforces this opinion: there is an alternative interpretation which is consistent with the logical trend of the Treatise. The difference (I −S) constitutes a capital for the firms not because of a convention but because it is financed by an income produced in a previous period. The demonstration rests on two lines of argument: Any income brings to its holder the purchasing power on the corresponding product. This is the consequence of the principle of the net creation of deposits that we have considered earlier on. Banks can issue money in relation with the operation of production only if they receive an equivalent product in the same process. The Treatise defines a strict equality between the income and the national product. Following this principle, the holders of the remunerations (I −S) should be able to buy the corresponding product. But they cannot do it. The investment goods (I −S) are not available to the public. The reason for this must be found in an economic operation. The goods defined by the difference (I −S) have already been sold. They were purchased through the payment of the remunerations. Paying the income (I −S), the firms have acquired an equivalent product. And they could do it only in spending an income obtained in a previous period. The profit inflation is, according to this interpretation, the spending of an income in the production of the investment goods. The difference between the cost of investment and the amount of macro-economic saving is the result of a special way of financing investment. (I −S) creates an excess spending as far as profit is spent twice on the market of the products. The profit is spent through the payment of the remunerations (I −S) because it implies the purchase by the firms of the corresponding product and it is also spent by the public which uses the income (I −S) to buy the consumption goods. Now we can conclude his presentation of the Tract and the Treatise. Keynes had two objectives in his research on inflation. First he wanted to inventory the different sources of increase in the prices of goods and services. There, his ambition stands both on a didactic and practical level. He wanted to forge a tool enabling us to give a precise diagnosis of the economic situation and thus to elaborate an adequate policy against inflation. This resulted in the distinction between income inflation, capital inflation and profit inflation. Income inflation is defined as an increase in the unit cost of production. Capital inflation is a financial phenomenon; it is the consequence of the public’s choices in investment and the attitude of the banking system. Profit inflation has its origin in real

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production. The second objective of Keynes was to provide a precise analysis of the theory of forced saving. He demonstrated that this is a specific form of inflation because it causes a loss for the public as a whole in favour of the firms. This theory of forced saving is completely new because it is not based on the spending of a money in excess but on the spending of profits. Financing the production of investment goods with a pre-existing profit, the firms create an excess demand in real goods. Although the Treatise earned laudatory reviews, the heart of the analysis was not really understood. The commentators most of the time likened profit inflation to Wicksell’s analysis and the price of aggregate demand to a price index. The letters exchanged between Keynes and Hayek are particularly revealing to that matter. Hayek reduced the inflationary gap to an excess of money whereas Keynes, in his answers, tried unsuccessfully to convince him that this interpretation is mistaken. What is the situation nowadays? The theory of forced saving is often ignored by the macro-economics textbooks where the quantitative theory is given the prominent part; unlike the principle of effective demand or the theory of the propensities, it is alien to most students in economics. The General Theory has cast its shadow on the Treatise. This classification of Keynes’s works was beneficial to the theory of unemployment or the theory of growth but unfortunately it left a clear field for the most extreme Monetarist analysis of inflation. THE GENERAL THEORY AND AFTER: THE CONFRONTATION BETWEEN THE ANALYSIS OF THE INFLATIONARY GAP AND THE IDENTITY BETWEEN SUPPLY AND DEMAND The principle of the identity between aggregate supply and demand was already formulated in the Treatise: we have seen that, in this work, income is strictly equivalent to the national product. But there was an exception to this identity: the existence of profit, which was not included in the national income, allowed an excess of demand on supply. We will demonstrate further on that there is no contradiction: in spite of the identity, an inflationary gap can still be conceived of. The writings of Keynes posterior to the GT show us the way to remove the contradiction. However, in the GT, Keynes did not provide any satisfactory answer to this question. Bringing the profits back into definition of the national income to conform to the current usage, Keynes proposed a quantitativist approach to the problem of inflation from which, up to now, the Keynesians and post-Keynesians have not been able to escape.

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A recurring quantitativism Let us have a fresh look at chapter 21 of the GT, entitled ‘The Theory of Prices’. Keynes explained there, that an increase in the quantity of money, which implies an increase in the effective demand, may have various consequences: an increase in the volume of production or a wage and price increase or a combined effect. In the latter case, Keynes used the term state of semi-inflation. The true or absolute inflation refers to the case of an increase in effective demand producing an increase in the cost-unit (and in the price level): When a further increase in the quantity of effective demand produces no further increase in output and entirely spends itself on an increase in the cost-unit fully proportionate to the increase in effective demand, we have reached a condition which might be appropriately designated as one of true inflation. Keynes 1971b:271 Two different relations are taken into consideration here: one between the quantity of money and the effective demand, the other between the effective demand and the price level. Keynes studied those relations one after the other to explain, through their combination, the effect of a variation in the quantity of money on the price level. Studying each relation separately does not mean, he says, that they are independent from one another: ‘For example, the proportion, in which an increase in effective demand is divided in its effect between increasing output and rising prices, may affect the way in which the quantity of money is related to the quantity of effective demand’ (p. 297). The effective demand to which the author makes reference here is not a demand in the usual sense. Let us consider Z and D, the aggregate supply and demand. The aggregate supply is measured here through the supply price of the produce of a given amount of employment N, that is the price which is just sufficient, for the entrepreneur, to realise a given level of employment. The aggregate demand corresponds to the expected proceeds by the entrepreneurs when they offer the produce of N. Finally, the effective demand is defined by the intersection of the two curves representing the two functions: ‘The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand’ (p. 25). Being the intersecting point of aggregate supply and demand, the effective demand is therefore, as Schmitt points out, ‘both a demand and an offer. It is supply-demand’ (Schmitt 1972:117). In this perspective, Keynes explains the effect of an increase of the quantity of money on the effective demand through the supply side of the (effective) demand. With this view in mind, he considers the relation between the money supply and the interest rate: an increase in the quantity of money tends to lower the level of the interest rate. But the decreasing interest rate has an effect on the cash balances and on investment which in turn

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increase the effective demand. If the volume of production can no longer be increased, the full employment level being already reached, the effect of a variation in the quantity of money on the price level can also be analysed through the effective demand: the increase of the effective demand, meaning simultaneously the supply and demand price, results in a factor cost increase. We must not forget that Keynes also takes into consideration states of semi-inflation; this is precisely the case when wage increases are agreed before the full employment level is reached. Is the principle of effective demand consistent with the definition of the inflationary gap as an excess of demand over supply? We shall come back to this question later on. For the time being, we can observe that Keynes, unable to give a positive answer, had to approach the inflation problem through the evolution of prices and cost-units. This resulted in an inner contradiction in the GT. One of the ambitions of the GT, on which Keynes repeatedly insisted, was to get rid of the neo-classical dichotomy between real and monetary phenomena. Especially in chapter 21, Keynes criticised the economists who, following the tradition, deal separately with the theory of value, according to which (real or relative) prices are determined in relation with the supply and demand conditions, and the theory of money, under which the (monetary) prices depend on the quantity and velocity of money: ‘One of the objects of the foregoing chapters has been to escape from this double life […]’ (Keynes 1973:293). The correct dichotomy is, according to Keynes, between the theory of the individual firm or industry, and the theory of production and employment ‘as a whole’. And ‘as soon as we pass to the problem of what determines output and employment as a whole, we require the complete theory of a Monetary Economy’ (p. 293). Among the reasons underlying this ambition was the fundamental role of money in determining the level of economic activity: being, as stated in the famous formula, ‘a bridge between the present and the future’, money enables anticipations to influence the level of employment: ‘A monetary economy, we shall find, is essentially one in which changing views about the future are capable of influencing the quantity of employment and not merely its direction’ (p. vii). Another reason was that, as emphasised in chapter 4 of the GT, money is the only means through which we can obtain an homogeneous measure of production: it is money which measures goods and not the other way round. Unfortunately, the analysis of inflation which Keynes ended up with is precisely built on the opposite statement. If inflation is not conceived as a gap between supply and demand measured in money units, it can only be identified through the variations of the prices and the costs of the goods. But how can we judge that such variations are inflationary, that is are the result of a disequilibrium, without assuming at the same time that the real variables can be measured independently from the monetary variables? The main characteristic of the quantitative theory is that it determines prices from the relationship between two independent volumes: the quantity of money (corrected with a V coefficient, representing the velocity of money) and the

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quantity of goods. Therefore, each level of prices is by definition an equilibrium level. Having to face the problem of defining inflation, this theory can only compare the equilibria determined at different times and can only assume that a variation in the price level is the sign of the diverging trends of the quantity of money and of the volume of goods. Though he analysed the transmission ‘mechanism’ of a variation in the quantity of money from the new perspective of effective demand, Keynes could not avoid the difficulties of the quantitative theory of money; as a matter of fact, he actually proposed a new formulation of this theory: ‘So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money’ (p. 296). The difficulty substantiated: the Keynesian heritage A review of the Keynesian economic literature confirms the problems already brought to light. In this respect, a number of quotations are quite telling. We have already noticed that the effective demand is an altogether different concept from the demand in the usual sense. However, and this has probably something to do with Keynes’s quantitative concluding remarks, the confusion between the two concepts was to prevail. For example the question of the determinants of the aggregate demand is at the centre of the debate between Monetarists and Keynesians: Monetarism and Keynesianism differ sharply in their research strategies and theories of aggregate expenditures. The Keynesian theory focuses on the determinants of the components of aggregate expenditures and assign a minor role to money holdings. In monetarist theory money demand and supply are paramount in explaining aggregate expenditures. Cagan 1989:197 Cagan adds: To contrast the Keynesian and monetarist theories, Friedman and David Meiselman (1963) focused on the basic hypothesis about economic behaviour underlying each theory: for the Keynesian theory the consumption multiplier posits a stable relationship between consumption and income, and for the monetarist theory the velocity of circulation of money posits a stable demand function for money. (p. 197) Here, beyond any doubt, Keynes’s effective demand is identified with aggregate demand as conceived in the traditional theory. What is at stake here, so we are told, is just the determinants of demand, the hypotheses ‘underlying each theory’.

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One cannot deny that the so-called post-Keynesians are more truly in line with Keynes’s approach. For example, P.Davidson is willingly using an income-based analysis; in so doing, he is upholding the novelty of the effective demand: the national product and the national income, aggregate supply and demand, are equivalent: Since the National Accounting System, which is used to measure GNP, is based on a system of double-entry book-keeping, the ‘double-entry’ offsetting the value of gross national production is the value of the total gross national income of the economy. Any price increase associated with GNP must be accounted for by an identical increase in the prices (that is, wages, rents, interest, profits) paid to income earners. Every price increase is an increase in someone’s income. Davidson 1991:88 This proposition is justified by the principle of double-entry applied to National Accounting. How can we define inflation in this framework? Davidson gives the following answer: The GNP can be thought of as a huge pie ‘baked’ or produced by the combined efforts of workers, property owners, and entrepreneurs. Each contributor to the production of this pie receives, in payment for his/her efforts, a sum of money income. This income gives the recipient a claim to a slice of the GNP pie. The size of the slice claimed depends on the price of the productive services the contributor has provided. Consequently, if the money which income people receive increases more rapidly than the size of the GNP pie (the ‘real’ output), then the GNP price level must rise (inflate) to keep the National Accounts in balance. p. 88 We are brought back to the problem already identified in the GT: having a simultaneous effect on aggregate supply and demand, an increase in the available quantity of money cannot be called inflationary unless we look separately at the quantity of money and the volume of production. Inflation only appears when the (monetary) incomes increase faster than the (real) product. Although in principle supply and demand can only be measured in monetary units, within an equivalence relationship, inflation is considered as an excess of money over the available product. Or rather, the problem being too obvious to be completely concealed, inflation is identified with a situation in which the comparison between money and product at two different moments reveals a greater increase in the quantity of money than in the product. But of course the problem remains the same: how can we measure an increase in the production if it is made up of goods physically different? ‘The problem of comparing one real output with

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another […] presents conundrums which permit, one can confidently say, of no solution.’ (Keynes 1973:79). Of course we could be tempted to dismiss these problems as purely theoretical ones with no practical consequences whatever. But here the economic policy is at stake. In this perspective, the post-Keynesians are led to question the restrictions on money creation advocated by the Monetarists; according to them, it has a severe drawback: it will restrict indiscriminately the volume of cash without taking any account of the diversity of its uses. The increase in the quantity of money is not by nature an inflationary phenomenon: it is a necessity to start production and to increase production. Davidson’s parable of the two islands (Davidson, 1991:100) will illustrate this. Let us consider the first island on which 10 apples are available, whereas the supply of money reaches 10 onedollar notes. If all the available dollar notes are spent on the apples, the price will be $1 per apple. Let us consider the second island on which 20 one-dollar notes and 10 apples are available. Assuming all other things equal, the Monetarists would conclude that the price per apple will be $2. Inflation appears each time the quantity of money is in excess relative to available goods: if the quantity of money had only reached $10, no inflation would have appeared on the second island. The problem is that there is no investigation whatsoever on the reasons why a greater supply of money is available on the second island. For example, it may be that the $10 in excess are spent on wages to workers employed for harvesting 30 more apples. In this case, the amounts to be considered are 40 apples and 20 dollars: the price for each apple will only reach 0.50 dollars. This criticism of the Monetarist propositions comes straight from the Keynesian concept of a monetary economy of production. In particular, it is on the same line of reasoning as the ‘finance motive’ introduced by Keynes in his papers, published from 1937 on, and in which he considered a money demand for financing production (we shall come back to this later on). However this criticism is not conclusive in itself: how can we use this distinction in every concrete situation? The post-Keynesians are quite uneasy about it. So they set aside the analysis of money and they try to explain inflation through the distribution phenomenon. Paraphrasing the famous formula introduced by Milton Friedman, Davidson concludes: ‘inflation is always and everywhere a distribution phenomenon’ (p. 100). The only remedy would be that society itself puts a limit to the individuals’ claims for higher incomes. That would mean an alternative to the control of the quantity of money. In particular, S.Weintraub proposed to put into operation a tax-based income policy that would charge the firms which agree to a higher wage increase than the increase in productivity.3 The creation of money would then no longer fuel the ‘struggle for distribution’. But, putting the emphasis on distribution, and particularly the reference to productivity gains, is again revealing of the quantitativist nature of this approach: the inflationary gap is still fundamentally considered as an excess in the quantity of money over the physical volume of goods and services.

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THE IDENTITY BETWEEN AGGREGATE SUPPLY AND DEMAND, THE BASIS OF A NEW DEFINITION OF THE INFLATIONARY GAP The identity of aggregate supply and demand is often held in suspicion. Is it not simply the consequence of special definitions? Is it not a truism deriving from accountancy and always verified ex post? This is not the place to examine the controversies surrounding the definitions of chapter 6 of the GT. However we can mention that Keynes found support for the identity in accountancy principles, although it originated from the definitions of income, saving and investment. But it is banking accountancy that is concerned here: the identity between aggregate supply and demand is thus legitimately founded on an objective characteristic of the monetary economy. Keynes developed thoroughly his analysis of money after the publication of the GT, especially in the articles concerning the finance motive. We shall see that these articles opened a truly new way of research: paradoxically the identity of aggregate supply and demand is consistent with the existence of a difference between them. The bilateral character of the monetary operations, a confirmation of the identity of aggregate supply and demand Let us quote Keynes: The prevalence of the idea that saving and investment, taken in their straightforward sense, can differ from one another, is to be explained, I think, by an optical illusion due to regarding an individual depositor’s relation to his bank as being a one-sided transaction, instead of seeing it as the two-sided transaction which it actually is. It is supposed that a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no saving corresponds. But no one can save without acquiring an asset, whether it be cash or a debt or capital-goods; and no one can acquire an asset which he did not previously possess, unless either an asset of equal value is newly produced or someone else parts with an asset of that value which he previously had. Keynes 1973:83 One cannot be more explicit. By its own nature, the money creation determines bilateral relations between the economic agents and the banks: money does exist only if it appears simultaneously in the column of the liabilities and in the column of the assets of the banks’ balance-sheet. Thus every deposit made into a bank implies that a loan is granted by the bank to some other agent, conversely,

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any loan granted by a bank implies a deposit of the same amount. As to the purchase of equities, it also implies a bilateral operation: facing the buyer, there is always a seller, the savings of the former is demanded (invested) by the latter. It is true that the wording of the effective demand principle is rather ambiguous. Keynes explains that employment is determined by the intersection of the supply price of a given amount of employment and the demand price expected by the entrepreneurs. So it seems that supply and demand could differ ex ante, before being related through an ex post identity.4 In fact, the reference to the necessary equality between deposits and credits from the banks lifts any ambiguity: it is impossible that the spending of incomes might be lower or higher than the amount created. Such an inequality is inconsistent with the definition of money. What is consistent with it, however, is that demand from the consumers might not be sufficient: investment, financed by savings, includes, as Keynes insisted in chapter 7 of the GT, involuntary inventories piled up in the firms.5 The principle of effective demand, on the other hand, has to do with the anticipations by the entrepreneurs who try to anticipate what will be the demand from the consumers and determine a corresponding level of employment. And obviously the anticipations could prove wrong. That is precisely what Keynes considered in the notes which he wrote from the lectures he gave in 1937: ‘The expected results are not on a par with the realised results in a theory of employment’ (Keynes 1971d:179). The expression of the principle of effective demand has a second ambiguity which must be confronted. We know that Keynes thought the price level ‘unsatisfactory for the purposes of a causal analysis which ought to be exact’ (Keynes 1973:39). He then went on to measure the product in employment units, which are made homogeneous through the wage units.6 However are not the aggregate supply and demand, whose meeting point constitutes the effective demand, measured in prices? And the prices include the profits as well as the wage incomes. Is not the principle of effective demand, which constitutes ‘the substance of the General Theory’ (p. 25), inconsistent with the choice of the units of measure? The inconsistency is only superficial. If, as is obviously the case, the anticipations of the entrepreneurs concern the prices—their proceeds— it is nevertheless the volume of employment which is determined by the effective demand, this volume being measured through the homogeneous wage units. More specifically, the coexistence of two different references, the costs and the prices, far from being a useless complication, does play a key role in the analysis of the distribution problem. The profits made by the firms are distinct from the costs: their formation depends on the prices realised on the market. They are transfer incomes, which derive from the incomes defined in the cost spending. Thus, they are not additive incomes: we verify that the wage incomes do constitute a comprehensive measure of the product (and identically of the national income).

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A definition of the inflationary gap Let us go back to the post-Keynesians according to whom inflation stems from the distribution of income. Two complementary possibilities can be envisaged. Inflation results from the determination of wages and/or that of profits: Labor succeeds in reaping more money as wages, and business then obtains more money by raising the prices of the products by more than their increased cost from the increased wages. But both labor and business still find that the increased money cannot give them more than 100 percent of the product—only higher prices. Lerner 1979:219 And of course in this scheme, the agents anticipations regarding inflation play a significant role, each category trying to protect its revenues against the consequences of the expected price increase. ‘If these expectations could vanish, there would no longer be the pressures on workers to demand higher pay’ (p. 221). Which, as P.Davidson emphasised, is typical of a monetary economy of production characterised by delays between the payment of monetary wages and the selling of the produced goods.7 We are not to deny that the distribution phenomenon considered by these authors could cause and fuel the price increase. And it seems quite sensible to try to find a remedy to such situations through adequate policies.8 These phenomena, as we are going to verify now, do appear within the framework of the identity of aggregate supply and demand: they are not the consequences of a macro-economic disequilibrium. But it could be that inflation is also a disequilibrium between supply and demand; and, in this case, the usual policies are totally ineffectual; more than that, if they are put into operation, and particularly if they are applied in all strictness, they will have unfortunate effects, particularly regarding employment. Those two cases considered by the post-Keynesians, the wages and the profits increases, can be analysed on the basis of the propositions of the GT in the following way: The product being measured in wage units, a variation in those units is just a variation of the measuring scale. There is no disequilibrium between aggregate supply and demand. Even if such phenomena are considered undesirable, because they usually lead to a modified distribution, they however do not hinder the perfect equivalence between the product and the available incomes. The supposed inflationary character of a money wage increase is invalidated by the fact that every modification in the measure of the costs (supply side) simultaneously affects the demand side: the identity between supply and demand is not put into question. Conversely, the price increase, which is the condition of the profit formation and also of their increase, is not detrimental to the identity: the profits are, by their own nature, a component of the measure of the product defined by the wage cost. What determines the prices—and their variations—is

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the part of the product that is transferred to the firms and their beneficiaries. But, after all, is there not an inner contradiction in searching for a gap between two things that are identical by definition? Indeed there remains one possibility. Keynes acknowledged that, in his eagerness to build a unified theory of production and money in the GT, he bypassed some ‘technical details’ relating to money. That was not the case in the Treatise, where he was ‘still moving along the traditional lines of regarding the influence of money as something so to speak separate from the general theory of supply and demand’ (Keynes 1973:vi). But after the publication of the GT, he elaborated on some of those ‘technical details’; particularly in his rejoinders to B.Ohlin, D.H.Robertson and J.R.Hicks concerning their criticisms on the liquidity preference theory, he came to elaborate, in a paper published in the Economic Journal in June 1937, a new motive for the demand for liquidity, the ‘finance motive’. The bank, he wrote, provides the firms, willing to invest, with cash which does not employ any existing savings: But ‘finance’ has nothing to do with saving. At the ‘financial’ stage of the proceedings no net saving has taken place on anyone’s part, just as there has been no net investment. ‘Finance’ and ‘commitments to finance’ are mere credit and debit book entries, which allow entrepreneurs to go ahead with assurance. Keynes 1971d:209 Following renewed criticisms from Ohlin, Robertson and Hawtrey, a second paper appeared in December 1937. Then, in September 1939, Keynes came to the subject once more. He maintained broadly the same line of argument. In spite of his critics, he defended the idea that finance, which is provided to the firms through credit lines, is really a revolving fund: As soon as it is ‘used’ in the sense of being expended, the lack of liquidity is automatically made good and the readiness to become temporarily unliquid [from banks’ point of view] is available to be used over again. Finance covering the interregnum is, to use a phrase employed by bankers in a more limited context, necessarily ‘self-liquidating’ for the community taken as a whole at the end of the interim period. p. 219 But then, how could the cash provided in this way be ‘self-liquidating’? Is not any expense, incurred through a new production, followed by the formation of an investment and an equivalent saving? It is not possible that the situation of the banks could remain unchanged: I cannot see that any revolving fund is released, any willingness to undergo illiquidity set free for further employment, by the act of the borrowing

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entrepreneur in spending his loan. The bank has become a debtor to other entrepreneurs, workpeople etc. instead of to the borrowing entrepreneur, that is all. The borrowing entrepreneur remains a debtor to the bank: and the bank’s assets have not been altered in amount or in liquidity. Robertson 1971:228–9 This criticism from Robertson is undoubtedly well-founded; however it does overshoot its target on one important point. Without going thoroughly into the details of the controversy, let us consider a specific point that Keynes raised in his first paper. It is possible, then, that confusion has arisen between credit in the sense of ‘finance’, credit in the sense of ‘bank loans’ and credit in the sense of ‘saving’. I have not attempted to deal here with the second. It should be observed that a confusion between the first and last would be one between a flow and a stock. Credit, in the sense of ‘finance’, looks after a flow of investment. Keynes 1971d:209 He used this same argument against Robertson: A large part of the outstanding confusion is due, I think, to Mr Robertson’s thinking of ‘finance’ as consisting in bank loans; whereas in the article under discussion I introduced this term to mean the cash temporarily held by entrepreneurs to provide against the outgoings in respect of an impending new activity. p. 229 And indeed, referring to the debt of the banks passed on from the entrepreneur to other entrepreneurs and to the employees, Robertson overlooked an essential ‘technical detail’. The cash provided by the banks to the firms has not the same nature before and after the real payments: the investment, which here means financing a new production, is a flow which results in the building up of a stock, both investment and saving at the same time. The cash created by the banks is immediately taken on by the deposit of the (new) incomes created in the production. It is only in this sense that the finance provided by the banks is immediately made good, through the banks themselves as a matter of fact, as soon as the spending has occurred. ‘The “finance”, or cash, which is tied up in the interval between planning and execution, is released in due course after it has been paid out in the shape of income, whether the recipients save it or spend it’ (p. 233). The ‘finance motive’ allowed Keynes to analyse the monetary conditions of production. The income payments by the firm are flows which are not taken from any existing stock or capital: it is a money creation. And this onward flow in—which is also simultaneously a flow out, the unilateral liability

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incurred by the banks being balanced accordingly —results in the building up of a stock, the households’ savings, which, from the firms point of view, is also an investment. How could the analysis of inflation benefit from the ‘finance motive’? Let us recall that the analysis coming from the quantitativist quarter, which Keynes and the Keynesians are not really able to escape from, is trying to measure the inflationary gap through the comparison of two stocks, the stock of goods and the stock of money. The problem is that the stock of goods cannot possibly be measured independently from money. Any variation in the quantity of money affects the measure of the quantity of goods so that aggregate supply and demand are always in equilibrium. Taking into account the flows preceding the existence of the stocks opens a new area for research. Indeed it is logically possible to conceive of a gap inside the sphere of the flows: the disequilibrium would appear within the money creation, whose result, identically supply and demand, would have then two different measures, one defined in ‘constant’ money and the other one in ‘current’ money. Now, is not such a proposal in full accordance with the profit inflation analysed by Keynes in his Treatise? If the development of the revolution which Keynes brought in the analysis of money and income, in the GT and ‘after’, seemed, at first, to repeal the profit inflation, it finally appears as a condition of an accurate exposition of the inflation phenomenon. The ‘true state’ of inflation does not occur when there is an excess in the quantity of money while full employment is reached, but whenever the flux of remunerations, which defines the measure of the goods—measuring both aggregate supply and demand identically—includes the spending of profits formed in a previous period: in this instance, the firms are able to buy investment goods which, although included in the measure of the product, are nevertheless not available for sale to the public, thus creating a gap between current supply and demand. NOTES 1 2 3 4

On this question see Rattagi 1994. Keynes 1971c, p. 34. Cf. Weintraub 1979, p. 231–47. ‘Myrdalian ex ante language would have saved the General Theory from describing the flow of investment and the flow of saving as identically, tautologically equal, and within the same discourse, treating their equality as a condition which may, or not, be fulfilled’ (Shackle 1989, p. 51). 5 Keynes 1973, pp. 74–6. 6 Cf. ibid., pp. 37–45. 7 ‘In any money economy, the production of goods and services can be conceptualised as being sold via a forward market, since contractual commitments for hire and forward delivery are always undertaken by someone before production begins’ (Davidson 1991, p. 88).

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8 Although some economists doubt that it is necessary to avoid inflation systematically, seemingly its consequences are not all negative; see Phelps 1985.

Part III LEARNING FROM THE PAST

5 THE MARX-HAYEK CYCLE AND THE DEMISE OF OFFICIAL KEYNESIANISM Meghnad Desai

INTRODUCTION The problems of inflation and unemployment have remained with economists for the last thirty five years but they change in their form. In the heady days of the Phillips Curve, economists thought in terms of trade-off between inflation and unemployment, but the levels of these variables were rather modest—inflation of about 5 per cent at most and unemployment of 2 per cent, or at worst 2 per cent. Since the oil shock we have spiralled upwards. Today in OECD countries we are speaking of unemployment of 10–12 per cent and inflation, after having gone up to 25 per cent, is now back down in many countries at below 5 per cent. Even so, governments are unwilling to reflate their economies to reduce unemployment lest inflation should flare up. In France the franc fort policy has been the topic of debate in the Presidential elections and the prospect of a single European currency promises further deflation on the way to convergence. Keynesian policies, which used to be the standard response, have been abandoned in all countries. Perhaps the USA should be thought of as an exception, but here it is the monetary policy of the FED and the benign neglect of the dollar in foreign exchange markets which has brought unemployment down to 5.5 per cent. In all European countries Keynesianism has been abandoned. Is this a matter of ideology or are there ‘real’ forces behind this switch? It is this question that I wish to tackle and I do it by looking at the work of Hayek and Marx in relation to Keynes. In this chapter I want to attempt a broad application of Hayek’s theory of the cycle to recent events. By recent I mean the course of the capitalist economy in the years since the mid-1960s. I wish to set up a framework that can encompass the success of the Keynesian Revolution as well as its decline. Of all his contemporaries it is Keynes who had a particular meaning for Hayek and it is as the anti-Keynesian par excellence that Hayek is known among economists today. The course of the post-Keynesian capitalist economy, say 1973 onwards, can be understood as a working out of a Hayekian cycle. Whereas the stagflation of the

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1970s defeated the Keynesian policy maker, it vindicated, forty years after their first appearance, Hayek’s writings on the cycle. But it will be also my contention in this chapter that while Hayek comes into his own after the oil shock of 1973, his theory cannot and did not explain the reasons why the Keynesian Golden Period came to an end. Here we need Marx’s theory. Marx is one author whom Hayek despite his vast range and deep erudition never ‘took on’. His critique of socialism concentrated on minor figures such as Saint Simon and Otto Neurath. Nor have Marxists had any truck with Austrians in recent years, again not taking them on in an explicit critique. Historically of course, Marxists and Austrian economists co-existed in BöhmBawerk’s seminar, to which Rudolf Hilferding, Rosa Luxemburg and Nikolas Bukharin went at various times. This is not the occasion for a critique of Austrians from a Marxist perspective or vice versa. Indeed my belief is that once the dust settles on the crumbled Leninist edifice, there will be much fruitful exchange between economists of all persuasions but especially between Austrians and Marxists. Hayek and Marx have much to learn from each other and much that they would recognise as familiar in the work of the other—the complex discussion of heterogeneity of capital, the disequilibrium nature of capitalism, the centrality of the business cycle for the rejuvenation (reproduction) of capitalism, the peculiarity of money and credit under capitalism, the importance of unintended consequences of human actions and so on. In what follows, I wish to synthesise the business cycle theories of Marx and Hayek to provide an explanation of the course of advanced capitalism since the war. The starting date can be any time after 1945 and the end date can be anywhere after the recession of the early 1980s. But it is a long cycle I wish to explain. I shall not construct an econometric model but carry along a rough picture of the major variables I need—unemployment, inflation, interest rates. The perspective is global rather than national though I shall refer to some British data that are better known to me. In what follows I give a brief sketch of Marx’s theory of the cycle and a slightly longer one of Hayek’s theory. Then I relate the course of the global economy in the period 1960–90 to a synthetic version of the two theories. In brief, Marx’s theory explains why the Keynesian Golden Period ended and Hayek’s theory explains the stagflation of the 1970s and the restructuring of capitalism during the 1980s. MARX'S THEORY OF THE CYCLE Marx was perhaps the first economist to treat the phenomenon of the trade cycle —a ten year long phenomenon for him—with seriousness. Indeed he is the first ‘classical’ economist who sought to make the trade cycle an integral part of his theory of capitalism. Although Juglar had written his book on the cycles in 1862, he had no serious analysis to offer (Juglar 1862). J.S.Mill was aware of the

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likelihood of a general depression of the economy but cycles do not figure prominently in his scheme of things. Tooke was gathering much data in this period and Marx of course respected Tooke a lot. But as a theorist of the cycle, Marx has to be regarded as the pioneer, bar none. In the writings published during his lifetime (a small proportion of his total oeuvre), it is in Capital, Vol. I, Part VII, that Marx offers his theory of the cycle as part of the General Law of Capital Accumulation. Here the cycle is explained by the movements in the rate of profit. As accumulation proceeds, the Reserve Army of labour gets steadily smaller. This puts an upward pressure on wages. In the one-good model of Capital, Vol. I, there is no problem of price/value transformation, so we can take the rise in real wages as a rise in variable capital. In the absence of any dramatic changes in productivity, the ratio of surplus value to variable capital (s/v) or equivalently (but, beware, only in the one-good case, not generally) the ratio of non-wage income to wage income falls. The rate of profit, p, is calculated on the total capital advanced, i.e. constant capital, c, plus variable capital. By a simple piece of algebra Eqn 5.1 Here r is the rate of surplus value and g is the organic composition of capital or the ratio of constant to variable capital. In the boom, r falls as wage pressure rises. At a certain stage, capitalists seek to restore their profit rate by raising the productivity of labour. They do this by replacing labour by fixed capital. Thus the ratio g goes up with some positive effect on r due to (1) depression of wages (2) raising the productivity of capital. This leads to high unemployment which starts the next phase. Later, Marx added to and (in my opinion) considerably confused this simple and elegant argument. In the last chapter of Capital, Vol. II he put forward a Scheme for Expanded Reproduction which demonstrated in a two-good model the probability of cycle-free growth.1 In Capital, Vol. III, Marx did not so much discuss the cycle as the long-run tendency of the rate of profit to fall. Thus even if an endogenous reaction to a fall in the profit rate sets off a cycle, Marx thought that such an attempt may fail. This was hedged about with many qualifications. The controversy about Marx’s theory of the cycle is unending. For our purposes it suffices to stick to the theory in Vol. 1. This is above all a parsimonious model and concentrates on the basic variables such as the wage/ productivity ratio, the capital—labour ratio (more or less) and the profit rate. It has also been elegantly formalised by Richard Goodwin in his Festschrift essay for (appropriately enough) Maurice Dobb. In ‘A Growth Cycle’, Goodwin puts forward a model in terms of modern national income accounting variables. He takes the share of labour in total income as one of the two basic variables. He starts with a Phillips Curve in real wages with the proportion of labour force employed (v in his notation) as determining the rate of growth of real wages . The difference between and the growth of labour productivity equals the rate of growth of labour’s share in total income But the level of labour’s

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share gives us the level of non-labour income and, dividing by the capital/income ratio, the rate of profit. (Note that in Goodwin’s definition capital is only fixed capital; Marx would add the wage bill.) If all profits are invested, then the growth of output equals the rate of growth of capital, which equals the rate of profit. But as labour productivity may also grow, the growth of employment is the difference between output and productivity growth. Now if we assume constant growth rates for the labour force ( ) and for labour productivity ( ) and a constant value for the capital income (y) output ratio ( ) Goodwin’s model is complete. Eqn 5.2 Eqn 5.3 In this model, the long-run equilibrium is a constant rate of profit [( + )] and a constant proportion of labour force employed (the ‘Natural Rate’) [( + )/ ]. But this long run is never reached. Instead, the economy cycles perpetually round and round this equilibrium. The length of the cycle (L) depends on the parameters in the following way: but it is a long rather than a short cycle (Atkinson 1969; Desai 1984a). Thus without imposing a falling rate of profit, Goodwin produces a Marxian cycle from the interaction in the labour market (the real wage Phillips Curve) and accumulation behaviour. There is of course no learning in this model and capitalists accumulate all profits without regard to the phase of the cycle. But despite these simplifications, Goodwin has captured the Marxian cycle.2 In the Marx-Goodwin model neither money nor credit plays any role. Marx did integrate money and production in earlier parts of Capital, Vol. II though not in his controversial scheme for Expanded Reproduction. In Capital, Vol. III there is some discussion of the conflict between rentiers and capitalists and ideas on fictitious capital and credit booms. But there is no fully integrated model of money and capital which would lead to endogenous cycles (Panico 1983). This is indeed exactly what Hayek attempted over a period of nearly twenty years between 1925 and 1945. HAYEK'S THEORY Hayek took his inspiration from Böhm-Bawerk and Wicksell and Walras. He attempted to build a general equilibrium (GE) scheme following Walras but adding money and heterogenous capital. Since the Walrasian model did not generate cycles, Hayek explicitly set about to improve upon it by accepting the logic of GE but expanding it by correcting its omissions. In GE, only relative prices mattered, thus money had to act on the economy not in some quantitytheoretic story of the aggregate price level but via its effect on relative prices. Hayek developed a suggestion of Mises that it was the maldistribution of bank

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credit as between the consumption goods producers and the capital goods producers which triggered off the boom. He combined this idea with the Austrian capital theory notion of the period of production. Hayek surveyed but found inadequate the then existing theories of the trade cycle in his Monetary Theory and the Trade Cycle (1929/1933). He then advanced his own theory in Prices and Production (1931). This led to much discussion among younger economists such as Shackle, Hicks and Nurkse. Hayek however faced bewilderment on the part of older colleagues, especially those in Cambridge. Sraffa criticised him severely but Hayek defended his position (see Desai 1982 for a discussion and bibliography). In the early 1930s, he developed his ideas further. But as soon as The General Theory appeared, economists began to find Hayek’s theory over-elaborate. Kaldor, a star pupil of Hayek, went into direct opposition. When Hayek came to retell his story of the trade cycle in 1939 in Profit, Interest and Investment, his efforts met with much hostility. He was thought to have changed his mind completely and done a 180° turn. His first explanation in Prices and Production was thought to contradict the later one in Profit, Interest and Investment. In any case Keynes had provided a novel revolutionary way of doing economics. Hayek’s theory involved many complications such as heterogeneous capital, stages of production, and price gradients. In The General Theory, capital as a stock was for the most part taken as given; the only stock that mattered was money. Output could be taken as homogeneous and prices also seemed to play a minor role. Production was a problem-free process; the focus was on the demand side. Hayek’s theory of over-investment seemed bizarre as an explanation of the world of the 1930s (see Desai 1991 for a discussion of Kaldor’s critique of Hayek). Hayek was not being inconsistent as between Prices and Production and Profit, Interest and Investment; he did however change his exposition. In the first book he took his readers through the somewhat esoteric Austrian capital theory by means of a triangular diagram representing the structure of production. He had assumed a variable actual (money) rate of interest and initially at least thought that he had no money illusion in the wage bargain (he was dissuaded from this by Sraffa’s critique). The economy in Prices and Production started at full employment and then for some reason or another a gap opened up between the natural and the actual rate of interest. Hayek took a lowering of the actual rate of interest at which the banks offered loans to be the initial ‘shock’. This led to the initiation of projects with a longer period of production than hitherto feasible. But due to full employment this leads to a wage explosion as workers are bid away from their old jobs to the new ‘production line’. Although Hayek does not make it explicit, it is best to think of a Hayekian economy as a fully integrated firm producing the single consumption good. Within this firm there are ‘divisions’ at various stages of production and supply prices of semi-finished goods to the next stage are in an equilibrium gradient determined mainly by the rate of interest. Now the new production line starts at

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the earliest stages and cannot produce consumer goods till it comes to the end of its (longer) production period. In the meantime, it is bidding resources away from the old production line, thereby reducing the supply of consumer goods. Thus prices rise as well as wages and there is forced saving, i.e. wages lag behind prices. The credit line continues to feed the new production industry but at some stage banks run out of reserves or there is a gold outflow. Panic ensues. The interest rate rises sharply. But at the higher interest rate the new production line is no longer feasible so it is abandoned in its half-complete stage. The old production line cannot however immediately absorb the extra workers. The abandoned halfprocessed goods (capital) of the new production line are of no use to the old production line; capital is heterogeneous. So there is excess capacity in the new, now abandoned, line and capacity shortage in the old line. The unemployed labour can only be absorbed slowly as the old industry builds up capital in the form of half-processed inputs. Reflation will not help because the problem is not a lack of demand but a shortage of supply. There has been mal-investment and its effects can only be slowly eliminated from the system. This somewhat condensed version of Hayek’s theory brings out three features —the importance of sectoral allocation of bank credit, the price-wage nexus and the structure of production (see Desai and Redfern 1994 for an analytical presentation). In Hayek’s model, there is no substitutability between the intermediate inputs of the new and the old production line. There is also no explicit theory of why banks grant loans to the new and not the old productionline entrepreneurs. But the combination of these elements leads to a sharp rise in interest rates when panic strikes, and the false boom has to be paid for by a long depression (though Hayek would not admit that label) while the economy gets back to equilibrium. In Profit, Interest and Investment, partly to adapt his message to the new Keynesian fashion, Hayek admitted sticky money wages, began the cycle with unemployment rather than full employment, flirted with concepts of the accelerator (as he labelled the Keynesian multiplier) and explicitly mentioned the profit rate instead of the natural rate.3 There is less emphasis on the Austrian capital-theoretic elements. While all these changes confused people, the basic elements of the theory are the same in Prices and Production and Profit, Interest and Investment (see Desai 1991 for a synthesis of the two models). The workers are by and large passive in Hayek’s scheme of things. In Prices and Production he does mention that one reason for the end of the false boom may be a desire on the part of the workers to recoup their lost position by restoring the previous real wage. But the basic ‘struggle’ is between the bankers and the producers. The cycle is started off as a false boom fed by cheap credit and is ended when bankers lose their nerve and stop the supply of cheap credit. There has been little attempt to formalise Hayek’s theory.4 Thus it is hard to say what is the implied cycle length. Hayek would perhaps regard any attempt at answering such a quantitative question as anathema. But since it is based on new

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investment coming into actual production, the Hayek cycle is a long one, ten to fifteen years rather than two to three. RECENT ECONOMIC HISTORY AS A MARX-HAYEK CYCLE There are clear parallels between the two models of the cycle. If we take Hayek’s hint in Profit, Interest and Investment and interpret the natural rate of interest as the rate of profit then the Marx-Goodwin model and Hayek’s Profit, Interest and Investment version have parallels. In the Marx-Goodwin model, the equilibrium profit rate is constant while the actual profit rate traces out a cycle; in Hayek’s model, the natural rate is constant but it is the distance between it and the fluctuating actual rate of interest which causes a cycle. The Marx-Goodwin model has no money illusion in the wage bargain but the capitalists’ behaviour in reinvesting all profits without regard to actual profitability is rather mechanical. In Hayek’s scheme it is the banks’ lending behaviour that is mechanistic; how one set of producers end up with all the credit on promise (implicitly) of higher expected profits, leaving the businesses in existence high and dry is never fully explained. In Prices and Production there is a lot of detail about the structure of capital, and especially in the theory’s Profit, Interest and Investment version it would be easy to suspect, if one was not familiar with Austrian capital theory, that Hayek’s was a two-sector model. It is of course the model of a vertically integrated economy in traverse to being supplanted by another vertically integrated economy which has more sectors, i.e. a longer period of production.5 But it is not my purpose here to carry out a synthetic critique of the two models. I wish to demonstrate in a broad quantitative way though without constructing an explicit model that the course of advanced capitalism is explained by the Marx-Hayek models. These are the broad stylised facts of the period which I seek to explain: 1 There was a combination of high, full or over-full (net immigration of foreign labour) employment in the period 1950–75 with a period of low (3 to 4 per cent) inflation in the 1950s and even early 1960s accelerating towards but not quite reaching a double digit inflation level and a passive monetary policy designed to keep interest rates relatively low until the mid-1970s. 2 The course of the economy reversed in the 1975–90 period, with high unemployment levels (double if not treble the average of the earlier period), an acceleration of inflation after the quadrupling of oil prices, and a reassertion of monetary policy and the deliberate engineering of a severe recession in 1980–81. 3 A side effect of the quadrupling of oil prices was the easy availability of credit from the western banks, which lowered interest rates well below the newly-risen rate of inflation. Much of this credit went to the Third World; it was only after the second oil price rise in 1979 and the hardening of

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monetary policy in the adoption of Monetarist policies which raised the rate of interest into double figures and brought about the Third World Debt crisis. Another way to characterise the period is to say that official Keynesianism ruled in the Golden Age up to 1975; it fought a battle against resurgent Monetarism during the 1970s and lost. Monetarism was dominant for a brief period, say 1979–85 in Anglo-Saxon countries at least, as an official policy. We have now entered a period of doctrinal truce where officially governments are neither Keynesian nor Monetarist but inflation has priority everywhere above unemployment and interest rates persist above inflation rates (in Western Europe in contrast to the USA substantially so). But we are moving into a period of fixed and managed exchange rates in the face of a volatile global financial market; there is much cooperation between Central Banks and a resolve to guide rather than follow the market as far as exchange rates are concerned. Why did Keynesianism decline? I wish to argue that in the late 1960s/ early 1970s advanced capitalist economies faced a crisis of profitability: the rate of profit began to move down and in some views, dangerously so. This happened before the oil price rise of 1973, which added high inflation to the conjunctural problem of declining profit rates. This combination forced the Western economies eventually to abandon Keynesian demand management and adjust to restore profitability in a Marx-Goodwin fashion but along an elongated Hayekian path. Let us look at the evidence. The complaints about inflation were muted during the 1950s, coming mainly from unreconstructed right wing economists in the USA and West Germany. The Keynesians were blasé about this attack but there had already begun among the Keynesians a search for an explanation of inflation. Arthur Brown’s book The Great Inflation (1955) covered the period 1939–51 and sought an explanation in various directions. It was this that inspired A.W.Phillips to put forward his explanation in the now famous 1958 article. The recession of 1957–8 was the first time that inflation had persisted despite higher unemployment in the USA. This was indeed even at that time a cause for invoking Hayek’s name as someone who had predicted stagflation. But the appearance of the Phillips paper was seized upon by Samuelson and Solow in their 1960 AEA paper The Analytics of Anti-inflationary Policy as the ‘Keynesian’ explanation for the missing link in the official Keynesian model. As the 1960s wore on, the Phillips Curve failed to provide a satisfactory policy tool. The political economy of advanced capitalism with universal franchise, powerful trade unions and frequent elections made it costly for any political party to pursue the logic of the Phillips Curve too far by creating high unemployment. A rise in unemployment which now looks moderate (as in the UK in 1971 to 1 million) was thought to be critical. Stories of trade union power were woven into the Phillips Curve in a quasi-Marxist interpretation. There was a widespread debate on the shifts in the Phillips Curve and about its instability.

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In econometric explanation variables were added as were equations to contain the problem of accelerating inflation within the Phillips Curve (Hines 1964). The two strands that remained unreconciled to Keynesianism were Chicago (encompassing as somewhat disaffected fellow travellers the neo-Austrians) and Marxists. Some Marxists were even beginning to come to terms with the Keynesian success and modify some of their earlier disbelief (Mandel 1964:56– 67). Other Marxists remain unreconciled (Mattick 1969). The breakthrough came however in 1970 from an empirical investigation into the course of profitability from a Marxist perspective. It is to the credit of Andrew Glyn and Robert Sutcliffe that in 1969, well before the OPEC crisis, they analysed the inflationary problem in terms of reduced profitability as a result of workers’ power (Glyn and Sutcliffe 1971 and later as a book 1972). There is no evidence that Glyn and Sutcliffe (hereinafter GS) were aware of Goodwin’s 1967 paper. Their investigation was factual rather than econometric. Others had looked at the same data but GS interpreted them in a different model. Profitability has no role to play in Keynesian models (although it did begin to appear in some Cambridge Growth Models at this time) and there had been no attempt to interpret the course of wages and prices in terms of their implications for profitability. But GS provided evidence that profitability was going down in many advanced capitalist countries through the 1960s. This was later confirmed by Nordhaus in his 1974 Brookings paper. But GS had no fool-proof theoretical scheme. As usual, other Marxists disagreed with them. But in the light of Goodwin’s model, it made perfect sense. As full employment persisted through the 1950s and the 1960s, the money wage bargain had become an implicit real wage bargain (the coefficient of the inflation term in the wage equation becoming not significantly different from unity). What is more, the workers were obtaining real wage increases in excess of productivity growth; the share of labour in total income was going up. Here was a problem that the official or indeed any other school of Keynesianism had not worried about. Profits play no role in The General Theory although one could interpret the Marginal Efficiency of Capital and the Aggregate Supply Price as embodying some role of long-run and short-run profitability respectively. Some Keynesians influenced by Kalecki worried about profits being too high due to oligopolistic powers but the prospect of low profitability causing a decline in employment was until the late 1960s not entertained by Keynesianism. This is why the Keynesian policy reaction was to plump for tax cut/investment subsidies (USA Kennedy-Johnson Policy) or devaluation (UK 1967, USA 1971). In the context of a fully employed economy, neither was a long-run answer; tax cuts and investment subsidies had to be financed either by a tax on wage incomes (through indirect taxes or regressivity in direct taxes) or by a fiscal deficit which either raised interest rates if fully funded or added to purchasing power and hence inflation or a trade deficit if financed by money creation (this holds only at full employment). The context of

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electoral politics made overtly regressive taxation unpalatable and inflation was becoming a workers’ complaint as much as that of bankers by the late 1960s. But within the political economy of advanced capitalism, i.e. given the implicit post-1945 social contract of full employment, universal adult franchise, competitive elections and trade union rights, the recourse to higher unemployment was impossible. Incomes policies—a class compromise—were tried in many countries but failed eventually to tackle the problem (Sweden and Austria were exceptions). The Marx-Goodwin path of restoring profitability via higher unemployment seemed politically not feasible. Thus the sharp turning point from full employment to less than full employment was not witnessed in the early 1970s when profitability had begun to decline. The quadrupling of the price of oil marked a structural break. It affected profitability adversely in the advanced capitalist countries and deindustrialisation began to be feared as capital quit advanced economies in search for higher profits in the Third World (the multinational form of capital helped here). Official Keynesianism responded to this by an expansion of the public sector through the 1970s to maintain high employment levels. Incomes policies became central to the reconciling of inflation and employment targets, but with the exodus of capital abroad the real private economy was shrinking. The Fiscal Crisis of the state, in James O’Connor’s catchy title, had arrived (O’Connor 1973). Official Keynesianism had not been aware of the problem that the private profit-making economy could constitute a limit on the size of the public nonprofit-making sector. The formula for the multiplier assumed a sufficiently large productive economy. The distinction between productive and nonproductive labour familiar to classical and Marxist economists has no substance in Keynesianism. Nor, moreover, does it bother neoclassical economists. They looked upon the problem as crowding out, budget deficits creating excess money growth and the impossibility of running the economy at a level of unemployment below the Natural Rate without incurring runaway inflation. By ignoring the role of the oil price rise, the Monetarists were able to blame the inflation solely on domestic money creation. Through the 1970s, the Monetarists pressed the Keynesians about the nature of inflation, the viability of an inflation-unemployment trade-off and the effects of public expenditure on the private economy. While the theoretical ground was never fully conceded by the Keynesians, in policy matters the Monetarists had come to rule the roost by the late 1970s. In 1979, the Federal Reserve Board adopted monetary targets at about the same time as the victory of Mrs Thatcher in the British elections. It was in this period, 1973–9, that Hayek’s name rebounded from polite obscurity to international guru status. The award of the Nobel Prize (jointly with Gunnar Myrdal), his publications from the Institute of Economic Affairs, his acknowledged influence on Mrs Thatcher meant that Hayek was going to be a potent influence on economic policy.

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The Hayek cycle is different from that implied by Monetarism. Friedman’s 1968 AEA Presidential Address contains implicitly a cycle in inflation and unemployment but it is not and has never to my knowledge been made explicit. There is especially a great vagueness in Friedman’s cycle about what causes the upper turning point. Friedman also treats the half loop to the left of the long run Phillips Curve symmetrically with that to the right. Hayek’s theory, by contrast, implies that a downswing will take quite a bit longer than the upswing since a lot of distortions have to be shaken out of the economy. The turning point arrived in 1979 with the adoption of Monetarist policies, but in the UK at least the perspective was Hayekian. Unemployment, which was caused by the adoption of Monetarist policies, was not only much higher than any experienced previously but as late as 1983 during the General Election the government discouraged hope of any immediate reflation. They took the view that the downturn would just have to take as long as was necessary to generate ‘real’ jobs (this resolve weakened on the eve of the 1987 election and Mr Lawson engineered a Keynesian boom, but that is a separate story). Hayek’s influence did not eliminate the political business cycle; it merely stretched it across two elections. In the USA, the recovery from the recession was engineered by a flagrant deficit spending boom disguised as a supply side miracle. Hayek had less impact there compared to the UK or West Germany. The sharp rise in interest rates in 1979–80 corresponded perfectly to the turning point Hayek had predicted in Prices and Production and Profit, Interest and Investment. It came after the second oil price rise rather than the first; it came not due to loss of reserves but due to the continued rise in budget deficits through the latter half of the 1970s. The crisis was manifest in the foreign exchange markets. The collapse of the pound-dollar rate in August 1976 brought the IMF and some form of monetary discipline to the UK and provides the date for the demise of official Keynesianism (‘The Party is Over’ as Tony Crosland put it, reflected also in Callaghan’s famous speech to the Labour Party Conference saying we cannot spend our way out of a recession). For the USA it was the parallel collapse of the dollar in the last year of the Carter administration which pressed home the Monetarist lesson. Through the 1980s there was a remarkably parallel effort in many advanced capitalist countries at restoring profitability while recovering from the deepest postwar recession. Instead of relying merely on the high unemployment, structural reforms—such as deregulation, privatisation, altering the legal prerogatives of the trade union movement, weakening the income transfer mechanism, implementing tax cuts to the benefit of the better off—were put through. It was the perestroika of capitalism. The old social contract of the New Deal/Keynes-Beveridge welfare capitalism was unilaterally rewritten by governments. The commitment to full employment was dropped. It was as a result of these efforts that the actual profit rate was restored; the technical progress in telecommunications and electronics may have even raised the equilibrium profit rate.

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But while the 1979–80 turning point, which doubled if not tripled the nominal interest rate, came in classic Hayekian fashion in the advanced capitalist countries, the full course of a Hayekian pattern was felt in the Third World. Recall that the Hayekian boom is not caused by public spending or budget deficits (though he adapted his theory to these Keynesian facts) but by commercial banks and their loan policies. The initial shock which started off this process was left unspecified by Hayek. But the OPEC price rise in October 1973 gave the perfect starting point. Commercial banks in the West found themselves with surplus petrodollar liquidity which they had to loan out. The nominal interest rate fell sharply. The demand for loans came not so much from the private capital in advanced countries, as it was relocating in the Third World anyway. It came from Third World governments and parastatals with or without collaboration from Western multinationals. These loans were for long term projects, many in connection with oil exploration or seeking alternative energy sources, projects which had not been feasible at previous interest rates or at the previous oil prices. The expected profits were large although these projects were likely to take long. Other projects such as the development of the Amazon River region in Brazil would have been equally inconceivable if the interest rates had been high. Vast amounts of loans were made by the banks to the Third World, all ostensibly for commercially viable projects. A Hayekian boom was set off; the Third World did not suffer from the low growth rate and stagflation during 1974– 9 as did the developed countries. The aggregate demand effects of these loans were favourable. But it was the sudden raising of the interest rates in 1979–80 which brought the boom to an abrupt end. Despite a second rise in the oil price, many oil-oriented projects had to be abandoned. Debt servicing charges became so high that they were unpaid and cumulated into higher debts. The Third World Debt crisis had arrived. The resolution of the debt crisis has taken more than ten years and the end is not yet. Third World countries which incurred these debts mainly in Latin America and Africa had a decade of depression to correct for about five or six years of boom. The debt overhang has affected the creditor banks as well and a lot of the debt has been sold off through debt-equity swaps at ludicrously low prices. The cycle, whose course started in 1974 but which is not yet complete, is the most classic illustration of what Hayek was talking about in Prices and Production and Profit, Interest and Investment. This is of course no consolation to the suffering groups in these countries—but then economics was never a kind master. SOME ANALYTICAL SUMMING UP The Marx-Goodwin cycle predicts that sooner or later high profitability gives over to low profitability via the effects of high employment on the wage bargain. This happened by the late 1960s/early 1970s everywhere in the advanced capitalist countries. There followed a hiatus during 1973–9 when official

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Keynesianism tried to tackle the problem of inflation but did not see it as a problem of restoring profitability. The many attempts at providing high levels of employment while keeping inflation low failed because thereby the decline in profitability was not reversed. Unemployment rose though not much over this transitional period. But official Keynesianism suffered a body blow from which it has not recovered. The delayed turning point when it came in 1979 took a Hayekian form of a sharp increase in interest rates leading to a deep recession which was engineered as part of a deliberate policy to restore profitability (improve competitiveness). High unemployment was allowed to persist, in Western Europe more so than in the USA, while competitiveness improved. Economic recovery in Western Europe could only be dated from the mid- 1980s and in the case of the UK at least it was premature in Hayekian terms. Profitability has been restored in the UK as the Bank of England data show, though not to the previous high levels of the early 1960s. The cycle of easy borrowing and later difficult repayment which has lasted since 1974 in the Third World is a connected aspect of the Hayekian cycle but it is not fully interpreted with the cycle in the West. There has been no restoration in profitability and the downturn has been long and severe. NOTES 1 The publication of this volume in 1884 led to a long controversy among Marxists as to how to reconcile Vol. II with Vol. I. (See Rosa Luxemburg (1913/1951) for a survey.) 2 [There have been many extensions and amendments. See Desai (1973) and the papers in Goodwin, Kruger and Vercelli (1984) and Stone (1990).] 3 In one of his rare references to Marx, Hayek says that had Marx not given the profit rate such a bad name, no one would have needed the label ‘natural rate of interest’. See Profit, Interest and Investment (1939), page 4, footnote 1. 4 A very early but not persuasive attempt was made by R.G.D.Allen in his short appendix to Evan Durbin’s book Problems of Credit Policy (1935). 5 Pasinetti’s classic work (1973) on vertically integrated economies may be of help in clarifying Hayek’s dynamics.

6 UNEMPLOYMENT AND PRICE STABILITY Aspects of the Marshallian legacy on the monetary economy Peter Groenewegen It should be noted at the outset of this chapter that the criticisms Keynes (1973:XXII–XXIII, 292–3) made of what he called ‘classical economics’ in terms of a classical dichotomy between real economy and monetary economy, or the theory of money and the theory of value, are difficult to apply to the upholders of the Marshallian Cambridge tradition discussed in this chapter, that is, Robertson, Keynes and Marshall himself. It needs equally to be emphasised that this proposition does not necessarily apply to other, sometimes self-styled, upholders of the Marshallian tradition, of which Pigou is undoubtedly the major, but not the only, example. Especially from the sixth edition onwards when it became a single, self-standing volume of foundations, Marshall’s Principles (volume 1 of an initially projected two volume treatise)1 was very clear in its warnings that virtually all of its conclusions were to be taken as provisional. This provisional nature arose from the fact that the treatment in that volume largely left out highly pertinent aspects of money, credit, international trade, government action, market combinations and so on (Marshall 1961: esp. XII–XIII, 593–5, 722). This is the real sense in which Marshall’s Principles constitutes unfinished business. Keynes himself appears to have appreciated this facet of his master’s work (Keynes 1973:XXIX) though with rather few exceptions it since then has been ignored even when aspects of the Marshallian heritage of Maynard Keynes are explicitly being analysed. Negishi (1985) is one of the more important exceptions to this tendency2 of mis-reading Marshall.3 ‘Unlike Walras, Marshall did not dichotomise his system into an abstract moneyless system and monetary system. Money does exist from the beginning, though its purchasing power is assumed to be constant when relative prices are considered’ (Negishi 1985:170, cf. p. 174).4 Negishi (1985: 170–3) based this finding on his interpretation of the Walrasian position, with its emphasis on ‘nonmonetary’ tatônnement in market clearing, combined with insufficient stress on the ‘store of value’ function of money, of which Walras, however, is less guilty than some of his followers (for example, Patinkin 1956, to use Negishi’s example). Although aspects of Negishi’s argument on this are somewhat controversial, the main thrust of his conclusion, that Marshall was more aware of the dangers in the classical dichotomy than many of his contemporaries, stands firm. This is perhaps explicable in terms of Marshall’s

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natural sense of caution; it is also very clearly implied in one of his favourite mottoes, ‘the many in the one, the one in the many’.6 Negishi (1985:174–6) illustrates the argument more positively by outlining his version of Marshall’s ‘monetary’ theory of the trade cycle. There it is argued Marshall’s theory is that of a monetary economy, in which the changes in the purchasing power of money have real consequences inducing, for example, changes in capital market transactions, in output and in employment, and hence also on relative prices. The trade cycle was first briefly analysed by Marshall in Economics of Industry (Marshall and Marshall 1879:150–7), reiterated in his evidence prepared for Royal Commissions (Marshall 1926: esp. 7–10) and, perhaps most importantly, partly reproduced in the later editions of the Principles (Marshall 1961:595–6, 710–11, 714–16) to highlight the provisional nature of the conclusions predicated in that work. Negishi (1985:178–81, cf. his chapter 2, esp. 18–22) likewise indicates that despite the close resemblance of Marshall’s temporary equilibrium prices in the corn market (Marshall 1961:332– 6) to Walrasian tatônnement prices (cf. Kregel 1992), there is a difference partly from the consciousness by which Marshall stressed his constancy of marginal utility of money income assumption which at one stage splashes over into considerations of the credit market (Marshall 1961:334–5 and n.1). This difference becomes greater when firms are brought into play. Marshall’s firms do not perceive the perfectly elastic demand curve of Walrasian perfect competition, assuming any quantity can be sold at a given price. They are limited by their own market. Marshall used this property of his firms particularly in his solution to the ‘Courtnot problem’, arguing that for ‘trades in which the economies of production on a large scale are of first rate importance, marketing is difficult’, hence firms are likely to find in this situation that ‘this particular demand curve for their own special market [is] very steep, perhaps as steep as [their] own supply curve…’ (Marshall 1961: 458). Marshall’s unquenchable thirst for realism implied a reluctance to engage in abstractions of a perfectly competitive world with neutral money. Moreover, money was also Marshall’s measuring rod for use in decisionmaking in any realistic economic situation. Money not only acted as a measure of the ‘force of a person’s motives’ in either securing a ‘desirable satisfaction’ or ‘undergoing a certain fatigue’ (Marshall 1961:15), it was crucial for aggregating heterogeneous production costs which, relative to revenue flows, determined entrepreneurial decisions about levels of eco nomic activity and production. For Marshall, such aggregation was always done in money terms (Marshall 1961: 359–62). This is the real justification for Marshall’s provisional assumption that the purchasing power of money should be taken as constant for much of the argument in the Principles. It thereby also provides the explanation why results based on this generally unwarranted assumption, given the regularity of business fluctuations Marshall consciously observed over his lifetime, could only be seen as equally ‘provisional’. Emphasis on the crucial measuring role of money in facilitating economic decision-making in consumption and production also

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underlies much of his interest in securing means to approximate price stability for the decision-maker. This chapter does not address the wider issues raised in Marshall’s nonWalrasian economics. Instead, its first section presents a discussion of Marshall’s extensive concerns with the monetary economy in his published writings from the 1870s onwards, linking them specifically with issues of price stability and unemployment. It then examines the notions of ‘monetary economy’ embodied in the early (that is, largely pre-1930) work of Robertson and post-1926 work of Keynes, and its associations with price stability and unemployment. A final section draws some brief conclusions from this excursus into Cambridge monetary history. MARSHALL AND THE MONETARY ECONOMY Marshall’s first interest in economic studies coincided with the period of depression following the 1866 financial crisis. He subsequently witnessed regular depressions of trade during the 1870s, 1880s and 1890s and hence accepted Lord Overstone’s views that these were aspects of ‘an established cycle’ in which confidence and prosperity generated over-trading and speculation, convulsion and crisis, followed by distress (Marshall and Marshall 1879:153).7 Subsequently, Marshall’s rather few preserved observations on the various manifestations of this phenomenon of industrial capitalism were largely made in the context of Royal Commissions. They took the form of submissions and oral evidence for the currency commissions of the 1880s. When, in the early 1890s, he himself was a member of a Royal Commission, that on labour (Groenewegen 1994b), Marshall reported in some detail on the irregularity of employment as part of the Commission’s final summary of the evidence it had heard. Marshall’s early interest in the topic can be gauged from the annotations he made to his copy of Mill’s Principles,8 the first book he claimed to have read on economics. From Mill’s Book III, in which his thoughts on money and crises are largely contained, Marshall would have become quickly familiar with midnineteenth century mainstream opinion on cycles and monetary theory. Mill’s treatment was all the more useful because of his tendency in the Principles to present both sides of the argument in a sympathetic manner. This is visible in his treatment of the currency/ banking school controversy and of the question whether general over-production or deficient demand was a real possibility, as Malthus, Sismondi and Chalmers had maintained against Say, James Mill and Ricardo. The support in this context which J.S.Mill gave to Say’s Law was breached by his qualifications to this proposition. More particularly, Marshall would have learnt from Mill that money in general could only be seen as a veil. After prices had adjusted to changes in the quantity of money and exchanges were conducted on the basis that money was only a counter, the significance of a monetary economy as against ‘barter’ became almost nugatory. However, changes in money and credit did affect the volume of transactions through the

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redistributional impact which accompanied the change in the price level. This effect was implicitly confined to the short run. Although Hume’s prognosis of potential monetary effects on real activity levels was criticised by Mill, he did admit income effects from price-changes through what he described as ‘zero-sum’ redistributional transfers. A monetary economy did therefore have significant effects on transaction levels in the short run, before changes in money supply and credit yielded a ‘general and permanent rise of price’ (Mill 1865:334). However, business fluctuations were explicitly associated with a credit economy. Moreover, Mill implicitly admitted that the existence of competitive markets by themselves could not solve the problem of crisis and depression: some official credit management through the Bank of England appeared desirable.9 The manner in which Marshall had learnt his Millian lessons is visible in his treatment of changes in the purchasing power of money in Economics of Industry (Marshall and Marshall 1879, Book III, chapter 1).10 Although Marshall indicated that a full treatment of this subject belonged to a projected companion volume (Economics of Trade and Finance), money induced changes were an important ‘short period’ explanation of the deviation of market prices from what he then called normal, competitive values, thereby indicating that an unchanged purchasing power of money assumption was only appropriate to long-run analysis. This chapter also provides Marshall’s only systematic account of the cycle in print,11 and demonstrates the significance he ascribed to the monetary economy for causing alterations in activity and employment levels via the effect changes in money and credit had on price levels. The actual mechanism of Marshall’s credit cycle has been relatively frequently described (for example, Hansen 1951:270–6; Wolfe 1956: 82–94; Eshag 1963: 77–84; Bridel 1987:48–51; Laidler 1990:58–61). Although these discussions all emphasise the monetary nature of Marshall’s analysis, they highlight different features of the cyclical mechanism which Marshall presented. Marshall’s account of the cumulative nature of the credit cycle in both its upswing and downswing phases is standard classical theory, including the explanation he gave for the crisis in terms of the growing awareness of experienced lenders about the danger signs in a credit boom which ultimately triggered some spectacular failure through a refusal to renew loans to an over-extended speculative borrower (Marshall and Marshall 1879:152–3). In his summary of Marshall’s theory, Eshag emphasises Marshall’s attribution of the beginning of a credit cycle to good harvests.12 He also mentions Marshall’s emphasis on the interdependence of industries in the process through creating additional markets for each other’s products and the uneven impact of cyclical change on different industries, with producers of fixed capital prone to greater fluctuations in demand than those of consumer goods, causing different rates of price changes as between wages, raw materials and finished commodities. Bridel (1987:49) stressed points in Marshall’s account which later became important in discussions of the 1920s and 1930s. Those were its implicit emphasis on hoarding, because people in some of the phases of the cycle have the power to

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purchase but choose not to exercise it; the variations in output and employment which accompany the credit cycle; and, third, the rigidity in money wages relative to commodity prices which gives a counter-cyclical pattern to real wages over the course of the cycle. Above all, Bridel (1987:50–1) stressed the short term nature of Marshall’s analysis, arguing that when normal, competitive values rule, the errors of anticipation by economic agents, and by other destroyers of business confidence in the process are effectively eliminated by definition. Wolfe (1956) and Laidler (1990) emphasise the price instability aspects of Marshall’s account with Laidler (1990:59) focusing on the wage stickiness postulate as an ‘explanation of fluctuations of real income and employment’. Marshall’s account of the credit cycle also confirmed the validity of Say’s Law in the version J.S.Mill used to combat the ‘fallacy’ of over-production. However, Marshall qualified this by indicating that the power to purchase created by the income generated from new production (supply) need not always be exercised and, in general, would not invariably be exercised once ‘confidence was shaken’ in the context of a financial crisis. Hoarding at this stage is a reality of economic behaviour so that for this phase of the cycle at least, Say’s Law breaks down. A number of observations can be made on this aspect of Marshall’s discussion of the cycle. First, Marshall never used Mill’s argument against the possibility of general excess supply which pointed to the fact that a situation of excess supply in all commodities implies a shortage of money and general purchasing power. Second, Marshall’s adherence to Say’s Law in 1879 had weakened as compared to earlier in the 1870s when, at one stage, he dogmatically appealed to the ‘familiar economic axiom that a man purchases labour and commodities with that part of his income which he saves just as much as he does with that which he is said to spend’ (Marshall and Marshall 1879:32). Third, later work associated with Royal Commissions did much to elucidate his notion of speculative hoarding in the wider context of the demand for money. This subject had been left rather undeveloped in the 1879 treatment, where it was largely treated as a reluctance to invest in a lower confidence business climate where demand and returns were considered too low (Marshall and Marshall 1879:154–5). Considerations like these indicate the evolving nature of Marshall’s thought on the subject, a matter not always sufficiently, or adequately, taken into account in the discussions of his cycle theory.13 Marshall had been regularly lecturing on these topics at Bristol, and previously at Cambridge, and his interest in the problem of low activity and employment was undoubtedly maintained because of the hardship this imposed on workers and their families. A paper on continuity of employment, its effects on workers and its remediable causes, provided the next public opportunity for Marshall to raise the issue of business fluctuations, albeit in a rather unsystematic way. After describing the ‘want of employment’ as a ‘terrible evil’, Marshall included among its causes some unpreventable ones like bad harvests; some, like wars, ‘outside our scope’ and some, ‘like new inventions…which we should not wish to remedy’ (Marshall 1885:175–6). Remediable causes he summed up as those

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arising from insufficient information or from fluctuations in demand generated by changing fashions. In the context of inadequate information as a cause, Marshall was particularly anxious to remedy excessive speculation during a boom by the diffusion of sound information about the real prospects for particular investments, combining this with active moral suasion against the evils of gambling in business, or unwarranted speculation. More cautiously, he wished to establish a committee of experts to forecast industrial ‘storms’ and, more generally, ‘trade weather’ conditions, to use his metaphors. Most importantly, he desired official government publication of information on changes in the purchasing power of gold, combined with government assistance to facilitate fixed-units-of-purchasing-power contracts to safe-guard the public against redistributive consequences of fluctuations in the price level, thereby removing a major source of business uncertainty (Marshall 1885:77–81). This, together with a proposal for a more flexible Bank of England approach to normal cash reserve limits in order to steady the money market more effectively in periods of crisis, reiterated the monetary aspects underlying fluctuations in trade and employment for Marshall at this stage. The next two years saw a concentrated effort by Marshall in emphasising remedial action to mitigate instability in activity and employment levels. The first came in the answers he provided in early 1886 to a set of questions on currency and prices circulated by the Royal Commission on the Depression of Trade and Industry. In his answers, Marshall supplied the Commission with a ‘law of hoarding’ of metals, which related rising hoards to rising metal prices and vice versa, behaviour based on the price expecta tions generated from past experience in the market. In the context of his 1879 association of price and trade fluctuations, the answers also reflected on the relative merits of price rises against price falls, in which the first were described as conducive to keeping industry better employed, while the second induced better spending habits in the working classes because ‘they think themselves worse off than they are’ (Marshall 1926:9). However, steady and small price changes in either direction were much to be preferred to ‘violent fluctuations of prices’, the last warranting the remedy of a tabular standard of value by which to fix contracts at constant prices to remove uncertainty in transactions from changing money values, the remedy Marshall had proposed in outline in 1885. In addition, to enable greater Bank of England flexibility in cash reserve limits for stabilising credit flows, Marshall proposed a system of ‘symmetallism’ which, by introducing gold and silver in fixed combinations as the official reserve for the note issue, mitigated the effective currency contractions imposed by increasing world gold shortages from the early 1870s. This placed issues of price stability at the centre of the stage for mitigating business fluctuations and their associated losses of employment. A systematic presentation of these proposals for dealing with price fluctuations as a means to stabilise trade and employment provided the contents of Marshall’s first contribution to the Political Economy Club (February 1887) to which he had been elected in June 1886. The paper was published the following

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March in the Contemporary Review. It ascribed the evils of price instability to the false signals imparted by nominal prices, particularly bad in periods of rapid price rises. In such periods, real interest rates can become very low or even negative, and real wage changes are disguised for the wage earner, imparting uncertainty to contracts and inducing perverse reactions in the credit and labour markets. Price rises generate further price rises by the encouragement they give to purchase in order to beat the expected price rises, a process facilitated by the availability of cheap credit from low real interest rates. Price rises in addition inflate profits, because wages lag behind commodity prices in the upswing, carrying further artificial stimulus to activity and employment levels. On the other hand, when prices are falling, real wages rise, encouraging reduced employment from lower production since employers by lowering supply, help to improve the market for their own goods. Such a strategy, when universally applied, Marshall warned in full awareness of the fallacy of composition involved, diminished work for every one and destroyed everybody’s market. Hence price instability cumulatively worsened fluctuations in trade and employment in both upswing and downswing. Price instability is therefore to be deplored not because it causes the cycle but because it greatly aggravates its adverse consequences (Marshall 1887 [1925]:189–92). This diagnosis made it important for Marshall to press his remedy for price fluctuations through a more flexible currency regime enabled by his symmetallist proposal and, failing that, to safeguard business transactions including wage contracts from the impact of price changes by his tabular standard (indexation) proposal, thereby mitigating the excesses of the cycle.14 The Royal Commission on the Depression of Trade had recommended a similar form of inquiry into gold and silver prices because it had been left with unresolved monetary issues from its deliberations. This enabled Marshall to revisit the problem of price stability, employment and business fluctuations and to sort out questions, previously left in abeyance. These included the issue of money neutrality and the validity of the quantity theory of money. Together with other problems, these were canvassed in the preliminary memorandum he submitted to the Commission in November 1887, on which he was questioned during the following months. Both submission and evidence show Marshall’s continued adherence to the remedies for price instability he had proposed earlier that year, that is, his symmetallist proposal and tabular standard project (Marshall 1926:30–6, 101–15) because of his continuing belief in the association between price instability and size of the amplitude of the cycle in business activity. However, his evidence looked more closely at the causes of price instability, and particularly the influence thereon of money and credit. This shows Marshall as critical of the accepted opinion on the quantity theory and on the rationale for hoarding. On the former, Marshall accepted the ‘common doctrine that prices generally rise, other things being equal, in proportion to the volume of the metals which are used as currency, [but] …changes in the other things which are taken as equal are very often, perhaps generally, more important than the

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changes in the volumes of the precious metals’ (Marshall 1926:34, cf. Keynes 1971b, II:49). For once, these things were comprehensively listed in a document Marshall prepared for the Commission, but which does not seem to have been published by it: The quantity theory…admits that the general level of prices is affected by many causes besides the quantity of currency. We have to take account of (i) the volume of currency; (ii) population, (iii) the amount of goods produced per head of population, and their wealth generally; (iv) the amount of business to which any given amount of wealth gives rise; (v) the proportion of these payments that are made for currency; (vi) the average rapidity of circulation of the currency (and under this head provision may be made for the locking up of money in hoards, in bank cellars, military chests, etc); (vii) the state of commercial and political confidence, enterprise, and credit; and this last head might be again divided. (The influence of cost of production shows itself in the amount of the metals available for currency purposes; and the anticipation of a change in the cost of production is among the many causes which determine the amount of hoarding.) Now, since the general level of prices is determined by all these seven elements acting together, it is quite possible that one or more of them may be tending to move general prices in one direction, while yet the net result of all the forces acting on prices is to move them in the other. I do not then regard the theory as leading us to expect that an increase in the amount of currency would always or even generally cause a rise in prices, but only that it will cause prices to be higher than they otherwise would have been if all other changes of the time had gone on as they have done, but the volume of currency had not increased. For instance, a change in the proportion of business which is done for currency may exert as great an influence on general prices as a large addition to the volume of the currency. And, if it were true that a diminution in volume of the currency immediately called forth an increased use of cheques, clearing-house certificates, etc., then, indeed, the net effect on general prices might be very slight and very slow. But there is no evidence that this is the case. On the contrary, history seems to show that the periods in which banking facilities of various kinds have increased most rapidly have been those in which the metallic currency has been increasing in volume and not those in which it has been diminishing. And when the matter is closely examined, it will, I think, be found that this historical result is just what might have been expected a priori. The most potent in practice, and the most troublesome in theory, of all the causes which may affect general prices are movements of general confidence, enterprise, and credit. They are the creatures of opinion. And the prevalence of the opinion that a fall in the gold price of silver will lower

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prices may certainly cause such a fall, when it occurs, to check confidence, enterprise, and credit, and may thus somewhat lower the average level of prices. Marshall 1888:3 This passage shows the somewhat heterodox nature of Marshall’s views on the determinants of the price level and, among other things, likewise suggests the interdependence of real and monetary phenomena necessary for understanding the complexity of any actual situation. More particularly, it suggests that the interdependence of ‘general prices [and]…movements in general confidence, enterprise and credit’ are the most troublesome for accepted doctrine. Furthermore, the note explains Marshall’s views on hoarding, which likewise were far from conventional, and, more generally, the problems inherent in simple generalisations about the demand for money in the community. As to hoarding, Marshall categorically stated that, ‘I do not admit what many people say, that anybody who hoards must be foolish, and that there are not likely to be many people foolish enough to hoard who can afford to do it’ (Marshall 1926:59)15. Marshall’s development in his evidence of the process by which an influx of money stimulated economic activity by an initial reduction of the discount rate, and how this gradually raised prices and subsequently, the discount rate, is too well known to need discussion here (see Marshall 1926, e.g.: 49–52; Eshag 1963: 8–12; Bridel 1987:36–44; Laidler 1990:48–50). Features of this analysis which do need some stress are two, both dealing with what Marshall saw as the long run, ‘permanent’ outcomes of this process. First, ‘the average rate of discount permanently is determined by the average level of interest rates in my opinion, and that is determined exclusively by the profitability of business, gold and silver merely acting as counters with regard to it’ (Marshall 1926:41, cf. 51–2). Second, Marshall was very coy about admitting a proportional impact on prices from a change in the quantity of money, because the other things which needed to be kept equal, were never equal. Anticipating Friedman’s helicopters, Marshall indicated that only if ‘a postman could go round and distribute to everybody the increased currency straight off, then I think that would in a primitive state of society act upon prices directly’ (Marshall 1926:45, my italics). Marshall’s reference to a ‘primitive society’ in this context suggests the credit cycle was for him a historically relative phenomenon, implicitly applicable only to advanced industrial societies with developed credit systems. Such relativity is also explicitly ascribed to the phenomenon of unemployment which Marshall associated with a specific stage of industrial development (Marshall 1926:92–3). Earlier (Marshall and Marshall 1879: 155), attention had been drawn to the different impact of falling prices during a trade depression on the self-employed operating without large capital investments and modern manufacturing, foreshadowing to some extent the contrasts between co-operative production and modern industry made by Robertson and Keynes during the 1920s and 1930s (discussed in the next section). Unemployment was also associated with falling

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prices by Marshall, because such a climate increased business risks and hence plant closures as compared to periods when prices were rising. However, previous situations of rising prices eventually worsened the situation by attracting less skilled persons into business, and reducing incentives to productive improvements which a more competitive business climate provided. Hence, rising prices created the potential for subsequent business failure on a larger scale, particularly when this trend was reversed and prices started to fall (Marshall 1926:90–2). In this evidence Marshall also associated unemployment with the credit cycle via the price instability this generated. The Final Report of the Royal Commission on Labour, with which Marshall was associated as one of its members, addressed irregularity of employment as part of its final review of the evidence. This review is interesting because Marshall privately claimed to have substantially prepared this section of the Report himself16 eventhough, as with all such publications, it had ultimately to be seen as a joint product. The report described three types of irregular employment: That associated with industrial fluctuations, or cyclical unemployment; chronic excess labour supply within a particular industry, or structural unemployment; and ‘ordinary vicissitudes of work in a normal state of trade’, or seasonal unemployment (Royal Commission on Labour 1894:73). Only the first is of interest in the context of this chapter. The discussion of the causes of trade fluctuations in the report reminds one greatly of Marshall’s 1879 discussion and its subsequent developments. The state of credit is signalled as a major cause; fluctuations in foreign trade are similarly identified, as are sudden shocks to demand from wars, crop failures and the imposition of new tariff barriers abroad. Industries most adversely affected by such fluctuations are in the capital goods sector, especially in shipbuilding, iron and steel, and coal; but the effects of such fluctuations are rapidly transmitted to other sectors of industry. Sudden changes in fashions (recall Marshall 1885) are also given some prominence (Royal Commission on Labour 1894:174). Remedies for the problem likewise reflect Marshall’s earlier thinking. Public provision of better information, including labour registries, is the major set of remedies. Public employment, except for highly productive purposes, was firmly rejected by the Commission as was, not surprisingly, the ‘socialist’ solution of organising all production and employment on collectivist lines.17 Equally unsurprisingly, the Commission therefore went no further in its recommendations on the subject than to suggest that consideration should be given to preparation of a counter-cyclical productive public works programme in which the Labour Department could give assistance (Royal Commission on Labour 1894:103).18 Given his lack of appreciation of the principle of effective demand, support for such policies did not make Marshall a Keynesian. This is very strikingly illustrated by Marshall’s questioning when fellow Labour Commissioner, Tom Mann, was in the witness box. This dealt with surplus population, the demand for labour and general demand in the economy as a whole. In a series of questions

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on whether reduced hours of work would raise employment and eliminate surplus population, the effects of this on aggregate demand were discussed, given the increased purchasing power additional employment would generate. When Mann initially admitted that this additional purchasing power for workers came from diminished profits, interest and rent as well as from ‘more efficient production’ (Q. 3,275), Marshall chose to describe this process not as an increase in demand but as a mere transfer of purchasing power, refusing to allow that some increase in demand could arise from new production inspired by the additional demand from newly employed workers. This exchange19 shows how much Marshall remained entrapped in the consequences of Say’s Law as he saw them (cf. Keynes 1973:258). In his mind, there was no prospect of additional demand from the increased employment through reduced working hours because this created no new output. Marshall’s analysis in the final chapter on progress of the Principles, substantially added from the fifth edition of 1907, briefly reiterated these views from his decades of thinking on fluctuations, price instability, unemployment and standards of comfort. A note on the lower wages following the introduction of the eight hour day in Australia (Marshall 1961:701 n.1, dating in part from material included in the 1895 third edition) indicates that some of these wage effects arose from ‘an over-sanguine estimate of the economic efficiency of short hours of labour’ as well as from ‘reckless inflation of credit’ and a ‘series of droughts’. This was perhaps a softening of his earlier denial of the possibility of such efficiency gains when questioning Mann. The chapter also discussed the effects of price instability on wages, in which matters of industrial fluctuations were raised on lines resembling his earlier views, already reported. Since the subject is raised in the context of a discussion of standardised wage levels (the ‘common rule’, as contemporary practice described it), Marshall’s introductory comments link excessive wage growth and increased employment at such wage levels to a credit inflation. ‘But very soon the inflation of credit subsides, and is followed by depression; prices fall, and the purchasing power of money rises; the real value of labour falls, and its money value falls faster’ (Marshall 1961:709). Substantial numbers of the labourers hired during the boom are dismissed, ‘production is checked, …thereby checking the demand of other branches of industry’. Marshall blamed overpayment of wages relative to the efficiency of those hired, a consequence of trade union policy on ‘standardised wages’. This exacerbated the employment effects of the cycle. Better adjustment of wages to efficiency levels, that is, a more flexible trade union attitude to the standardisation of wages, mitigates the problem. Marshall asserted by way of concluding this section on unemployment and wages that the only effective remedy for unemployment is a continuous adjustment of means to ends, in such a way that credit can be based on the solid foundation of fairly accurate forecasts; and that reckless inflation of credit

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—the chief cause of all economic malaise—may be kept within narrower limits. Marshall 1961:71020 The section itself concludes with the statement that want of confidence can effectively break the Say’s Law (Mill’s ‘principle’) nexus between production and demand, by inducing some people to refrain from exercising their power to purchase, particularly in the financing of investment. Gradual revival of confidence, generally beginning in the consumer goods section, spreads cumulatively to all sectors, including eventually the capital goods sector, and a new upswing of activity gets underway. A footnote attacking underconsumptionist thought (Marshall 1961:711 n.1) argues that ‘in times of depression the disorganisation of consumption is a contributory cause to the continuance of the disorganisation of credit and production. But a remedy is not to be got by a study of consumption, as has been alleged by some hasty writers.’ Admitting the cycle was a real and recurring phenomenon, associated with shifts in confidence, credit policy and the organisation of production, was as far as Marshall ventured in his Principles, though this, he also reminded readers (Marshall 1961:710), was not the place to argue the matter in detail. The matter was in fact never fully argued by Marshall. Book IV of Money, Credit and Commerce (1923), which promised to deal with business fluctuations and unemployment in a systematic way, never did so and in general failed to transcend Marshall’s work on these subjects from earlier decades. In fact, much of its content reproduced such earlier work and Marshall himself may have had little to do with part of its composition (cf. Groenewegen 1995, chapter 19). A single innovation in its contents is the emphasis given to the internationalisation of the phenomenon (Marshall 1923:251–3 and cf. 236). For Marshall, the topic remained therefore among many items of unfinished business in economics. Notes on the subject preserved in the Marshall Archive suggest that what would have been written in the book, had Marshall had the mental power to do so, would have derived from the work of some of his students, rather than have inspired them.21 The discussion in this section portrays Marshall’s concern with the monetary economy in some of his published writings concerning the credit cycle, particularly in connection with the associated problems of price fluctuations and unemployment. Some special features of this, admittedly incomplete, analysis need to be highlighted. Over the short run, money is seen as not neutral and fluctuations in its value over the course of the credit cycle affect decision-making by entrepreneurs with respect to investment and employment, often in an exaggerated manner, because of the misleading information such changes in the value of money help to convey. Hence short run in the monetary context appears to be different from that with respect to supply. Moreover, as Goodwin (1982: 17) recalled, for Marshall ‘the short period is very much shorter for expansions than for contractions’. Greater price stability, Marshall argued, will mitigate the

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amplitude in output and employment fluctuations over the cycle, and is therefore a policy target to be aimed at, either to be achieved through appropriate flexible monetary policy or, if this fails, by securing a facility for fixed real price contracts through the indexation mechanism of a tabular standard. The cycle itself is not a purely monetary phenomenon; but its amplitude is exacerbated by credit fluctuations. Its causes derive from a variety of real factors, which provide sudden shocks to the system (harvest failures, war, and so on). Moreover, the credit cycle, and the associated ‘irregularity’ of employment, are phenomena only observable in advanced industrial societies, operating via the profit motive and in a framework where decisions to produce and offer employment are made by individual entrepreneurs. These features of the credit cycle, as can now be shown, were part of Marshall’s legacy on the subject to some of his Cambridge students. THE MONETARY ECONOMY IN ROBERTSON AND KEYNES The works of Marshall’s students of specific concern to this chapter are as follows. The first are Dennis Robertson’s A Study of Industrial Fluctuations and its sequel, Banking Policy and the Price Level; the second are Keynes’s Treatise of Money and aspects of the transition therefrom, as indicated by early surviving drafts of The General Theory (Robertson 1915, 1926 [1949]; Keynes 1971b, 1979). The focus of this discussion is not a reinterpretation of these substantial and difficult works; it is merely to examine their contents with respect to the assumptions they make about the nature of the economic system they deal with when analysing the credit cycle and, in that context, to examine remarks made about the appropriateness of price stability and its association with securing output growth and increased employment. This will enable some demonstration of the use these authors made of this aspect of Marshall’s legacy.22 Robertson’s Industrial Fluctuations presents a theory of the general trade cycle in combination with a discussion of output fluctuations in individual industries. Its emphasis is on real factors, organised in true Marshallian fashion around phenomena of supply and demand in the latter, and to a lesser extent even in the first.23 The discussion of general trade fluctuations is likewise conducted on some rather specific assumptions. Robertson’s starting point is to abstract from ‘the existence in modern industry of a monetary mechanism and a system of wage labour’ (Robertson 1915:121), thereby explicitly recognising the association between the phenomenon of cycles and these essential features of modern industrial society. Elsewhere the book argues that some of its argument does not depend on the ‘existence of a monetary economy’ (Robertson 1915:13 n.1), a strategy designed to stress the real considerations in cycle theory relating to the role of investment and to deny the proposition advanced by others that cycles were essentially a monetary phenomenon (211–12).

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Towards the end of the book, these assumptions are relaxed (Robertson 1915: 206). Introducing the capitalist entrepreneur into the argument produces the result that the scale of production is likely to be smaller when such entrepreneurs make the decisions (as compared with the outcomes of the decision-making process by co-operative units of workers) and that, in addition, there is an asymmetry in the control which entrepreneurs exercise over their workers’ labour effort. They cannot easily make them work harder but they can prevent them from obtaining employment through their control over the means of production (Robertson 1915:209– 11). Likewise, a monetary system enhances the amplitude of the cycle. In the boom, an influx of money comes via the banking system and in the first instance increases the financial resources of entrepreneurs; the fact that money wages lag behind prices at this stage (‘now so generally admitted as scarcely to require detailed illustration’, Robertson 1915: 215) further pushes resources into entrepreneurial hands, hence encouraging strong, if not excessive, investment. During the weeks or months of crisis, tight money, caused by greater demand for money balances to accommodate higher prices combined with a need to finance higher wage bills—although accompanied by higher discount rates and sometimes a refusal to give credit on any terms—makes its influence felt on economic activity in two ways. The first, and less conspicuous, effect is its tendency to lower prices, particularly for manufactured consumer goods. A second ‘and more dramatic effect’ is curtailment of customary business credit for financing current operations, inducing a general restriction of production with different impacts on different industries.24 The subsequent period of depression generates more falling prices assisted by currency changes and an increased flow of goods for sale as firms try to gain cash flow. These falling prices redistribute income from profits to wages, thereby reinforcing entrepreneurial incentives to restrict output and employment. Robertson’s theory is critical of Marshall’s on a number of points (for example, Robertson 1915:226 n.3, 228) but most importantly, it is critical of Marshall’s policy preference in the context of business fluctuations: The desirability of stable prices to improve business decision-making and avoid the extremities of outcomes during boom, crisis and depression. Robertson (1915: 243, 244), to the contrary, explicitly argues that ‘it is by no means clear that steadiness of prices is desirable’ or that ‘a stable market [can] be secured by means of a stable price [level]’. In fact, on his argument about the nature of the cycle, price rises are vital for securing an investment boom in essential construction goods, so that a little inflation has to be seen as a good thing.25 A decade after the publication of Industrial Fluctuations, Robertson (1926 [1949]) returned to the analysis of the subject, giving greater emphasis to issues of banking policy and monetary aspects of the cycle. The new book repeated his criticism of conventional thinking on stabilisation policy objectives (output stability via price stability) on the ground that both some inflation and some output instability was essential for satisfactory long term economic development (Robertson 1926 [1949]:viii, 26, 31, 32). The very sophisticated and complex

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arguments on saving—investment and banking policy (Robertson 1926 [1949]: chapters 5, 6) need not be gone into in any detail. The point to stress for the purpose of this argument is that Robertson maintained the method of dealing explicitly with conditions pertaining to a monetary economy and that, from the point of view of comprehensively analysing fluctuations in output and prices, that monetary economy needed to be a capitalist, entrepreneurial economy as well (Robertson 1926 [1949]:ix, x, 19). This is not surprising, since the bulk of the new book was an explicit restatement of the older one (Robertson 1926 [1949]: 5), though the restated analysis was considerably condensed and sharpened. In his discussion of the assumptions, Robertson indicated that, in a capitalist system, optimum output is an ambiguous term since worker and entrepreneurial preferences may vary as to their desired output levels. Second, reactions of the monetary system to output/productivity changes imply various possible outcomes, of which price rises are preferred by Robertson because they provide a more direct stimulus to output growth than falling or stable prices. By its reactions to real changes such as a rise in productivity in a particular industry, the monetary system therefore influences price, output and employment outcomes. Since output fluctuations are exaggerated under conditions of modern industry which tend to be capital intensive, the role of the modern banking system in capital formation needs to be carefully explored in any realistic analysis of output fluctuations. Price level changes, to put it in another way, are essential to bring saving and investment into the necessary relationship required by output growth, a result difficult to attain when price changes in themselves alter the needs for capital and saving in a monetary economy. The last point is explained as follows. Price rises entail positive investment in circulating capital to preserve its real value; price rises induce a lengthening of the period of production by making the holding of stocks more attractive, hence requiring more investment. Moreover, the additional demand for finished output which stock building implies, generates capacity constraints and hence a desire for investment to increase productive capacity. Monetary factors therefore intertwine with the real mechanisms, disturbing the balance between saving and investment and generating output fluctuations as investment and savings in turn exceed each other. Cyclical fluctuations are in this way part and parcel of the monetary economy organised on modern, capitalist lines. The impossibility of a banking system to provide industry with the ‘right quantity of circulating capital and also to keep the price level unchanged’ was the novel proposition of the analysis, as was the argument that when the necessary price changes are admitted, these changes induce ‘stresses which are not beneficial’ (D.H.Robertson to Keynes, May 1925, in Keynes 1971c:32–3). The association between price level and output fluctuations and their impact on saving and investment is another way of presenting the novel part in Robertson’s analysis and the one that Keynes particularly admired at the time they discussed the book during the proof stages. Some of it ‘is very interesting and new and important’ Keynes wrote to Lydia Lopokova in May 1925 (Hill and

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Keynes 1989:332), though it had taken time and considerable argument for Keynes to reach that position on his friend’s book.26 Over the subsequent years, that initial reaction altered somewhat. In the Treatise (Keynes 1971b, I:293–302) and not long thereafter (Keynes to Robertson, 6 October 1931; 22 March 1932; in Keynes 1971c:272–3, 275–89) Keynes became rather more critical of aspects of what he had called ‘Dennis’s egg’, though nevertheless continuing to appreciate its pioneering contributions on the subject (Keynes 1971b, I:171–5, II: 101). Despite this fact, much of the analysis of the credit cycle in the Treatise resembles Robertson’s analysis in Banking Policy and the Price Level, although there are differences in emphasis and in theoretical apparatus. Profit inflation, from wages (and other costs) lagging behind prices over part of the boom, plays a crucial role in Keynes’s story, though there is less emphasis on ‘forced savings’ than in Robertson’s account. The natural rate of interest is therefore also given greater emphasis relative to the rate of discount, reflecting disparities between investment and saving which, on the basis of the fundamental equations, explain the existence or absence of a profit inflation. Price level variations are thereby linked to output and employment variations via profit effects and savings-investment imbalances (Keynes 1971b, esp. chapters 18–20). Many of these elements, it may be recalled, were present in Marshall’s account of the credit cycle, though not in a systematically developed argument. The analysis of the Treatise likewise relied in general on the existence of a modern capitalist society, characterised by enterprise and a modern monetary system essential for its operations. This is most strikingly demonstrated at the start of Keynes’s historical illustration of the Treatise theory, where enterprise is seen as crucial, and is linked directly to ‘expectations of profit’ combined with the ability of entrepreneurs to gain access to the resources necessary for them to be able to exploit the situation. The last, Keynes argued, ‘almost entirely depends on the behaviour of the banking and the monetary system’ (Keynes 1971b, II:149). The links in the theoretical system of the credit cycle are also clearly explained. Increased output depends on adequate working capital; output rapidly contracts if there is surplus liquid capital. ‘An important factor of instability is thus introduced into our economic life’ from the fact that industry is ‘extraordinarily sensitive to any excess or deficiency…in the flow of available output ready to be fed back into the productive process’. If this flow is deficient, the means to full employment are absent; if it is in excess, the incentive to full employment is lacking. Price changes, by their impact on saving and investment, both have the ability to restore equilibrium and to explain the violence and rapidity of the slump or boom (Keynes 1971b, II:146–7, cf. I: 277–92, 302–4). An American lecture given in 1932 put the matter even more simply. Profits arise from the difference between sales proceeds and costs. Costs are factor payments, that is, wages, salaries, interest and rent, forms of income which are either spent on consumption or saved. Sales proceeds arise from spending on consumption goods and capital goods, that is, consumption and investment.

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Hence investment greater than saving, the equivalent of sales proceeds exceeding costs, raises profits to stimulate activity cumulatively. A slump arises when savings are greater than investment. This process also affects the prices of commodities, often differentially, so that comparisons of commodity inflation, income inflation and profit inflation are crucial parts of the overall analysis (Keynes 1971c: 352–3). Keynes’s development of these ideas increasingly brought him into conflict with Robertson, as is shown by their correspondence during the debates following publication of the Treatise. The manner in which this controversy gradually became enmeshed in definitional squabbles over saving and hoarding is not relevant to the discussion of this chapter. However, it coincided with Keynes’s development of a new book, drafts and outlines of which are extant from early 1932 and in which, initially, Keynes grappled with the notion of a monetary, enterprise economy, as the proper setting for a monetary theory of production and employment. From this, The General Theory of Employment, Interest and Money gradually emerged. Evaluating Keynes’s arguments on the relevance of such institutional foundations for explaining price and employment fluctuations in this preparatory material forms a fitting conclusion to this exploration of the development of this aspect of the Marshallian legacy by Robertson and Keynes. Early draft tables of content for The General Theory highlight the importance of the institutional facets of the problem in Keynes’s thinking in the aftermath of the Treatise. The earliest draft preserved is entitled ‘The Monetary Theory of Production’ and, in its introductory definitional book, clearly intended to deal with the importance of the ‘profit’ economy to explain investment, expenditure and output, adding a historical retrospect critical of the ‘classical’ or ‘orthodox’ view of the subject. A subsequent 1932 draft gave the title of ‘The Monetary Theory of Production’ to Book II (Book I is simply called ‘Introduction’, and was presumably intended to be brief). Its contents replicate the analysis of the ‘profit’ economy of the previous draft (Keynes 1979:49–50). A year later, a new preserved outline changed the title of the book to ‘The Monetary Theory of Employment’, with chapter 1 now to be devoted to ‘the Nature and significance of a Monetary Economy’ (with all explicit references to the ‘profit’ economy deleted from chapter headings but not from the argument —Keynes 1979:62–8). A subsequent outline, now called ‘The General Theory of Employment’, starts with chapters developing the nature and significance of the contrast between a co-operative and an entrepreneur economy, as well as a discussion of the characteristics of the latter.27 By December 1933, a new draft outline still stressed the distinction between co-operative and entrepreneur economy as an important distinction between the ‘classical’ and the ‘general’ theory of economics (Keynes 1971c:421) but by mid-1934 the emphasis is explicitly removed from the chapter headings though it may have been at that stage still intended to be part of the subject matter of the opening chapter, simply called ‘the general theory’. By that stage, the final title of the book had been decided as

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General Theory of Employment, Interest and Money (Keynes 1971c:423). The published version of the book (Keynes 1936 [1973]) retained only few explicit references to the subject of ‘non-monetary’, ‘monetary’ economy apart from the general remarks on the subject in the preface to which attention was drawn in the opening sentence of this chapter. However, the non-neutrality of money obviously remains an important part of the story. What were the characteristics of this distinction which Keynes thought so important in the initial stages of preparing The General Theory from the argument contained in the Treatise? The starting point was the importance of the ‘profit’ economy with money profits (cash flow?) a crucial attribute of a contemporary entrepreneurial economy. Much of this perspective came from the Treatise, though there was a shift from emphasising its association with price levels to stressing impacts on output and employment as clues to the inherent instability of the ‘profit’ economy (Keynes 1973:381–9, written circa 1932; Keynes 1979:511–17, dated 10 October 1932 and 14 November 1932 respectively). The later drafts concentrate on the distinction between effective labour supply price flexibility and capital supply price behaviour, associated by Keynes with the distinction between Pigou’s ‘real-wage’ economy and the monetary (entrepreneurial?) economy in which money rewards dominate markets and decisions. At this stage (14 November 1932), Keynes also associated these distinctions with short- and long-period positions, toying with the notion of describing the ‘classical’ (Marshall and Pigou) theory as a ‘special case, i.e. with a long-period position corresponding…to a particular assumed policy on the part of the monetary authority’ (Keynes 1979:54–5). By the end of 1932, these notions were therefore still in a considerable state of flux in Keynes’s thinking about what constituted a more general’ theory. By 1933, ‘monetary’, ‘entrepreneur’ (‘profit’) economies still dominated the analysis. ‘Barter economy’, perhaps better described, Keynes argued, as a’realwage’ or co-operative economy, was now associated with Ricardo and Marshall and argued to be essentially ‘neutral money economies’, that is, attempts to deal ‘with an entrepreneurial economy which is made to behave in the same way as a co-operative economy’ (Keynes 1979:63–8). By the end of 1933, these notions continued to be explored, with the classical perspective still identified with a real reward, ‘real-wage’ economy, or with the ‘neutral money’ approach in which money operated as a very useful medium of exchange but with no special qualities which defined its ‘moneyness’. At this stage, the neutral money economy of the ‘classics’ (Ricardo and Marshall) is also linked explicitly to Say’s Law. In addition, the distinction between co-operative and entrepreneur economy is described as bearing some relation to ‘pregnant’ observations of Marx28 (Keynes 1979: 76–83). By then, Keynes had also produced his well known contribution for the Spiethoff Festschrift on the monetary theory of production which, interestingly for the purpose of this chapter, ascribes the neutral monetary position explicitly to Marshall’s Principles via his assumption of holding the purchasing power of money constant for the purpose of its analysis29 (Keynes

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1971c:408–11). Reflecting the outlines of The General Theory for these years, Keynes’s Michaelmas lectures for 1932 and 1933 are titled The Monetary Theory of Production’ instead of ‘The Pure Theory of Money’, the title they had for 1929–30 (Keynes 1971c:411). The characteristics of the entrepreneur economy are given further detailed discussion in a draft chapter associated with the outline for the end of 1933. Firms (entrepreneurs) organise production, leasing fixed capital and hiring labour, but financing their own working capital, one of the reasons they need to be able to sell output as quickly as possible for cash to maintain their levels of operation. Investment (leasing of fixed capital) depends on expected cash flow—Keynes called this the primary entrepreneurial decision—only then will it be decided how much employment is offered, the second entrepreneurial decision. Classical theory, which concentrates on the individual firm, looks at the competitive process by which firms try to minimise capital and labour costs and attempt to gain the largest possible market share for selling their output. They ignore the aggregate consequences of the process, depending on aggregate costs, aggregate expenditures, and the potential for employment fluctuations when these aggregates fluctuate. Alternatively, the classical economists have invented procedures (‘aggregate expenditures and aggregate costs always keep step’; ‘chance causes operating to keep employment below full employment are counteracted’, Keynes 1979:91), which effectively turn an ‘entrepreneur’ (money) economy into a co-operative economy. Hoarding is one way by which the neutral, co-operative economy is disturbed. More importantly, aggregate costs and expenditures do not necessarily keep in step for labour and capital market reasons. Expected proceeds relative to costs based on real wages and capital costs determine the employment level, not real wages by themselves. A non-neutral economy becomes the economy based on effective demand. By assuming a co-operative or neutral economy, the classical theory assumes automatic full employment. It has no room for the ‘failure of organising’ which leaves ‘the marginal utility of output…greater than the marginal utility of effort’, that is, the situation of ‘chronic unemployment’ (Keynes 1979:97–9, 101–2). This is the manner in which the matter was ultimately presented in the opening chapters of The General Theory. The characteristics of the monetary economy were kept to a more special place in chapter 17 which defined the essential properties of interest and money, the theoretical foundation for the monetary theory of interest which, via its role in determining investment, sets limits to the level of employment (Keynes 1936 [1973]: 3–39, 222–40). The critique of classical economics (Ricardo, Marshall and Pigou) is therefore set initially in an institutional framework dealing with the modern, monetary enterprise economy, though the characteristics of that economy were not firmly established until relatively late in the construction of Keynes’s book and then really only discussed in the chapters on the classical postulates, on the essential properties of interest and money and in the subsequent chapters dealing with wages, prices and the quantity theory of money. Only then was money presented

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as the crucial ‘link between the present and future’ (Keynes:1936 [1973]:193–4) and are there references to the different possibilities for a free enterprise economy as compared with ‘command’ economies or socialist regimes (Keynes 1936 [1973]:267, 269). The notion of the monetary, enterprise economy was therefore gradually absorbed into the new theory and in the process these matters lost the sharpness of new discovery which Keynes intended to give them at first. Post- The General Theory correspondence with Dennis Robertson indicates that the road Keynes travelled to his The General Theory started from the discussions over Banking Policy and the Price Level, but that Keynes could never accept that ‘Marshall related it all to the Royal Commission in an affirmative sigh, that it had been well known to Pigou for years past and is to be found in a footnote to Industrial Fluctuations’ (Keynes 1971d: 94).30 But remnants stayed. The impossibility of perfect price stability ‘in an economy subject to change’ (Keynes 1936 [1973]:218) is straight Dennis Robertson, just as the asymmetry in periods of deflation and inflation between workers in relation to work (Keynes 1936 [1973]:291) is the mirror image of Dennis Robertson’s discussion of the asymmetry in the entrepreneur’s control over the ability to work of the labour force. Moreover, although Keynes was quite right in not wishing to accept that Marshall had said it all, Marshall had said a great deal, and more in fact than the references to Marshall in The General Theory indicate, sympathetic, at least relative to Pigou, though these references may be (cf. Groenewegen 1994a:31–4). CONCLUDING COMMENTS The conclusions which can be drawn from this account are relatively straightforward. There was a significant Marshallian heritage on the monetary economy, obfuscated though this was through the fact that the Principles became a volume of preliminary foundations and the companion volume on Money, Credit and Commerce failed to deliver anything new. The monetary aspects of Marshall’s explanation of the cycle, his acceptance of the short period breach of Say’s Law by the rationality he ascribed to hoarding; the ambivalent attitude to the quantity theory in the context of its stringent ceteris paribus clauses made a classical dichotomy difficult to sustain except as a very long-term, permanent position. Furthermore, the emphasis on the need for price stability to reduce the impact of the detrimental consequences from wrong decision-making during the cycle, together with the associated admission of real consequences from changes in prices for employment and output decisions, gave teeth to the warning the Principles contained about the provisional nature of its results in the absence of thorough treatment of monetary, credit and other factors not dealt with between its covers. These all point to Marshall’s awareness of the importance of the monetary economy and its special problems. However, as was also clearly stated in the first part of this chapter, little of this material was ever systematically elaborated, and even if it had been, it was certain to have stopped far short of the theoretical position Keynes eventually reached in The General Theory.

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That position had its own ambiguities and shortcoming, some partly induced by the compromises with the old doctrine some of his friends managed to persuade him to include over the four years the book was in preparation. Was this the case with the reduced explicit emphasis the monetary economy received in the final published version as compared with its promised treatment foreshadowed in the early tables of contents which survive? Preserved correspondence sheds little light on the process by which these aspects of the theoretical revolution Keynes wanted to make were dethroned from their initial pre-eminence, to resurface more obliquely in later chapters after receiving only faint recognition in the chapters of the introductory book. Yet, for many, the implications of the monetary, enterprise economy, for full employment and price stability, are what The General Theory is all about. This provides the real climate for the problems which Keynes sought to address by a drastic revision of the old theory. It was a path which Alfred Marshall, his ‘old master’, and some of his later Cambridge colleagues had also attempted to take. The extent to which Keynes was aware of these attempts during the early 1930s is perhaps one explanation for the background treatment The General Theory accorded this matter. Irrespective of this, a historical account of the Cambridge perspective on the nature of modern, monetary society assists to illuminate this aspect of the development of The General Theory and the role played therein by Robertson’s work of the 1920s. It likewise further clarified the ambiguous Marshallian roots in this process. The above also enables some brief observations on more contemporary matters. Marshall’s anti-inflation and pro-price stability stance, as the way for eliminating unemployment and cyclical instability, has returned to favour, especially in central banking circles. Dangers in such a policy of inflation first, to which the young Robertson was particularly alert, continue to be worth stressing. Likewise, the Marshallian perspective embodies elements signalled as important by the ‘New Keynesians’: frictions in the system, lapses from competition, the importance of good information, the hysteresis involved in groping for new equilibrium states. In this sense, the chapter shows how easily the old is reborn in modern, more sophisticated, dress and that new Keynesianism is nothing more than yet another manifestation of what Joan Robinson described as preKeynesian theory after Keynes. NOTES * In the preparation of this chapter, financial assistance from the Australian Research Council is gratefully acknowledged. In revising an earlier draft, I have been assisted with comments from Tony Aspromourgos, Robert Clower, Don Patinkin and Mathew Smith. I thank them for the suggested improvements; the remaining mistakes are my own.

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1 For a detailed account of the Marshallian project, see Whitaker (1990) and Groenewegen (1995: chapters 12 and 19). 2 Others include Davidson (1972 [1978]). 3 Milton Friedman’s (1949 [1953]: esp. 65–8) famous reading of the Marshallian demand curve is perhaps the most well known example of such a restrictive misreading of Marshall’s Principles; Pigou (1917 [1952]:163; 1927: esp. 118–21; 1949) happily sinned in this matter as well. 4 The second sentence of this quote from Negishi seems too strong. It should have been qualified to a statement reading something like this, ‘though there is a tendency by Marshall for the purchasing power of money to be held constant in the preliminary treatment of relative prices as part of the generally useful method of partial equilibrium involving ceteris paribus abstraction’. In correspondence Patinkin has described the form of abstraction in the text (determining relative prices on the assumption of constancy in the price level) as the ‘valid dichotomy’, describing this as his own practice, shared with Friedman and Pigou in the references cited in the previous note. My reading of Marshall suggests that he thought this abstraction could never be valid for any realistic analysis of relative price changes. 5 Some examples are Kregel (1992), which shows that parts of Marshall’s temporary market equilibrium analysis are identical to Walras’s theory; Eatwell and Milgate (1983), which demonstrates the problems in attributing an inflexible price assumption as underpinning Keynes’s theoretical position in The General Theory; and see Marshall’s 1870–1 paper on monetary theory (in Whitaker 1975, I: 165– 76) for Marshall’s version of Walras’s analysis of service d’approvisionnement. 6 On the frontispiece of Marshall (1919) but on its general importance in his mature thinking, see his letter to Edgeworth, 17 April 1909 (in Pigou 1925:442) and Marshall to A.L.Bowley, 21 January 1901 (in ibid: 421). 7 Layton’s lecture notes from Marshall’s class in October term 1904 (Trinity College, Cambridge, Layton Papers Box 15) include a diagram which indicates the various phases of the cycle as summarised by Lord Overstone (1837 [1847]: 31). A similar diagram in Marshall’s hand is preserved in the Marshall Archive (Red Box 2(5)). 8 Marshall’s copy of the People’s Edition of Mill (1865) is preserved in Cambridge University Library, d.62. 9 In particular Mill (1865), Book III, chapters XII–XIV, XXIII–XIV. Marshall was initially rather sceptical of Mill’s denials of the possibility of over-production, juxtaposing it with contrary authorities including an extract from the Springfield Republican (undated) on ‘overproduction’ pasted adjacent to Mill (1865:337) and a quote from Sargant (1867:50–55) which, contrary to Mill and Fawcett, concluded that ‘overproduction is possible’, and written adjacent to Mill (1865:338). 10 Marshall’s analysis of the credit cycle in Economics of Industry also drew on Bagehot (1873 [1962]: chapter 6) and Overstone (1837 [1847]) from which Marshall quoted the description of the phases of the cycle (Marshall and Marshall 1879: 153). 11 Marshall frequently quoted extracts from this account in later years, for example in his evidence to the Royal Commission on the Depression of Trade (Marshall 1926: 7–9), the Principles (Marshall 1961:710–11, a passage which dates from the fifth edition); Money, Credit and Commerce (Marshall 1923: 249–51). Only in 1886, that is, well before completing the Principles, did Marshall indicate explicitly that

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12

13

14

15

16 17

18

he adhered almost totally to what he had written in 1879 (Marshall 1926:9), implying less complete acceptance of the 1879 argument at later stages. Eshag (1963:78 and n. 38) suggests that Marshall later modified his adoption of this point from Bagehot (1873 [1962]: 70–3) by listing other potential factors for starting a credit upswing such as ‘war or rumours of war’ and ‘the opening out of promising new enterprises’, points which he derived from Giffen’s (1877) critique of Bagehot’s account. Eshag (1963), for example, although exhaustively referring to Marshall’s relevant writings on fluctuations, fails to draw attention to their chronological development with respect to specific ideas and concepts. Laidler (1990:60–1) draws attention to some improvements to Marshall’s 1879 account made in later work, including the Principles. The quotation from Marshall and Marshall (1879) in the text was reproduced by Keynes (1936 [1973]:19), whose attention had been drawn to it by Joan Robinson (Keynes 1973:79 and n. 1). Marshall had to defend the second proposal in the letter columns of the Economist (5, 12 March 1887:302, 307) and against the onslaught of Giffen who thundered against fancy monetary standards in the pages of the Economic Journal (Giffen 1892). A full discussion is in Groenewegen (1995, chapter 11: 350–1). Marshall defended the first proposal in evidence before the Royal Commission on the Values of Gold and Silver, as shown below. Marshall justified this belief by the example that potential ‘precautionary’ demand for money balances could absorb nearly the whole of the British gold stock, assuming only a small per capita balance of £10 for this purpose (though this was 27.5 per cent of average per capita income as he had estimated it in Marshall 1885: 77). In addition he based it on evidence drawn from Tooke and Newmarch’s History of Prices (1957), which pointed to the enormous amount of dishoarding which was disclosed in Britain during the run-up to the resumption of specie payments. Marshall was a great admirer of Tooke, and was not adverse to many conclusions from the Banking school position on money in relation to prices, as disclosed by some of his evidence (e.g. Marshall 1926:59, 44–5). Mary Paley Marshall to John Maynard Keynes, 22 March 1926, cited in Groenewegen (1994b:286). Royal Commission on Labour 1894:77–8, 82–7. Much of this discussion about the inefficiency of public sector employment creation and the expansion of public enterprises was along the lines of Alfred Marshall’s position on the subject. See Groenewegen (1995: chapter 16:593–6) for an extensive discussion of this topic. The recommendation is of sufficient interest to reproduce: 312. In periods of commercial depression there is always a demand that public authorities should undertake new works, whether remunerative or not. And though it is doubtless true that the community may well afford to suffer some material loss, rather than allow large numbers of the working classes to suffer the hardship and the deterioration caused by long periods of enforced idleness, yet the plan of starting new works in a hurry for the purpose must be regarded with some anxiety, on account of its wastefulness and other evils. But we think that, with a little forethought, public authorities might during more prosperous times prepare plans for works that are

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needed, but are not urgent; and hold them in readiness for times of depression. The information obtained by the Labour Department might prove of some value in assisting public authorities in this matter. 19 A flavour of the exchange is given by the following questions (by Marshall) and answers (by Mann), in which Mann seems to have the better perception of the dynamics of the situation, as revealed in his answer to Q. 3,300: 3,296. But I want to know where the particular point in that argument that I have gone on, is wrong. The working bakers get 70/– a week more, that is to say, 50 more working bakers come in and get 70/– a week and spend it in making a new demand for goods, and that 70/– comes out of the pockets of the master bakers, and they therefore have to withdraw an old demand for exactly 70/–. There is therefore, in my view, no change in the aggregate amount. At what step is there a change?—Again, it seems to me, I must repeat what I have said, but perhaps I can put it in another form. It is the same argument that I used when I said ‘If this be no point then I shall be glad to learn it.’ 3,297. I want you rather to point out what fallacy there is in that particular argument because it claims to be conclusive?—I want to see human energy get to work upon the raw material to create and give value, a portion of which value will come to those whose energies have been set free to engage upon it, giving them what they require, and allowing the requisite margin of profit and interest if need be, for we are under a condition of things in which profit and interest are allowed. 3,298. But we are not supposing that more bread is baked?—Oh, yes. I want to suppose that more bread is baked. I must contend that more bread would be baked because of the increased demand, which demand is made possible by the opportunities of the workers for getting into contact with the raw material. That brings it to this again, simply an improvement upon the present methods of organising industry. 3,299. But do not you see that what we are trying to find out is whether a diminution of the hours of labour would cause an increased demand?—I may say distinctly, yes, because it would improve the present organisation of trade. 3,300. And what you say is, if I understand you rightly, that there would be an increased demand because there would be an increased production, that increased production being to meet the increased demand; that seems to me to be arguing in a circle?—It may; but it seems to me to be perfectly sound. For instance, if by some means I was possessed of the requisite capital and could get in contact to-day with some of the workers in the east of London, I would tell this class to make furniture, and this class to make bread and other articles of trade, and to engage in other departments of trade. I would say ‘Here is the workshop accommodation, here are the tools, and I advance what is requisite for your sustenance whilst you are creating value here.’ If a man was creating value to the extent of 2/– per week I would say, then surely it is advisable to get that which he had created, leaving a margin for

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managerial expenses. There would be a new industry created, so to speak, and not interfering with and detracting from what other people had been doing before. It would be making their latent demand an effective demand. I may say that a re-adjustment of the working hours would practically do that without taking that special step that I have suggested might be taken. Royal Commission on Labour 1893:227–8 20 An undated fragment (circa 1895) is worth quoting in this context: ‘to attribute this social malaise [of business failures] to the fall of prices, instead of to the previous and morbid inflation, which caused it, is as reasonable as to attribute the headaches which follow a night of feasting and rioting to want of sufficiently nourishing breakfast, instead of to the bad condition of the digestive organs that took away the appetite for breakfast’ (Marshall Library, Marshall Archive (Red Box 2(3) Money)). 21 Notes in Red Box 2 (5) on ‘Fluctuations Developing into Crises’, comment on Robertson (1915): ‘make large use of Dennis Robertson. Probably quote from him’ (dated 14 August 1920). Notes on wage fluctuations prepared in October 1909 drew on early work by Walter Layton. Marshall’s comments on Robertson are used in the next section of the chapter (note 23 below). 22 The intellectual co-operation between Keynes and Robertson at this time is well known, as is its breakdown after the publication of The General Theory. See, for example, Presley (1978:75–84); Mizen and Presley (1994); Kahn (1984:61– 4) and the correspondence between Keynes and Lydia Lopokova (Hill and Keynes 1989, esp. 325, 327, 332, 333). 23 In his annotations on Robertson (1915) entitled ‘Robertson and Aftalion’ (18 March 1920), Marshall noted with pleasure Robertson’s comment that ‘my method is the right one’. The notes peter out at pp. 23–7, that is after about 10 per cent of Robertson’s book. Presley notes that on 20 September 1920 Marshall wrote to Robertson ‘that he often used his Study in this preparation of Money, Credit and Commerce’ (Presley 1978:83 and n. 65), a misleading statement on Marshall’s part to say the least, given the state of Marshall’s notes on the subject and the peculiarities in the writing of his last book noted earlier. In his 1915 book, Robertson’s use of Marshall was confined to the Principles and his evidence to the Gold and Silver Commission (1888) excluding therefore the account of the cycle given in Economics of Industry, by then successfully ‘suppressed’. 24 Tight money, Robertson argues (1915:221–2), for example, advantages industries using raw materials traded in highly organised, speculative markets. 25 Robertson (1915:246–9) elsewhere espoused Alfred Marshall’s remedies of more information, improved banking policy and emphasised the social advantages of falling prices (rising real wage levels) during the depression phase. He (Robertson 1915:253 n. 1) also supported a public works policy against the negative views of Pigou, and especially Hawtrey, arguing that in periods of depression savings are not applied to productive investment hence denying what became known as the Treasury view which emphasised the crowding out effects of public works. Robertson (1926 [1949]:94–6) was more cautious of endorsing a counter-cyclical public works policy because of the difficulties in getting the timing right (and cf. on this point, note 18 above).

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26 See especially the exchange of letters between the two, largely during May 1925 (Keynes 1971c:29–41). 27 This reinforces the belief that ‘general’ as a qualifier for ‘theory’ in the title of the book was designed to focus on the more realistic nature of the monetary/ entrepreneurial economy analysis as compared with the more special case of the cooperative/communistic/socialist/non-monetary/real wages economy analysis which Keynes ascribed to Ricardo, Marshall and Pigou (cf. Keynes 1979:52–5, 66–8; and see Rotheim 1981). 28 The source for the Marx reference is McCracken, Value Theory and Business Cycles, New York, 1933, p. 46, but Keynes does not seem to have pursued it beyond stating that Marx’s money circuit implies a money profit economy. Had he pursued it further, he would have realised that Marx used the analysis to criticise Say’s Law and Mill’s principle, to use the name Ricardo gave Say’s Law in his discussion of ‘general gluts’. It seems surprising that Sraffa did not alert Keynes to this, since he would almost certainly have discussed with Keynes his views on the essential properties of money which formed the foundation for Keynes’s chapter 17 in The General Theory (Keynes 1936 [1973]:222–44 and esp. p. 223 n. 1 which associates some of the propositions raised with Sraffa’s review of Hayek in the Economic Journal, March 1932). The General Theory, despite its sympathetic reference to Marx as a member of the economic underworld (with Gesell and Douglas), gives no credit to Marx for being an early, and perceptive, critic of Say’s Law, far more perceptive than Malthus was on this score (ibid:32, 355). 29 Keynes relied in this context on Marshall (1961:61–2) without drawing attention to the provisional nature of this assumption for a ‘volume of foundations’ as Marshall explicitly does, nor drawing attention to the other qualifications Marshall made of this assumption, as noted at the start of this chapter. 30 This letter responded to Robertson’s notes on The General Theory in the 1936 Quarterly Journal of Economics (Robertson 1936). Its p. 174 n. 8 refers to Pigou’s Industrial Fluctuations as one of the several accounts indicating that a percentage increase in consumption generates a more than percentage increase in the demand for instrumental goods; p. 179 n. 2 mentions Marshall’s evidence.

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AUTHOR INDEX

Allen, R.G.D. 150 Atkinson, A.B. 140, 178 Antonelli, P. 178 Arrow, K.J. 178 Ashenfelter, O.K. 178 Aspromourgos, T. 173

Carter, J. 148 Cencini, A. v, vii, 1–14, 17–60, 36, 70, 178, 179 Chalmers, T. 154 Clark, A. 179 Clower, R. 173 Coase, R.H. 179 Coddington, A. 179 Colonna, M. 179 Crosland, A. 148

Bagehot, W. 174, 178 Bain, A.D. 178 Baranzini, M. v, vii, 1–14, 61–72, 178, 179, 180, 181, 185 Barro, R. 178 Baumol, W J. 178 Bean, C.R. 178, 180 Behman, S. 170 Blackaby, D.H. 179 Blanchflower, D.G. 179 Blinder, A.S. 178 Boggio, L. 179 Böhm-Bawerk, E. von 138, 141 Bootle, R. 179 Bortis, H. 179 Bowley, A.L. 173 Bradley, x, vi, vii, 9–10, 107–34 Bridel, P. 154, 155, 160, 179 Britto, R. 179 Brown, A.J. 145, 179 Brown, C.V. 179 Bruno, M. 179 Bukharin, N. 138

Davidson, P. 126, 127, 130, 134, 173, 179 Dawson, G. 179 Desai, M. vi, vii, 11–12, 137–50, 179, 180 Dobb, M. 139 Domar, E. 180 Drèze, J.H. 180 Durbin, E.F.M. 150, 180 Eatwell, J. 173, 179, 180, 183, 184 Edgeworth, F.Y. 173 Engel, E. 7, 66, 68, 180 Eshag, E. 154, 155, 160, 174, 180 Feinstein, C.H. 180, 181 Fiorentini, R. 180 Fisher, I. 44, 45, 180 Flemming, J.S. 19, 24, 180 Friboulet, J.-J. vi, vii, 9–10, 107–34 Friedman, M. 27, 34, 36, 44, 45, 46, 48, 125, 127, 147, 160, 173, 180, 181

Cagan, P. 179 Callaghan, J. 148 Cannan, E. 100, 179 Carlin, W. 179

Gapinski, H. 183, 186 Giffen, R. 174, 181 Gilbert, C.L. 181 177

178 AUTHOR INDEX

Glyn, A. 145, 181 Gnos, C. vi, vii, 9–10, 107–34, 181 Goodhart, C.A.E. 18, 32, 37, 41, 42, 43, 44, 181 Goodwin, R.M. 139, 140, 143, 144, 145, 146, 149, 150, 163, 180, 181, 186 Gordon, R.J. 181 Gowland, D.H. 181 Greaves, J.P. 181 Groenewegen, P. vi, viii, 12–14, 151–77, 181 Grubb, D. 181 Guillebaud, G.W. 183 Hagemann, H. 179, 181 Hahn, F.H. 181 Hansen, A.H. 154, 181 Harcourt, G.C. 178, 181 Hargreaves Heap, S.P. 181 Harrod, R.F. 182 Hawtrey, R.G. 182 Hayek, F.A. von vi, 11–12, 122, 137–50, 177, 179, 180, 181 Hendry, D.F. 180 Hession, C.H. 111, 181, 182 Hicks, J.R. 131, 181, 182 Hilferding, R. 138 Hill, P. 166, 182, 176, 181, 182 Hines, A.G. 145, 182 Hinshaw, R. 181, 182 Hollingsworth, D.F. 181 Hoon, H.T. 184 Hudson, J. 24, 182 Hume, D. 154 Hunt, L.C. 179 Jackman, R. 182 Jaffé, W 186 Johnson, H.G. 182 Johnson, L.B. 146 Juglar, C. 139, 182 Kahn, R.F. 176, 182 Kaldor, N. 49, 141, 180, 181, 182 Kalecki, M. 147 Kanaginis, G. 184 Kennedy, J.F. 146

Keynes, J.M. vi, 1–4, 9–14, 17, 18, 26, 30, 36, 37, 43, 44, 45, 46, 49, 66, 70, 76, 81, 84, 85, 87, 88, 89, 90, 93, 96, 100, 104, 105, 107–34, 137–50, 151–77, 180, 181, 182, 183, 184, 185 Keynes, R. 166, 182 Kregel, J. 152, 173, 182 Krüger, M. 150, 180, 181 Laidler, D.E. 154, 155, 160, 174, 182, 183 Landesmann, M.A. 183 Lawson, A. 147 Layard, P.R. G. 178, 179, 185 Layton, W. 176 Leontief, W W. 183 Lerner, A.P. 130, 183 Lindbeck, A. 183 Lopokova, L. 111, 166, 176 Lowe, A. 183 Luxemburg, R. 138, 150, 183 McKinnon, R.I. 183 Malthus, T. 154 Mandel, E. 145, 183 Mann, T. 161, 162, 175 Marconi, M. 183 Marshall, A. vi, viii, 12–14, 107, 109, 110, 111, 113, 115, 117, 151–77, 181, 182, 183, 184, 185, 186 Marshall, M.P. 174, 183 Marx, K. 137–50, 177, 183 Matthews, R.C. O. 181 Mattick, P. 145, 184 Meiselman, D. 125 Milgate, M. 173, 179, 180, 183, 184 Miliband, R. 183, 184 Mill, J. 154 Mill, J.S. 139, 153, 154, 155, 174, 177, 184 Mises, L. von 141 Mishkin, F.S. 184 Mizen, P. 176, 184 Mulvey, C. 182 Myrdal, G. 134, 147 Negishi, T. 151, 173, 184 Nell, E.J. 180 Neurath, O. 138

AUTHOR INDEX 179

Newmarch, W 186 Newman, P. 179, 183 Nickell, S.J. 184 Nordhaus, W. 145, 184 O’Connor, J. 147, 184 Ohlin, B. 131, 183 Ohno, K. 183 Oswald, A.J. 179 Overstone, Lord 174, 184 Panico, C. 140, 184 Parkin, J.M. 183 Pasinetti, L.L. 5, 7, 61–72, 150, 178, 184 Patinkin, D. 19, 152, 173, 184 Pheby, J. 186 Phelps, E.S. 134, 184 Phillips, A.W. H. 1, 24, 44, 45, 137, 140, 145, 147, 180, 181, 184 Pigou, A.C. 111, 169, 171, 173, 177, 183, 185 Pollack, R.A. 185 Poulon, F. 185 Presley, J.R. 176, 184, 185 Punzo, L.F. 181 Rasera, J.-B. 181 Rattaggi, M. 134, 185 Redfern, P. 11, 142, 180 Ricardo, D. 1, 4, 70, 105, 154, 170, 171, 177, 184 Robertson, D.H. vi, 13, 117, 131, 132, 151, 160, 164–8, 171, 172, 176, 177, 184, 185 Robinson, J.V. 14, 173, 174 Rockwood, C.E. 183, 186 Rotheim, R.J. 177, 185 Rowlatt, P.A. 185 Sacks, J. 179 Samuelson, P.A. 145, 185 Sargant, W.L. 174, 185 Saville, J. 183, 184 Say, J.B. 7, 12, 78, 154, 155, 161, 162, 170, 172, 177 Scazzieri, R. 63, 64, 178, 179, 181, 183, 185 Smith, M. 173

Schmitt, B. v, viii, 4, 7, 9, 29, 36, 53, 54, 57, 70, 75–105, 123, 185 Schoenmaker, D. 181 Schumpeter, J.A. 112, 185 Semmler, W 180 Shackle, G.L. S. 17, 134, 185 Sismondi, J.C. L. 154 Smith, A. 20, 186 Solow, R.M. 61, 145, 184, 185, 186 Soskice, D. 179, 186 Spiethoff, A. 170 Sraffa, R. 141, 142, 177, 185 Stone, R. 61, 150, 186 Summers, L.H. 186 Sutcliffe, R. 145, 181 Thatcher, M. 147 Thornton, H. 186 Tobin, J. 186 Tooke, T. 139, 174, 186 Trevithick, J.A. 35, 47, 182, 186 Veluppilai, K. 186 Vercelli, A. 150, 180, 181 Wallis, K.F. 180 Walras, L. 87, 88, 97, 141, 151, 152, 153, 173, 186 Weintraub, S. 127, 134, 186 Weizsaeker, C.C. von 186 Whitaker, J.K. 173, 182, 186 Wicksell, K. 110, 118, 119, 122, 141, 186 Withers, H. 107, 112, 113, 114, 115, 186 Wolfe, J.N. 154, 155, 186 Zoega, G. 184

SUBJECT INDEX

bottle-necks 63

Marx-Hayek model of the trade 143– 50; and price stability 157–63; and profits 139; Robertson’s theory of the credit 165–7; Robertson’s theory of the trade 164–5; trade 138–50, 164–5

capital: accumulation of 5, 55–60, 120, 139; amortisation of 8, 9, 54, 77, 93–105; and deflation 5, 56–60; fixed 5, 7, 8, 24, 53–60, 93–105, 140; and income 7, 88; and inflation 5, 53–5; heterogeneity of 138, 141; pathological 5, 55–60; and profit 56–8, 120, 121, 139; and saving 59; and wages 53–60, 139 Central Bank: and inflation 2, 22, 30–1 circular model 61–72 consumption: and inflation 26–7 cost of living: and inflation 2, 25 costs: and inflation 4, 32–4 credit: and bank deposits 27–31; and inflation 1, 27–30 cycle: credit 154–71; endogenous 140; Hayek’s theory of the trade 141–50; Keynes’s theory of the credit 167–71; Marshall’s theory of the credit 154–63, 171, 172, 174; Marx’s theory of the trade 138–40;

debt: external 149 deflation: and capital accumulation 5, 56–60; and capital amortisation 8, 9, 54, 77, 93–105; and demand 39, 45, 53, 55–7; and inflation 5, 17, 44–60; and interest rates 40–1, 60, 91, 118, 119, 148; and involuntary unemployment 3, 4, 5, 39, 75–105; and profit 54–7, 91–2; and saving 38–40; and the identity of supply and demand 45, 76, 77–89, 92, 122–33 demand: and deflation 39, 45, 53, 55–7; effective 64–5, 71, 75, 123, 124, 125, 129, 130, 161, 170; and inflation 1, 22–3, 26–31, 45, 53; and saving 26–7; total 8, 9, 10, 17, 38, 48, 76, 77–89, 92, 103, 116 demand- and supply-side 62 dichotomy:

180

SUBJECT INDEX 181

and the quantity theory of money 19– 20; between money and output 2, 17, 86, 92, 96, 151, 152, 172 duplication: and capital amortisation 8, 99–105 emission of money: and wages 20, 21, 32, 96, 114, 115 equilibrium: general 141; long-run 140 full employment 142, 144, 146 Hayek: on the trade cycle 137, 141–50 hoarding: and money 38, 84, 155, 156, 159, 168, 170, 172; and saving 38, 84, 168 homogeneity: the postulate of 35 horizontal model see circular model human knowledge 65 imports: and inflation 33–4, 36 income: and capital 7, 88; the expenditure of 83; and inflation 26, 33, 34, 113–22; and money 10, 20, 39, 115; and output 86, 87; and unemployment 42, 49, 79–85; and wages 52, 53, 54, 57 inflation: capital 10, 118–22; and capital 5, 53–5; and Central Banks 2, 22, 30–1; and consumption 26–7; and the cost of living 2, 25; cost push 4, 32–4; and credit 1, 27–30; and deflation 5, 17, 44–60; demand pull 4, 26–31, 34; and devaluation 1;

and excess demand 1, 22–3, 26–31, 45, 53; and the identity of supply and demand 1, 23, 25, 122–35; and imports 33–4, 36; and income 26, 33, 34, 113–22; and international payments 35–7; Keynes on 9–11, 107–35, 171; and the level of prices 19, 24, 26, 117; Marshall on 157–63, 172; as a monetary pathology 22, 37, 51–3; and the price index 2, 24–6, 117; profit 10, 118–22, 133; and profit 5, 10, 25, 130, 133, 157; and public intervention 1, 24, 30–1, 36, 37, 48; Robertson on 165, 172; and saving 1, 26–8; and technological progress 25; the traditional analysis of 4, 5, 24–36; and unemployment 4, 18, 44–51, 144, 146, 149; and wages 32–3, 45, 53, 162 input-output model 61–8 interest rates: and deflation 40–1, 60, 91, 118, 119, 148; money 105, 118, 141, 142, 148, 149, 157, 167 integration: vertical 61–72, 143 investment: and saving 10, 81, 83, 85–9, 128, 129, 132–3, 165–8 Keynes: on the credit cycle 109, 119, 167–71; on the identity of total supply and total demand 122–3; on inflation 9–11, 107–35, 171; on monetary economics 164–71; on profits 90–3, 120–2; on saving and investment 81, 84, 85, 128–30, 167, 168; on unemployment 87, 90–3, 104, 167, 168, 170, 171; on the value of money 114–18

182 SUBJECT INDEX

labour market 53, 55, 64, 157 Marshall: on the credit cycle 152, 154–63, 171, 172, 174; on inflation 157–63, 172; on monetary economics 153–64; on unemployment 153, 155–64, 172 Marx: on the trade cycle 138–40, 143–50 monetarism 144: and unemployment 147 money: bank 3, 18, 20, 96, 112; the demand for 19, 159, 165; the emission of 20, 21, 32, 96, 114, 115; as a flow 88; empty 9, 22, 26, 30, 48, 53, 54, 57–9; and hoarding 38, 84; and income 10, 20, 39, 115; nominal 9, 20, 96–105; as a numerical form 9, 86, 87; as a numerical vehicle 9; and output 2, 3, 4, 7, 10, 20, 21, 22, 31, 32, 39, 52, 86, 114; the purchasing power of 2, 4, 9, 23, 25, 33, 34, 37, 57, 153; the quantity of 2, 22, 123, 126, 127, 154, 160; as a sum of concrete numbers 87, 97; the supply of 3, 19, 21, 22, 32, 35, 36, 42, 154; vehicular 21, 32, 57; and wages 21, 53, 57, 58, 96; real 9, 96–105 multisector model 61–72 output: and income 86, 87; and money 2, 3, 4, 7, 10, 20, 21, 22, 31, 32, 39, 52, 86, 114 Pasinetti: on growth, distribution and accumulation 61–72 Phillips curve 1, 44, 45, 140, 145, 147 price index:

and inflation 2, 24–6, 117 prices: the level of 19, 24, 26, 117, 159 profit: and capital 56–8, 120, 121, 139; and deflation 54–7, 91–2; and inflation 5, 10, 25, 130, 133, 157; the investment of 5, 54, 55; Keynes on 90–3, 120–2; the rate of 56, 140, 144; and the trade cycle 139; and unemployment 56–60, 76, 89–96, 146; and wages 53–60, 129 purchasing power of money 2, 4, 9, 23, 25, 33, 34, 37, 57, 153; and total demand 75 quantity theory of money 2, 10, 18–24, 30, 111; and the classical dichotomy 19–20 Robertson: on the credit cycle 165–7; on monetary economics 164–71; on price stability 165, 172; on the trade cycle 164–5; on unemployment 164–6 saving: and capital 59; and deflation 38–40; and demand 26–7; and finance 131–3; forced 119, 167; and hoarding 38, 84,168; and inflation 1, 26–8; and investment 10, 81, 83, 85–9, 128, 129, 132–3, 165–8; and lending 39, 82; -propensities 64; and supply and demand 83 Say’s Law 8, 78, 155, 161, 162, 170, 177 stagflation 5, 44–51 structural change 61–72 supply and demand:

SUBJECT INDEX 183

and deflation 45, 76, 77–89, 92, 122– 33; the identity of 1, 23, 25, 76, 77–89, 92, 122–33; and inflation 1, 23, 25, 122–35; and saving 83; total 8, 9, 10, 17, 38, 45, 55, 75, 77–89, 103, 116 technological progress: and inflation 25; and unemployment 2, 37, 44, 47, 61–72 transition paths 63 traverse 63, 143 trends 63 unemployment: conjunctural 39; and deflation 3, 4, 5, 39, 75–105; desired 37, 43; frictional 38, 44, 46; Hayek on 142, 147–9; and the identity of supply and demand 77–89, 92; and income 42, 49, 79–85; and inflation 4, 18, 44–51, 144, 146, 149; involuntary 2, 3, 5, 7, 43, 44, 46, 55, 76–105; Keynes on 87, 90–3, 104, 167, 168, 170, 171; Marshall on 153, 155–64, 172; Marx on 139, 149; and monetarism 147; and money 17, 96–106; and national income 42, 49, 79–85; the natural rate of 46; and price stability 151–73; and profits 56–60, 76, 89–96, 146; Robertson on 164–6; and speculation 156; structural 38, 46, 62–72, 161; and technological progress 2, 37, 44, 47, 61–72; undesired 37, 43; voluntary 2, 3, 43, 44; and wages 45, 46

vertically integrated model 61–72, 143 vertical model 63–8 wages: and capital 53–60, 139; and the emission of money 20, 21, 32, 96, 114, 115; and income 52, 53, 54, 57; and inflation 32–3, 45, 53, 162; and money 21, 53, 57, 58, 96; and profit 53–60, 129, 139; and unemployment 45, 46 wage units 92, 129–31