The Failure of the New Economics, by Henry Hazlitt

The Failure of the “New Economics” (Henry Hazlitt, 1959)

Chapter II

POSTULATES OF KEYNESIAN ECONOMICS

2. Wage-Rates and Unemployment

In explanation of the passage I have just quoted, he goes on:

Wide variations are experienced in the volume of employment without any apparent change either in the minimum real demands of labor or in its productivity. Labor is not more truculent in the depression than in the boom — far from it. Nor is its physical productivity less. These facts from experience are a prima facie ground for questioning the adequacy of the classical analysis (p. 9).

Are they? Keynes has here tumbled into a glaring fallacy. The absence of change in physical productivity is completely irrelevant to money wage-rates. What counts in economics is only value productivity — and value productivity stated in this case, of course, in monetary terms. If the marginal productivity of a worker is a given unit of a commodity that previously sold for $10, and the price of that unit has now fallen to $5, then the marginal value productivity of that worker, even though he is turning out the same number of units, has fallen by half. If we assume that this fall in prices has been general, and that this represents the average fall, then the worker who insists on retaining his old money wage-rate is in effect insisting on a 100 per cent increase in his real wage-rate. Whether the worker is “truculent” or not is entirely beside the point. If prices fall by 50 per cent, and unions will accept a wage cut, but of no more than 25 per cent, then the unions are in effect demanding an increase in real wage-rates of 50 per cent. The only way they can get it, and retain full employment, is by an increase of 50 per cent in their physical (or “real” value) marginal productivity to make up for the drop in the price of the individual unit of the commodity they help to produce. [Hazlitt, 1959, p. 20-21]

3. No “General Level” of Wage-rates

1. The word “wages” is sometimes used in the sense of wage-rates and sometimes in the sense of wage income or total payrolls. There is no warning to the reader as to when the meaning shifts, and Keynes himself is apparently unaware of it. This confusion runs through the General Theory, and gives birth to a host of sub-confusions and sub-fallacies. [Hazlitt, 1959, p. 26]

4. “Non-Euclidean” Economics

But here is Keynes’s own definition of “involuntary unemployment”:

Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labor willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment. (His italics, p. 15.)

It would be hard to imagine a definition more wordy, involved or obfusc. I have read it an indefinite number of times, and as nearly as I can make out it means simply this: Men are involuntarily unemployed if an increase in prices relatively to wage-rates would lead to more employment. As soon as we translate Keynes’s statement into plainer English, its falsity becomes evident. Keynes’s statement overlooks the fact that such an increase of employment could have been brought about equally well by a lowering of money wage-rates, with commodity prices remaining the same. To recognize this possibility, however, would have been to recognize that the unemployment was not in fact involuntary. [Hazlitt, 1959, p. 30]

Chapter IV

OVERTURE

1. “Effective Demand”

The whole term “effective demand” is today either nonsensical or confusing anyway. Modern economists do not need the adjective “effective” in front of “demand.” Demand is effective by definition. If it is not effective, it is not called demand but need, desire, wish, or longing. The word “demand” implies the requisite desire along with the requisite purchasing power. If Keynes meant aggregate demand, then that is the adjective he should have used and stuck to. If he meant aggregate monetary demand or aggregate monetary purchasing power, then these are the terms he ought to have used when this was what he meant.

The confusions in his terminology merely compound the confusions in his thought. Immediately after the equation and the definition I have just quoted, Keynes tells us: “This is the substance of the General Theory of Employment” (p. 25). [Hazlitt, 1959, p. 48]

2. The Propensity to Consume

Equilibrium, in short, exists only when the conditions of equilibrium are fulfilled. One of those conditions is full employment. And full employment always exists when there is equilibrium.

When Keynes speaks, therefore, as he does here and elsewhere, of “equilibrium” with underemployment, he is talking nonsense. This is a contradiction in terms, like talking of an orderly chaos or a triangular circle. When Keynes speaks, in short, of an “equilibrium” with unemployment, he is not really speaking of a position of equilibrium at all, but of something quite different. He is speaking of a frozen situation, a frozen disequilibrium, a situation in which some price, interest rate, or wage-rate, or many prices, interest rates, and wage-rates, are prevented, either by contract, labor-union resistance, or government intervention, from adjusting to an equilibrium level.

This flagrant misuse of terms is one of the central fallacies of the whole Keynesian system. When this misuse is recognized, his whole system collapses. [Hazlitt, 1959, p. 52]

Chapter VIII

INCOME, SAVING, AND INVESTMENT

4. Keynesian Paradoxes

Keynes argues at times, as we have seen, that saving and investment are not only always equal but “merely different aspects of the same thing.” Yet he still keeps to his old habit of deploring saving while approving investment. So he must argue that saving reduces income and investment increases income — though “they are necessarily equal in amount,” and “merely different aspects of the same thing” (p. 74)! […]

“The error lies in proceeding to the plausible inference that, when an individual saves, he will increase aggregate investment by an equal amount. It is true, that, when an individual saves he increases his own wealth. But the conclusion that he also increases aggregate wealth fails to allow for the possibility that an act of individual saving may react on someone else’s savings and hence on someone else’s wealth” (pp. 83-84). … In sum, we are apparently to understand that while saving and investment are “necessarily equal” and “merely different aspects of the same thing,” yet saving reduces employment and incomes and investment increases employment and incomes! [Hazlitt, 1959, p. 90]

There is still another Keynesian paradox of savings (though they are ”necessarily equal” to investment and “merely different aspects of the same thing”):

Though an individual whose transactions are small in relation to the market can safely neglect the fact that demand is not a one-sided transaction, it makes nonsense to neglect it when we come to aggregate demand. This is the vital difference between the theory of the economic behavior of the aggregate and the theory of the behavior of the individual unit, in which we assume that changes in the individual’s own demand do not affect his income (p. 85).

The only way in which we can make any sense whatever of this whole otherwise baffling passage is to assume that when Keynes uses the word “saving” he is thinking merely of the negative act of not buying consumption goods; but when he uses the word “investment” he is thinking merely of the positive act of buying capital goods. And he falls into this primary error because he forgets his own previous insistence that “saving” and “investment” are “necessarily equal” and “merely different aspects of the same thing.” He is, in fact, thinking in each case of only one side of the transaction: “Saving” equals merely the negative act of not buying consumption goods; “investment” equals merely the positive act of buying or making capital goods. Yet these two acts are both parts of the same act!

The first is necessary for the second. An analagous thing happens in the realm of consumption goods alone. A man’s tastes change, and he switches from chicken to lamb. We don’t scold him at one moment for hurting the poultry raisers and praise him at the next for aiding the sheep raisers. We recognize that his purchasing power has gone in one direction rather than another, and that if he had not given up the chicken he would not have had the money to buy the lamb. Unless a man refrains from spending all his money on consumption goods (i.e., unless he saves), he will not have the funds to buy investment goods, or to lend to others to buy investment goods. [Hazlitt, 1959, p. 91]

Keynes has himself become entangled in the sort of naive and one-sided interpretation of the two terms, saving and investment, that so often trips up the man in the street when he talks of economic problems. We get some confirmation of this when Keynes writes:

In the aggregate the excess of income over consumption, which we call saving, cannot differ from the addition to capital equipment which we call investment. . . . Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. (My italics, p. 64.)

Why savings should be a “mere residual” (whatever that may mean) I cannot say. But the sentence I have put in italics reveals the undercurrent of Keynes’s thinking. It is not production that determines incomes; it is not work that determines incomes; it is “the decisions to consume and the decisions to invest”!
It may be hard to imagine Robinson Crusoe as a Keynesian, but if he had been, when he returned to England, and the reporters had interviewed him at the pier, the results might have run something like this:
“How do you account for your big income when on the island?” the reporters might have asked.
“Very simple,” Crusoe would have replied. “I decided to consume an awful lot, and what I didn’t consume I decided to invest; and as a result, of course, my income grew and grew.”
“Wasn’t your income determined by what you produced?” one puzzled reporter might have asked.
“Produced? Worked?” Robinson Crusoe Keynes would have replied, “What nonsense! We have changed all that!” [Hazlitt, 1959, p. 92-93]

5. Can Savings be Printed?

If the reader will turn back, for example, to page 84, and to the quotation there from Chapter 12 of the Treatise on Money, he will find that the respective definitions are at once nebulous and biassed. Saving, we are told, “is the act of the individual consumer,” whereas investment “is the act of the entrepreneur.”

Now the definition of an act, one would suppose, would be expressed solely in terms of the act itself, without the irrelevant introduction of who does it. When an “individual consumer” saves, we are apparently to understand, he merely “negatively” refrains from spending. Yet it should be obvious that he also, necessarily, invests in cash or bank deposits. When an entrepreneur “invests” he is, according to Keynes, doing something “positive,” even if it is only adding to his “liquid capital” — i.e., doing precisely the same thing as the naughty consumer who is merely refraining from spending all his income! [Hazlitt, 1959, p. 95]

Chapter X

“THE PROPENSITY TO CONSUME”: II

2. The Fear of Thrift

The influence of changes in the rate of interest on the amount actually saved is of paramount importance, but is in the opposite direction to that usually supposed. For even if the attraction of the larger future income to be earned from a higher rate of interest has the effect of diminishing the propensity to consume, nevertheless we can be certain that a rise in the rate of interest will have the effect of reducing the amount actually saved. For aggregate saving is governed by aggregate investment; a rise in the rate of interest (unless it is offset by a corresponding change in the demand-schedule for investment) will diminish investment; hence a rise in the rate of interest must have the effect of reducing incomes to a level at which saving is decreased in the same measure as investment (p. 110). [And Keynes goes on to conclude further that therefore] saving and spending will both decrease (p. 111).

It is amazing how many fallacies and inversions Keynes can pack into a small space, and especially how many fallacies, like a set of Chinese boxes, he can pack inside other fallacies.

A rise in the rate of interest, Keynes here argues, will not normally encourage an increase in the amount of savings but a decrease. Why? Because while a higher rate of interest might encourage more saving it would discourage borrowing. True. But the same sort of thing could be said not only about the price of loanable funds, but about the price of anything else. A higher price for any commodity will reduce the amount demanded unless the demand schedule is also higher. But it may be precisely because the demand for that commodity has increased that the price has been bid up in the first place. Therefore the higher price will not cause a reduction in the amount demanded for the simple reason that it is the increase in demand that has forced up the price. … If the rise in interest rates has been itself caused by a rise in the “demand schedule for investment” … then the rise in interest rates is merely an adjustment to the rise in the “demand schedule for investment,” … [Hazlitt, 1959, p. 131-132]

Chapter XI

“THE MULTIPLIER”

1. The Magic of It

Let us try to find in plainer language what it is that Keynes is saying here. He explains on the next page: “It follows, therefore, that, if the consumption psychology of the community is such that they will choose to consume, e.g. nine-tenths of an increment of income, then the multiplier k is 10; and the total employment caused by (e.g.) increased public works will be ten times the primary employment provided by the public works themselves” (pp. 116-117).

What Keynes is saying, among other things, is that the more a community spends of its income, and the less it saves, the faster will its real income grow! Nor do the implications of its own logic frighten him. If a community spends none of its additional income (from, say, the increased public works), but saves all of it, then the public works will give only the additional employment that they themselves provide, and that will be the end of it. But if a community spends all of the additional income provided by the public works, then the multiplier is infinity. This would mean that a small expenditure on public works would increase income without limit, provided only that the community was not poisoned by the presence of savers.

Keynes does not hesitate to accept this deduction, but he accepts it in a peculiar form. “If, on the other hand, they [the community] seek to consume the whole of any increment of income, there will be no point of stability and prices will rise without limit” … But just how did prices get into it? The “propensity to consume,” and “the multiplier,” we have been assured up to this point, are expressed in terms of “wage-units,” which, Keynes assures us, means “real” terms and not money terms. [Hazlitt, 1959, p. 137]

2. Not Fixed or Predictable

Let us try to look at one probable origin of the concept. If a community’s income, by definition, is equal to what it consumes plus what it invests, and if that community spends nine-tenths of its income on consumption and invests one-tenth, then its income must be ten times as great as its investment. If it spends nineteen-twentieths on consumption and invests one-twentieth, then its income must be twenty times as great as its investment. If it spends ninety-nine-hundredths of its income on consumption and invests the remaining one-hundredth, then its income must be a hundred times its investment. And so ad infinitum.
These things are true simply because they are different ways of saying the same thing. The ordinary man in the street would understand this. But suppose you have a subtle man, trained in mathematics. He will then see that, given the fraction of the community’s income that goes into investment, the income itself can mathematically be called a “function” of that fraction. If investment is one-tenth of income, income will be ten times investment, etc. Then, by some wild leap, this “functional” and purely formal or terminological relationship is confused with a causal relationship. Next, the causal relationship is stood on its head and the amazing conclusion emerges that the greater the proportion of income spent, and the smaller the fraction that represents investment, the more this investment must “multiply” itself to create the total income! [Hazlitt, 1959, p. 139]

3. “Saving” and “Investment” Again

One fallacy in the “multiplier” that is alone sufficient to discredit it completely is the assumption that the entire fraction of a community’s income that is not “consumed” is hoarded; that no part of this unconsumed income is invested. The “propensity to consume,” in brief, determines the “multiplier” only on the assumption that what is not spent on consumption is not spent on anything at all! If the propensity to consume is 7/10, or 8/10 or 9/10 or anything less than 10/10, the economic machine will run down unless “investment” rushes in to fill the “gap” left by “saving.” [Hazlitt, 1959, p. 146]

4. “Investment” Means Government Spending

Ruritania is a Keynesian country that has a national income of $10 billion and consumes only $9 billion. Therefore it has a propensity to consume of 9/10. But as in some way it manages to “save” 10 per cent of its income without “investing” the 10 per cent in anything at all, it has unemployment of 10 per cent. Then the Keynesian government comes to the rescue by spending, not $1 billion, but only $100 million on “investment.” For as the “multiplier” is 10 (because Keynes has written out a mathematical formula which makes it 10 when the marginal propensity to consume is 9/10), this $100 million dollars worth of direct new employment somehow multiplies itself to $1 billion of total new employment to “fill the gap,” and lo! “full employment” is achieved.
(Expressing this in terms of employment, we might say: When the propensity to consume of Ruritania is 9/10, then, unless something is done about it, only 9 million of Ruritania’s working force of 10 million are employed. It is then simply necessary to spend enough to employ directly 100,000 more persons, and their spending, in turn, will ensure a total additional employment of 1 million.)
The question I am raising here is simply why such a relationship between the marginal propensity to consume and the multiplier is supposed to hold. Is it some inevitable mathematical deduction? If so, its causal inevitability somehow escapes me. Is it an empirical generalization from actual experience? Then why doesn’t Keynes condescend to offer even the slightest statistical verification? We have already seen that investment, strictly speaking, is irrelevant to the “multiplier” — that any extra spending on anything will do. We have already illustrated this by dividing commodities into those beginning with the letters from A to W, and those beginning with the letters X, Y, and Z. But a still further reductio ad absurdum is possible.
Here is a far more potent multiplier, and on Keynesian grounds there can be no objection to it. Let Y equal the income of the whole community. Let R equal your (the reader’s) income. Let V equal the income of everybody of Y; whereas your income is the active, volatile, uncertain element in the social income. Let us say the equation arrived at is:

V = .99999 Y
Then, Y = .99999 Y + R
.00001 Y = R
Y = 100,000 R

Thus we see that your own personal multiplier is far more powerful than the investment multiplier. To increase social income and thereby cure depression and unemployment, it is only necessary for the government to print a certain number of dollars and give them to you. Your spending will prime the pump for an increase in the national income 100,000 times as great as the amount of your spending itself.

The final criticism of the multiplier that must be made is so basic that it almost makes all the others unnecessary. This is that the multiplier, and the whole unemployment that it is supposed to cure, is based on the tacit assumption of inflexible prices and inflexible wages. Once we assume flexibility in prices and wages, and full responsiveness to the forces of the market, the whole Keynesian system dissolves into thin air. [Hazlitt, 1959, p. 150-151]

Chapter XII

“THE MARGINAL EFFICIENCY OF CAPITAL”

2. Interest Rates Embody Expectations

“The expectation of a fall in the value of money stimulates investment,” he declares, “and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e. the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital” (pp. 141-142). This is the equivalent of saying that inflation, and even more, the threat of further inflation, is good because it stimulates investment and employment. [Hazlitt, 1959, p. 160]

3. Effects of Expected Inflation

Keynes even argues that the rate of interest cannot rise under the conditions he assumes, because if it did it would spoil his theory about the “stimulating” effect of the expectation of further inflation:

The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output — insofar as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, here would be no stimulating effect from the expectation of rising prices. For the stimulus to output depends on the marginal efficiency of a given stock of capital rising relatively to the rate of interest. (His italics, p. 143.)

Keynes’s admissions here are quite correct. “If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices.” But what is Keynes’s reason for supposing that the rate of interest will not rise with the marginal efficiency of capital? It lies in his assumption that “the marginal efficiency of capital” embodies expectations and that the rate of interest does not. The marginal efficiency of capital, by Keynes’s order, has entered the realm of “dynamic” economics, but the rate of interest, also by Keynes’s order, has been kept in the realm of “static” economics.

[…] If the marginal efficiency of capital embodies expectations, so do interest rates. To assume otherwise is to assume that entrepreneurs are influenced by their expectations but that lenders are not. … And, according to Keynes, the lenders will be perfectly agreeable to this. They will not demand a higher interest rate as an insurance premium against the depreciated dollars in which they expect to be repaid. [Hazlitt, 1959, p. 163-164]

4. Does Lending Double the Risk?

Let us continue, however, with Keynes’s “two types of risk”:

Now the first type of risk is, in a sense, a real social cost. . . The second, however, is a pure addition to the cost of investment which would not exist if the borrower and lender were the same person. [My italics.] Moreover, it involves in part a duplication of a proportion of the entrepreneur’s risk, which is added twice to the pure rate of interest to give the minimum prospective yield which will induce the investment (pp. 144-145).

This is pure nonsense. The risk is not “duplicated”; it is not “added twice”; it is simply shared. To the extent that the entrepreneur assumes the risk the lender is relieved of it; the lender assumes a risk only to the extent that the entrepreneur fails to assume it. Suppose entrepreneur E borrows $10,000 from lender L to start a small business. Suppose the entrepreneur loses the whole $10,000. Then a total of $10,000 is lost, not $20,000. If the entrepreneur makes the whole loss good out of his own pocket, none of it falls on the lender. If the entrepreneur goes bankrupt, or leaves town, without repaying the lender a cent, then the lender takes a loss of $10,000. But the borrower E has lost nothing of his own; he has simply thrown away L’s $10,000. If the borrower is able to make good $6,000 of the loss out of his own resources, but is compelled to default on the rest, then $4,000 of the loss falls on the lender — not more. Would Keynes argue that fewer houses are built with the mortgage system than would be built without it, because mortgages “double the risk,” or constitute “a pure addition to the cost of investment”? It is the mortgage, on the contrary, that enables the builder or owner to build or own the house. The mortgagor, on his part, assumes that the market value of the house above the amount of the mortgage gives him additional security (beyond the good faith of the mortgagee, the other resources of the mortgagee, and the mortgagor’s legal recourse against the mortgagee) which removes or minimizes his own risk. [Hazlitt, 1959, p. 166-167]

5. Confusions About “Statics” and “Dynamics”

The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between today and tomorrow. Even the rate of interest is, virtually, a current phenomenon; and if we reduce the marginal efficiency of capital to the same status, we cut ourselves off from taking any direct account of the influence of the future in our analysis of the existing equilibrium.

The fact that the assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality (pp. 145-146).

Few passages even of Keynes are more arbitrary or confused. Boom and Slump, we were told on page 144, are to be “described and analyzed in terms of the fluctuations of the marginal efficiency of capital relatively to the rate of interest.” But now we are to understand that whereas the marginal efficiency of capital is to be treated as a “dynamic” concept, the rate of interest is to be treated as a “static” concept. … The marginal efficiency of capital reflects expectations regarding the future, but the rate of interest “virtually” does not. [Hazlitt, 1959, p. 168-169]

Chapter XIV

“LIQUIDITY PREFERENCE”

2. Money is a Productive Asset

Before we go on to explain the theoretical reasons why Keynes’s liquidity-preference theory is wrong, we must first point out that it is clearly wrong. It goes directly contrary to the facts that it presumes to explain. If Keynes’s theory were right, then short-term interest rates would be highest precisely at the bottom of a depression, because they would have to be especially high then to overcome the individual’s reluctance to part with cash — to “reward” him for “parting with liquidity.” But it is precisely in a depression, when everything is dragging bottom, that short-term interest rates are lowest. And if Keynes’s liquidity-preference were right, short-term interest rates would be lowest in a recovery and at the peak of a boom, because confidence would be highest then, everybody would be wishing to invest in “things” rather than in money, and liquidity or cash preference would be so low that only a very small “reward” would be necessary to overcome it. But it is precisely in a recovery and at the peak of a boom that short-term interest rates are highest. See Appendix D, p. 448. [Hazlitt, 1959, p. 192]
(see also Huerta de Soto’s explanation of the ABCT)

3. Interest Is Not Purely Monetary

But as between the two, cash preference is much to be preferred to liquidity-preference, not only because it is less vague, but because it does not, like liquidity-preference, make Keynes’s doctrine self-contradictory. For if a man is holding his funds in the form of time-deposits or short-term Treasury bills, he is being paid interest on them; therefore he is getting interest and “liquidity” too. What becomes, then, of Keynes’s theory that interest is the “reward” for “parting with liquidity”? [Hazlitt, 1959, p. 193]

Chapter XVI

CONFUSIONS ABOUT CAPITAL

1. On Going Without Dinner

Moreover [Keynes continues], the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand (p. 210).

Even Keynes, one might suppose, would have stopped at this point to re-examine either his premises or his paradoxical conclusion. For what he is saying is that though saving and investment are “necessarily equal,” increased saving may mean decreased investment! [Hazlitt, 1959, p. 218]

To quote:

Moreover, in order that an individual saver may attain his desired goal of the ownership of wealth, it is not necessary that a new capital-asset should be produced wherewith to satisfy him. 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 article of wealth old or new. Every act of saving involves a “forced” inevitable transfer of wealth to him who saves, though he in turn may suffer from the saving of others. These transfers of wealth do not require the creation of new wealth — indeed, as we have seen, they may be actively inimical to it. (His italics, p. 212.)

I find it impossible to make head or tail of this argument, or to read any sense into it. Every sentence of it seems to be wrong. An act of net saving by any individual must involve the creation of a new capital asset. If it fails to do so, if it is in fact a mere transfer of an existing capital-asset (say a stock or a bond), then the only reason it does not lead to the creation of a new capital asset is that it must be offset by an exactly equivalent act of dissaving on the part of some other individual — either the person who sells the saver the existing capital-asset, or some other person. But if there is no offsetting act of dissaving elsewhere, then a net addition to saving by anybody must mean the creation of a new capital asset.

It is, moreover, impossible to see how a saver “forces” some other individual to transfer some article of wealth old or new. A man who earns a wage of $100 a week and saves $10 out of it has not “forced” his employer to transfer this $10 to him. He has earned it for his services; he has produced an equivalent value in return. [Hazlitt, 1959, p. 223]

2. Saving, Investment, and Money Supply

The way in which “the banking system can make it possible for investment to occur, to which no saving corresponds” is easier to describe, so we shall begin with it. A big manufacturer comes to his bank with a proposition to put up a new plant; and the bank, because it has faith in his judgment or shares his optimism, advances him $1,000,000 toward it. It does this by creating a deposit credit of $1,000,000 against which he is free to draw. Thus $1,000,000 of monetary purchasing power has been newly created. Let us assume that it constitutes a new addition to the outstanding supply of money and bank credit. This sum is invested in the plant. “Investment” has increased by $1,000,000. This increase is represented by a physical asset, which we shall assume is a net addition to the supply of capital instruments. The increase in “investment,” then, is real. But there has also suddenly come into being $1,000,000 of new “cash.” Is this a genuine saving? Keynes insists that it is:

The notion that the creation of credit by the banking system allows investment to take place to which ‘no genuine saving’ corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. . . . The savings which result . . . are just as genuine as any other savings. No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth (pp. 82-83).

But this is a very Pickwickian definition of “genuine” savings. The bank creates a “cash” balance by writing a credit on its books — and lo! this becomes “new” savings, and “just as genuine as any other savings,” because somebody must hold the new cash balance! On this definition, we create “new” savings, “as genuine as any other savings,” simply by expanding the credit supply. On the same reasoning we can create any amount of new “savings” we wish overnight, simply by printing that amount of new paper money, because somebody will necessarily hold that new paper money! [Hazlitt, 1959, p. 226-227]

4. Abundance Unlimited

Keynes then goes on to speculate upon what would happen in “a society which finds itself so well equipped with capital that its marginal efficiency is zero and would be negative with any additional investment” (p. 217). And this is not merely a hypothetical assumption for the purpose of deducing hypothetical consequences, nor even an assumption which is not supposed to be realized for an indefinitely remote future. If

State action enters in . . . to provide that the growth of capital equipment shall be such as to approach saturation point at a rate which does not put a disproportionate burden on the standard of life of the present generation . . . I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation (p. 220). [And, going further:] If I am right in supposing it to be comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero, this may be the most sensible way of gradually getting rid of many of the objectionable features of capitalism (p. 221).

Nonsense could hardly be carried further. The central problem with which economics deals, the problem with which mankind has been struggling since the beginning of time, is the problem of scarcity, and this problem is assumed away in a few blithe words. It is “comparatively easy to make capital-goods so abundant that the marginal efficiency of capital is zero.”

Did Keynes stop to think for a moment what this would imply? It would imply that capital goods were so abundant that they had no exchange value! And if they had no value, they would be as free as air or (most) water or other goods without scarcity. It would be worth nobody’s while to keep such capital goods in repair (unless it cost nothing, not even anybody’s labor, to keep them in repair). There would be no problem even of replacement. For as soon as there were a problem of replacement, it would mean that capital goods once more had a value and cost something to produce: therefore, presumably, capital goods would cost nothing [should be “something”] to produce.

Moreover, if the marginal efficiency of capital were zero, it would also mean that no consumer goods would have any scarcity, price, or exchange value. For as long as any consumer goods anywhere failed to reach the point of satiation, and had a price or a value, then capital to help produce these consumer goods would have some marginal yield above zero.

A marginal efficiency of zero for capital would mean, in brief, such an abundance of everything that neither capital goods nor consumers goods would have any scarcity, any price, or any exchange value. [Hazlitt, 1959, p. 231-232]

Chapter XVII

“OWN RATES OF INTEREST”

1. Speculative Anticipations are not “Interest”

Keynes should have had some intimation that he was talking nonsense, one would suppose, when he was explaining “own-rates of interest” to the reader: “Let us suppose,” he writes, “that the spot price of wheat is £100 per 100 quarters, that the price of the ‘future’ contract for wheat for delivery a year hence is £107 per hundred quarters, and that the money-rate of interest is 5 per cent; what is the wheat-rate of interest?” (p. 223). After a slight calculation he concludes that in this case “the wheat-rate of interest is minus 2 per cent per annum.” And he adds, in a footnote, “This relationship was first pointed out by Mr. Sraffa, Economic Journal, March, 1932” (p. 223).

Now a negative interest rate is in itself a foolish and self-contradictory conception, for it is impossible to imagine any sane person lending any amount of wheat or money or anything else in order to make a foreseen loss; and the term “interest rate” implies that the rate is foreseen if it implies anything. The term “interest rate,” again, implies that something is being lent by one party to the transaction and borrowed by the other, and that the principal sum (or object) is being returned by the borrower to the lender at the end of the contractual period. [Hazlitt, 1959, p. 238]

2. Impossible Miracles

On the same page, Keynes, in illustrating own-rates of interest theory, writes: “To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a per cent per annum in terms of money” (p. 224). The illustration is absurd and impossible. Never in history has wheat been “expected to appreciate at a steady rate of a per cent per annum in terms of money.” And it is impossible to imagine without self-contradiction the conditions under which such an expectation could exist. One would be the expectation of an absolutely fixed “objective” value for a bushel of wheat each year (month, day, and hour), combined with a steady annual (also monthly, weekly, and daily) depreciation in the value of the currency unit. Such an expectation, if general, would be falsified because speculative transactions would anticipate it immediately. Another condition would be one in which the value of the dollar would be expected to remain absolutely fixed while the value of a bushel of wheat appreciated at a steady rate annually (and presumably monthly, weekly, and daily). For such an anticipation to exist, we should have to imagine a condition in which everybody miraculously expected the demand for wheat to increase with complete regularity (and without speculative anticipation!) while the supply for equally miraculous reasons remained rigid; or one would have to imagine so finely adjusted a decline in the production of wheat as to make a steady appreciation in value at the same uniform rate possible. One would have to imagine a universally shared expectation upon which no speculator, no buyer or seller, acted! But the assumptions are too self-contradictory to pursue further. [Hazlitt, 1959, p. 242-243]

6. “Equilibrium” of an Ice Cube

I had, however [in the Treatise on Money], overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. . . . I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment (pp. 242-243).

This entire passage is pure nonsense. It is absurd, as I have frequently pointed out before, to talk of “equilibrium with less than full employment” because this is simply a contradiction in terms. The absence of full employment negates the very concept of equilibrium. [Hazlitt, 1959, p. 251]

But any living economy is always in “transition” — and fortunately so. An economy that had reached completely “stable equilibrium” would be an economy that had not only stopped growing but had stopped going. [Hazlitt, 1959, p. 252]

Chapter XVIII

THE GENERAL THEORY RESTATED

1. Economic Interrelationships

Within the economic framework which we take as given, the national income depends on the volume of employment, i.e. on the quantity of effort currently devoted to production, in the sense that there is a unique correlation between the two (p. 246). Our present object is to discover what determines at any time the national income of a given economic system and (which is almost the same thing) the amount of its employment (p. 247).

The national income is certainly not the same thing as the amount of employment. Nor is there a “unique correlation” between them. The United States with heavy unemployment would have an immensely higher income, either total or per capita, than India or China with full employment. And even within the same nation, say the United States, employment and income do not necessarily rise and fall proportionately. As employment gets fuller, production per man employed tends to fall. As unemployment rises, production per man employed tends to rise. This is partly because, when unemployment sets in, it is the least efficient workers that tend to be dropped first, and when employment rises, it is the less efficient (than those already employed) that must be hired. Moreover, when employment is assured, and other jobs are easy to obtain, there tends to be relaxation of effort on the part of workers, whereas when jobs are insecure, there is an increase of individual effort.

Again, either insistence on excessive wage-rates, or new inventions and improvements, may force the substitution of machinery for workers. In one case there may be a temporary fall in employment without any corresponding fall in production (or total income). In the other case there may be no net change in employment but a significant rise in production (and real income). The “volume of employment” does not necessarily mean “the quantity of effort currently devoted to production.” Part of “the effort devoted to production” consists in capital improvement, better management, a better balance of production, etc. “Full employment” can conceal gross inefficiencies in production, malinvestment, unbalanced output of consumer goods, and laxity. All of which Keynes consistently ignores.

“Changes in the rate of consumption are, in general, in the same direction (though smaller in amount) as changes in the rate of income.” (Keynes’s italics, p. 248.) In other words, when a man’s income rises, he consumes more; the more his income rises, the more he tends to consume; and when a man’s income falls, he consumes less! Tremendous discovery, which deserves all the italics that Keynes can give it. [Hazlitt, 1959, p. 256-257]

3. The Demand for Labor is Elastic

“When there is a change in employment, money-wages tend to change in the same direction as, but not in great disproportion to, the change in employment; i.e. moderate changes in employment are not associated with very great changes in money-wages” (p. 251).

This is a typical instance of Keynes’s reversal of typical or normal cause and effect. The significant thing, in most situations, is the effect of changes in wage-rates on employment. Looked at from this side, employment tends, of course, to change in the opposite direction from wage-rates. If there has been prolonged mass unemployment, as a result of labor-union insistence on excessive hourly wage-rates (in relation to prices and marginal labor productivity), then a fall of these wage-rates toward the equilibrium point will mean a rise in employment. If, of course, it is prices rather than wage-rates that have been above the equilibrium level, or if for some reason wage-rates have temporarily fallen below the equilibrium level, then an increase in the demand for goods due to a fall in prices, or some other change, or an increase in the demand for labor due to the low wage-rate, will mean an increase in both employment and wage-rates. In this special case the relationship stated above by Keynes would hold. But this is a comparatively rare and short-lived situation. Much more frequently, it is a downward adjustment in wage-rates (or a gradual rise in man-machine-hour productivity) that will bring a rise in employment. [Hazlitt, 1959, p. 259-260]

Chapter XIX

UNEMPLOYMENT AND WAGE-RATES

3. “Elasticity” of Demand for Labor

When we are dealing with unemployment, for example, we must assume that there is a reason for the unemployment. The most probable reason is that wage-rates are too high — i.e. that they are above the point of equilibrium. This may not be so; but it is certainly one of the hypotheses, if not the first hypothesis, that ought to be considered. Keynes never considers it. His examples tacitly assume that wage-rates are already at, or even below, the point of equilibrium. Only on that assumption could he reach the conclusion, as he does, that a reduction of wage-rates would mean a reduction of wage income, either by not increasing employment in the least, or by actually reducing it further. [Hazlitt, 1959, p. 272]

4. Fallacies of “Aggregative” Economics

Let us begin by looking again at the Keynesian term “effective demand.” We have seen that there is no need for the adjective. It implies that there are two kinds of demand — “effective” and ineffective. Ineffective demand could then only mean desire unaccompanied by monetary purchasing power. But economists have never called this demand. The term “demand” as used by economists has always meant effective demand, and nothing else. Inserting the adjective, then, adds nothing but confusion. [Hazlitt, 1959, p. 274]

5. The Attack on Flexible Wage-Rates

To suppose that a flexible wage policy is a right and proper adjunct of a system which on the whole is one of laissez-faire, is the opposite of the truth. It is only in a highly authoritarian society, where sudden, substantial, all-around changes could be decreed that a flexible wage-policy could function with success. One can imagine it in operation in Italy, Germany or Russia, but not in France, the United States or Great Britain (p. 269).

Such a statement fairly takes one’s breath away. Laissez faire means non-adjustment! Laissez faire means inflexibility! Authoritarianism means flexibility! Flexibility means rigidity! One thinks of George Orwell’s Nineteen Eighty-Four, where war is peace, ignorance is strength, and freedom is slavery. [Hazlitt, 1959, p. 276-277]

Chapter XXI

PRICES AND MONEY

3. What Theory of Prices!

It constantly leads him into tautology. “They may also have different elasticities of supply in response to changes in the money-rewards offered” (p. 302). But as “elasticities of supply” means “response” this could have been written more briefly, simply and clearly: “The response of their supply to changes in price may also be different.” Again, “the elasticity of effective demand in response to changes in the quantity of money” (p. 305) could be at once clarified and shortened by writing “the response of demand to changes in the quantity of money,” etc. And still again, “the elasticity of money-prices in response to changes in effective demand measured in terms of money” (p. 285) could have been phrased simply “the response of prices to changes in demand.”

It is largely on such pretentious pleonasms and circumlocutions that Keynes’s reputation for profundity seems to rest. [Hazlitt, 1959, p. 305]

6. Sacrosanct Wage-Rates, Sinful Interest Rates

And when Keynes declares that “the price-level . . . will depend partly on the cost-unit” (p. 302), he is saying that the average of all prices is determined and caused by a single price. Modern economic theory has made it clear not only that “costs” are themselves prices, but that “costs” and “prices” mutually determine each other.

How did Keynes come to slip into these logical monstrosities, these apparently quite gratuitous absurdities? The answer is that he considered these absurdities essential to this central thesis that it is always harmful even to think about reducing wage-rates: “If . . . money wages were to fall without limit whenever there was a tendency for less than full employment. . . there would be no resting-place below full employment until either the rate of interest was incapable of falling further or wages were zero” (pp. 303-304).

The hysterical supposition that any attempt to adjust wage-rates to bring them into equilibrium with other prices would cause wages to “fall without limit” and go to zero is a bugaboo that could scare only mental children. It is just what it sounds like — howling nonsense. [Hazlitt, 1959, p. 314]

Chapter XXII

THE “TRADE CYCLE”

1. A “Sudden Collapse” of the “Marginal Efficiency of Capital”?

“A more typical, and often the predominant, explanation of the crisis is,” he declares, “not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital” (p. 315).

Now the truth or importance that we attach to this statement depends once more upon the interpretation we give to Keynes’s ambiguous term, “the marginal efficiency of capital.” If it means merely the outlook for business profits (which in this context it does seem to mean), then it is true but obvious. For a collapse in the outlook for business profits is in turn merely another name for a collapse of confidence. A collapse in the state of confidence is, of course, an inherent part of the crisis. But this merely raises the question: What caused confidence to collapse? What caused the outlook for profits to turn sour? What brought on the sudden collapse in “the marginal efficiency of capital”?

This is merely one more illustration of the confusions Keynes gets into through the ambiguity of his own terms. If “the marginal efficiency of capital” means the expected yield of capital assets (as Keynes frequently tells us it does) then it is an expectation, a psychological phenomenon, dependent on the general outlook for business profits as businessmen estimate that outlook, correctly or incorrectly. If the “marginal efficiency of capital” means (as it seems on its face to mean) the present physical productivity of capital assets, then clearly it is not this that “collapses” in the crisis, either as cause or consequence. If, finally, “the marginal efficiency of capital” means the present monetary value of the goods that capital instruments help to produce, then a collapse in that monetary value may cause a collapse in the marginal efficiency of capital. But the causation is not the other way round.

In sum, Keynes’s explanation of the crisis as a sudden collapse of the marginal efficiency of capital is either a useless truism or an obvious error, according to the interpretation we give the phrase “the marginal efficiency of capital.” [Hazlitt, 1959, p. 321-322]

2. When Governments Control Investment

His distrust of a free economy is unconcealed:

It is of the nature of organized investment markets, under the influence of purchasers largely ignorant of what they are buying and of speculators who are more concerned with forecasting the next shift of market sentiment than with a reasonable estimate of the future yield of capital-assets, that, when disillusion falls upon an over-optimistic and over-bought market, it should fall with sudden and even catastrophic force (pp. 315-316). It is not so easy to revive the marginal efficiency of capital, determined, as it is, by the uncontrollable and disobedient psychology of the business world. It is the return of confidence, to speak in ordinary language, which is so insusceptible to control in an economy of individualistic capitalism. (My italics, p. 317.)

One incidental point brought out in this passage is that it extends the phrase “the marginal efficiency of capital” to the point where it means, “in ordinary language,” merely confidence! [Hazlitt, 1959, p. 323]

4. A Policy of Perpetual Inflation

Keynes’s economics is the economics of wish fulfillment, the economics of the Land of Cockaigne, where every problem can be solved by rhetoric:

Thus the remedy for the boom is not a higher rate of interest but a lower rate of interest! For that may enable the so-called boom to last. The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom (p. 322).

[…] Keynes proposes to do this, in effect, by a policy of perpetual inflation, of keeping the interest rate low by a constant expansion of the money-and-credit supply … Never once does he ask what would happen if wage-rates, in this full employment boom, started racing ahead of prices and wiping out profit margins. Never once does he say what he would do to stop this from happening. … His “remedy” is to keep the boom going by encouraging overinvestment and malinvestment, and then, when the boom cracks, to keep it going by lowering the rate of interest still more to encourage still more over-investment and malinvestment. He refused to recognize the rate of interest as a payment for anything real … He failed to recognize that the rate of interest is a market phenomenon like any other. [Hazlitt, 1959, p. 330-331]

Chapter XXIII

RETURN TO MERCANTILISM?

3. Wise Mercantilists, Stupid Economists

“For in an economy subject to money contracts and customs more or less fixed over an appreciable period of time, where the quantity of domestic circulation and the domestic rate of interest are primarily determined by the balance of payments . . .” (p. 348). I must interrupt here to point out that this is an obvious confusion of cause and effect. The balance of payments is itself heavily influenced and largely determined by relative rates of interest in different nations, relative national changes in the quantity of money, and relative changes in national price averages, or, rather, in specific prices. The balance of payments, in fact, is far more often a consequence of one or more of these other changes than they are of the balance of payments. [Hazlitt, 1959, p. 344]

Chapter XXIV

KEYNES LETS HIMSELF GO

2. The Euthanasia of the Rentier

When Keynes tells us that “the scale of effective saving is necessarily determined by the scale of investment,” he forgets that the primary causation is the other way round. Saving determines investment. Without saving, there is nothing to invest. Even on Keynes’s own definitions, investment cannot come into being without equivalent savings. To say that “the scale of investment is promoted by a low rate of interest” is to look at the matter solely from the point of view of the borrower, and to forget the point of view of the lender.

Suppose we applied Keynes’s dictums to buying and selling. We would then write something like this: “Buying is not determined by purchasing power, but effective purchasing power is determined by the scale of buying; and the scale of buying is promoted by low prices.” This would be immediately recognized as nonsense. [Hazlitt, 1959, p. 377]

3. Robbing the Productive

[He goes on] Thus we might aim in practice (there being nothing in this which is unattainable) at an increase in the volume of capital until it ceases to be scarce, so that the functionless investor will no longer receive a bonus; and at a scheme of direct taxation which allows the intelligence and determination and executive skill of the financier, the entrepreneur et hoc genus omne (who are certainly so fond of their craft that their labor could be obtained much cheaper than at present), to be harnessed to the service of the community on reasonable terms of reward (pp. 376-377).

In reply, it may be pointed out that capital will cease to be “scarce” only when it ceases to have value, so that anybody will be willing to give it away. It will cease to have value only when it either costs nothing to produce, or when its application ceases to reduce the costs (including time) of production of anything, or when the consumer goods that it helps to turn out themselves cease to be “scarce” and to have value — all of which conditions are impossible. [Hazlitt, 1959, p. 383]

Keynes concludes this section by writing: “It would remain for separate decision on what scale and by what means it is right and reasonable to call on the living generation to restrict their consumption, so as to establish, in course of time, a state of full investment for their successors” (p. 377).

But people have already been deciding this question as individuals and voluntarily, and not by collective compulsion (except through progressive income and inheritance taxes and so-called State “investment”). Having rejected the voluntary solution, Keynes is forced to look for a solution through compulsion, such as that made by totalitarian governments.

Incidentally, “full investment,” as we have seen, is a silly and meaningless phrase. It fails to recognize the illimitable improvements that are always possible in quality, and it is based on purely static assumptions. What becomes of “full investment” in a particular machine, for example, when a new machine or process is invented that makes the old one obsolete? [Hazlitt, 1959, p. 384]

4. The Socialization of Investment

These are to be left, as before, to the labor-union leaders, which are to continue to enjoy legal privileges and immunities denied to all other groups.

If we suppose the volume of output to be given, [Keynes continues] i.e., to be determined by forces outside the classical scheme of thought, then . . . private self-interest will determine what in particular is produced, in what proportions the factors of production will be combined to produce it, and how the value of the final product will be distributed between them (pp. 378-379).

This passage is an obvious self-contradiction. If the State determines how much will be invested, at what interest rate, and just where, it necessarily determines what in particular is produced and with what factors. Keynes’s scheme would take all of this out of private hands. He merely refuses to recognize the implications of his own proposals. [Hazlitt, 1959, p. 386]

Chapter XXVI

“FULL EMPLOYMENT” AS THE GOAL

I. Is It Definable?

Let us begin with the question of definition. The man in the street has few misgivings about this. “Full employment” means that “everybody” has a job. It means “jobs for all the people all the time.” […] In the General Theory, Keynes gives us two definitions, neither of which seems to have much relation to the other. On page 15 he gives an involved definition of “involuntary” unemployment which, as I have already tried to show (p. 30), is invalid. From this he postulates a state of affairs in the absence of “involuntary” unemployment: “This state of affairs we shall describe as ‘full’ employment, both ‘frictional’ and ‘voluntary’ unemployment being consistent with ‘full’ employment thus defined” (p. 16). In other words, “full” employment is a state in which there can be both “frictional” and “voluntary” unemployment! Full employment is not full. [Hazlitt, 1959, p. 399, 401-402]

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