CLASSICAL LIBERALISM
By Noah Nissani
Copyright 1997 -- Authorized free distribution of non-modified
copies for non-commercial purposes.
Chapter III POLITICAL ECONOMY -- Part II (Conclusion)
Contents:
Symbols
Formulas
1. Salary and Prices
2. Money
3. Quantity of Money, Circulation and
Gross National Product (GNP)
4. Monetary, Cost, and Demand Inflation
5. Trade Cycles. Keynesianism versus Monetarism
6. Epilogue
Notes
Symbols:
B=Bulk of merchandises and services exchanged by
money in a given period. It includes raw material
and work, together with finished goods.
p = Average price per unit of B.
G= Goods and services marketed by final users
in a given period.
P=Average Price per unit of G.
C=Average cost of production, transport and marketing
per unity of G, through the entire chain of
intermediaries from raw material to the final user.
S=Average salary per hour.
R=Capitalists' revenue.
RE=Relative Efficiency,
M=Marginal Cost. Cost of production of
factories that do not return gains.
H=Man-hours actually employed in producing G.
H'= " that would be required in producing G through
a chain of factories working at marginal cost.
V= Average times that unit of money passes from one
hand to another in exchange for commodities, services,
or work in a given period.
FORMULAS
P x G = H'x S (1a), C x G = H x S (1b),
R = (P - C) x G = (H' - H) x S (1c),
P x G = H x S + R (1d), S/P = G/H' (1e),
R/S = (H'-H) (1f), R/G = (H'-H)S/G (1g).
Q V=p B (3a) p B = k' P G + S H (3b),
Q V = k' P G + S H. (3c), Q V = k' P G + S H'- R (3d)
Q V = (k+1) P G = (k+1) S H' (3e), G=(G/H) H (3f),
(G/H')H' (3f')
----------------------------------------------------
1 SALARY and PRICES
Marginal cost (M) equals price (P) by its very definition i.e.,
the cost per unit at which goods are produced by factories
without returning any gains. Certainly, the cost of production
is divided between salaries, raw material, machinery, fuel,
etc.. However, the cost of each of these elements is finally
resolved at the salary level, through the respective marginal
cost of a chain of intermediary stages (1). Hence, the purchase
value of a given amount of goods (G) equals the man-hours (H')
that would have been invested in producing it, from the raw
material to the user's hands, through a chain of real or
virtual factories working at marginal cost, multiplied by the
average salary (S), i.e., P G = H' S (1a). Whereas the actual
cost of production of the given amount of goods equals the
average salary multiplied by the actual man-hours (H) employed
in the real chain of factories, i.e., C G = H S (1b).
Therefore, the capitalists' revenue (R) along the whole process
is calculatedby subtracting (1b) from (1a), and is expressed by
R=(P-C) G =(H'-H) S (1c). And from equations (1a) and (1c)
results P G = H S + R (1d), i.e., the purchasevalue of the
aggregate goods (G) equals the aggregate salaries plus
thea ggregate capitalists' revenue.
Equations (1a) and (1c) show that prices and capitalists'
revenue are directly proportional to salaries, S/P=G/H' (1e)
and R/S=(H'-H) (1f). Therefore, a general salary increase at
constant G, H' and H results in a proportional increase of
prices and capitalists' profits. The salary/prices and
profit/prices ratios remain constant, and only a devaluation of
money is achieved. This result is not so obvious to general
public, and the widespread belief that a general salary
increase can improve the living standard of the masses is
widely exploited by ignorant or with less-than-noble intentions
politicians. As a matter of fact, only an increase in
productivity, i.e. in the G/H' ratio, can improve the
purchasing power of salaries, as has been the case from the
beginning of the industrial revolution, by means of ongoing
innovation in tools and methods of production.
On the other hand, a sectoral raising of salaries increases the
prices of some products, entailing a devaluation of money
proportional to the increase of the average salary. Therefore,
the purchasing power of some workers will augment, to the
detriment of those whose salaries were not augmented. It can
also harm the profits of some enterprises to the benefit of
others, but it can hardly affect the real value of the
aggregate capital's gains, which will remain proportional to
the average salary.
Work is a conglomerate of services or crafts, each of them
having its own supply and demand market. Hence, in a real
free-market its price would have to fluctuated with the
supply-demand balance. However, work differs from the other
commodities in many aspects:
1) The aggregate value of work nearly equals that of all other
commodities put together, and hence its economic weight is
critical.
2) It is the ultimate raw material of every other commodities
and therefore its price determines all other prices.
3) As a result of trade union pressure and labor laws, salaries
are easily increased when demand exceeds supply, but rarely
lowered when supply exceeds demand. This makes it difficult to
reestablish the market equilibrium after an economically
excessive raising of salaries. For this reason there exists a
wide consensus among economists that a less of five percent
rate of unemployment leads to an unstable economy, which may
end in inflation. What might otherwise lead to an oscillation
around the economic level of wages, results from the
elimination of the lowering phase of the wage oscillation in a
constant inflationary process.
2. MONEY
Economy is based on specialized production, in which everyone
puts on the market specific goods to be exchanged for goods
produced by others. The difficult exchange of, for example, a
cow for a suit, is facilitated by the existence of an
intermediary merchandise, which must possess two fundamental
properties:
a) A stable and known exchange value with respect to the other
merchandises, what makes it universally acceptable.
b) A high value/weight ratio, that makes it easily portable.
From earliest times valuable metals such as gold and silver
have fulfilled the function of this intermediary merchandise.
This began in the form of pieces of metal broken and weighed
out in presence of the seller (2), and later as metal coins of
conventional value. Afterwards, the coins were replaced by
metal-backed paper-money issued by trustworthy banks in the
form of banknotes exchangeable for metal on demand.
The exchange value of metal and metal-backed money was
dependent on the supply and demand of gold and silver in the
world markets. Therefore, they could not fulfill in a totally
satisfactory manner the requirement of a stable value. And so
it happened, that in the last part of the 19th century, prior
to the discovery of gold deposits in Alaska and South Africa,
the increasing gold demand caused a general lowering of prices,
i.e, a deflation which was not less detrimental than its
counterpart, the inflation that followed in its wake with the
discovery of these new and rich gold deposits toward the
beginning of World War I. Furthermore, gold-backed currency has
no more reliability than that of the institution or government
issuing it, and the condition of being "gold-backed" has been
repeatedly violated each time a non-conservative monetary
policy was adopted.
It is only in recent times that the gold-backed currencies have
been substituted by "fiat" ones, i.e., by currencies whose
reliability is based on a conservative monetary policy aimed at
stability of prices. This currency stability is measured by the
constancy of the prices of a somewhat arbitrarily defined
basket of goods. In spite of the arbitrariness in the selection
of the basket, and of some questions that arise from the
variable quality of these goods, this method provides a better
monetary stability than that which could be achieved by
metal-backing of currency.
International agreements determine financial sanctions for
those nations whose currency suffers a level of inflation that
surpasses a conventional standard. But perhaps the most serious
penalty incurred is the damage that inflation inflicts to the
national economy, and the rejection of unstable currencies in
international transactions. Those nations whose currency is not
internationally accepted are forced to maintain stocks of
foreign currencies to finance their imports, instead of
enjoying the highly remunerative export of their own currency.
Today it is widely accepted, as a modern complement of the
liberal principle of separation of powers, that to assure a
non-inflationary monetary policy the power of to issue money
must be kept separate from that of using it. While the use of
money remains a function of the legislative and executive
powers, the issuing of money is presently being transferred to
an autonomous Central Bank, which is responsible for its
stability. It is still a debated question whether the Central
Bank must also be responsible for full employment and economic
growth. The supporters of extending the Central Bank function
to these two additional areas point out their close dependency
on monetary policy. The opponents object that the matters of
full employment and growth are better handled by labor
legislation and tax policy. Their transfer to the Central Bank
would force it to deal with them by monetary means, what would
lead to contradictory demands from the monetary policy.
3. QUANTITY of MONEY. Circulation and Gross National Product
(GNP)
Money includes in addition to the coins and bills issued by the
government every other real or virtual intermediary merchandise
used in commercial transactions, such as checks, promissory
notes, account transfers, credit cards, commercial credit etc..
Quantity of money is then the aggregate purchasing potential of
the people, enterprises, and institutions at a given moment.
The difference between the quantity of money, and the
governmental- issued currency is basically created by credit.
In practice, credit counts for many times the main part of the
means of payment, and bills and coins are scarcely used except
for minor retail purchasing.
As an illustration, in 1968 the total of bank deposits in the
United Kingdom amounted to 12,110 million pounds, while the
amount of issued bills and coins was only 3,572 million. Of the
latter nearly 700 million were held in the banks' safes, and
something like 2,800 million were in circulation (3).
Therefore, there were at the public disposal 2,800+12,110=
14,910 million pounds (4), of which 11,338 million pounds were
credit-money issued by the banks. To this sum one must still
add the credit offered by commercial firms, which constitutes a
significant part of the aggregate means of payment, i.e., of
the quantity of money.
To understand the mechanism of money issued by banks, let us
assume that all the payments are performed by check or credit
card, so that the sums are simply transferred from one bank
account to another. This assumption, which is becoming truer
with every passing days, only simplifies the explanation
allowing us to overlook the percent of issued money held in
cash by the public. Hence, it is assumed that the total of
issued currency (X dollars) is deposited in the banks. The
banks loan this sum to their clients by crediting it to the
clients' accounts. Hence, 2X dollars are now deposited in the
banks, and only half of them are loaned.
When the deposit's owner makes use of the money, owned or
borrowed, it simply passes from one account to another,
therefore there is a remainder of X dollars at the banks'
disposal for new loans. After this disposable remainder has
been loaned there would be 3X dollars in bank deposits and only
2X of them loaned. This process could continue ad infinitum,
were it not for the Central Bank demand that the banks must
retain in cash a certain percentage of the deposits. This cash
reserve, called liquidity, amounts in the above example
700x100/12,110=5,78 percent of the deposits (5). It is by
varying the liquidity, that the Central Bank controls the
quantity of credit-money issued by the banks. (6)
A process similar to that in which metal coins were replaced by
bills in the past, is occurring in our own day, when checks,
account transfers, and credit cards seem close to completely
displacing the circulation of government currency. Bank
deposits are today a currency-backed money issued by banks,
similar to the gold-backed paper-currency issued by the
government in the past.
An approximate calculation of the quantity of money needed by
the market can be made by means of the following simplified
model. Let's assume that all the employees receive their
salaries on the first day of the month. Therefore, the last day
of each month an amount of currency equal to the aggregate
monthly salary must be present in the bank accounts of the
employers, in order for to be transferred the next morning to
the accounts of the employees. During the month the currency
returns to the employers through a chain of service providers,
shops, etc., and the monthly cycle begins again. Hence, the
number of employees multiplied by the average salary gives an
approximate value of the minimum quantity of money required.
An economic parameter of no less importance than the quantity
of money is its velocity of circulation. If in the preceding
calculation the monthly salary is substituted by a biweekly
one, the quantity of money needed would be half of that
previously calculated. This half-quantity of money would run a
complete cycle twice a month, from the factory to the workers,
from them to the retail shop, the wholesaler, and once again to
the factory. Nevertheless, the aggregate value of the
transactions effected in a given unit of time would remain
unaltered.
"Money circulation" is defined as the product of the quantity
of money (Q) by the number of times (V) on average that an unit
of money passes from one hand to another in a given period.
Hence, it follows that Q V=p B (3a), where B is the aggregate
merchandise (7) involved in the transactions, and p, the
average price per unit of B, is an identity by the very
definition of its terms. V and B are relatively stable
parameters of the market, which cannot be directly influenced
by a change in Q or p. In practice, the quantity of money (Q)
is the only one of the above four parameters that can be
directly changed by the government. Therefore, an increase of Q
not balanced by a change of B or V, will necessarily lead to an
increase of p. Such an unbalanced increase in quantity of
money, which entails the raising of prices, is termed "monetary
inflation".
The aggregate merchandise (B) involved in commercial
transactions in a given period, includes finished goods and
services (G), together with the raw material, fuel and work (H)
used in its production. It also repeatedly includes the same
goods as their pass from the factory to the wholesaler, to the
retail shop, and finally to the user. When it is desirable to
avoid this repeated counting, the aggregate goods and services
purchased by final users (G) must be used in place of B. From
the respective definitions of B and G it results that p B = k'
P G + S H (3b), where P is the average price per unit of G, and
k' is a coefficient of proportionality between the aggregate
value of G, and that of B excluding work, which appears in a
separate term (S H). Therefore, from (3a) and (3b) results Q V
= k' P G + S H (3c), which using (1c)
becomes Q V = k' P G + S H'- R (3d).
Assuming that at a given distribution of relative-efficiency
(RE) among the factories of the market, the capital's revenue
(R) is proportional (8) to the amount of the goods marketed (P
G),we obtain k' P G - R = k P G. Now making use of P G = S H'
(1a) it follows that Q V=(k+1) P G (3e) and QV=(k+1) S H'
(3e'). From the equation (3e), and being V a relatively stable
parameter of the market, it follows that any increase in G
requires an augment of Q or a reduction of P. Therefore, an
issuing of money proportional to the increase in production
must be carried out in order to maintain the stability of the
purchasing value of money.
The aggregate final goods G is the product of the average
actual productivity or efficiency, i.e., the average
goods/man-hours ratio G/H, by the actual aggregate man-hours H,
G=(G/H) H (3f) or also G=(G/H')H' (3f'), where G/H' is the
marginal productivity, and H' the amount of man-hours that
would be employed in producing G if all the factories of the
market would work at marginal cost. Equations (3f) and (3f')
are closely related and in a competitive market, as it was
explained in the previous chapter, any increase in G/H entails
an increase in G/H'.
In the case of an increase in G which results from an increase
in G/H' at constant H', equation (1e) (S/P = G/H') shows that
the increase in marginal productivity entails a similar
increase in the salary/prices ratio. Equation (3e) (Q V=(k+1) P
G) means that any increase in G, independently of its cause,
requires a raising of Q to preserve the stability of prices P.
In the inverse case of an increase of G caused by an increase
in H', at constant marginal productivity G/H', it results from
QV=(k+1)S H' (3e') that a proportional increase of Q is needed
to avoid a reduction of salaries. From QV=(k+1)P G (3e) it is
clear that such an increase of Q does not entail any change in
prices. So that immigration, which is one of the main causes of
manpower increase, allows for a non-inflationary issue of money
that may be used to facilitate its absorption without charge to
the taxpayer.
The money value of the annual production of final goods and
services G, is named Gross National Product, GNP=P G, and it is
also frequently referred to as Gross National Income, GNI, and
defined as the sum of annual aggregate salaries and gains, GNI
= H x S + R. From equation (1d) results GNP = GNI. For GNP to
have an economic meaning, either P must be expressed in a
stable currency, or the effect of inflation must be deducted.
An increase in GNP that results from an increase in G, is
termed economic growth. It may result from an increase either
in productivity (G/H), or in the amount of man-hours (H). In
the first case it implies an increase in GNP per capita, which
is closely related to the living standard of the masses.
Demand Inflation. Cost Inflation. Monetary Inflation.
4. MONETARY, COST, and DEMAND INFLATION
Inflation and some of its causes and effects already have been
elucidated in the preceding sections. So, what remains to be
done here is to summarize, arrange and supplement the facts and
ideas concerning this complex and problematic aspect of
economy.
A currency of unstable value results in a general raising or
lowering of prices that disturbs the economy at all its levels,
from home-budget management to industrial planning. When prices
continuously vary, consumers lose their ability to evaluate
prices, and tend to pay as much as they are asked to pay. On
the other hand, shopkeepers worried that they will be forced to
pay for the replacement of the merchandise more than they are
receiving for it, tend to raise prices. The combined outcome is
catastrophic to the family budget.
Industrial and commercial management is based on long term
planning. The clothing industry, for example, must offer summer
merchandise to retail shops during the winter and partially
collect its value the coming autumn. Therefore, the prices in
the wholesale catalogs distributed in January must take into
account the expected value of money in September. The retailer,
in turn, must add the expected surplus he will be called to pay
for the following winter's merchandise, otherwise, the real
value of his capital would decrease. The uncertainty with
respect to the inflation rate in the future increases the risk
in every industrial or commercial transaction, and forces a
risk factor to be included in the prices. In such long term
planning, any difference between the expected and the actual
inflation rate, no matter in what sense, may lead to the
bankruptcy of enterprises, merchants, and families.
Inflation is a chain-reaction phenomenon, self-fed not only by
the inflation expectation, as was illustrated in the previous
paragraph, yet also by the demand of wage indexation that it
brings on. The link between salaries and the cost-of-living
index causes a temporary increase of some prices resulting in a
general augment of salaries, which in turn causes a general
increase of prices and so on. This chain reaction is so
dangerous that it is universally accepted that wage indexation
can never be 100%. The difference between the indexation and
100% acts as a waning factor that does not eliminate the
self-rising effect but prevents a total economic collapse.
Inflation is not a disease but a symptom of various economical
diseases, and its seriousness and the means of action against
it vary with its cause. An accepted classification of
inflationary processes according to their causes divides them
into monetary, cost, and demand inflation.
Monetary Inflation.
Accordingly to eq. Q V=p B (3a) an increase in quantity of
money (Q), over the amount needed to balance an increase in the
aggregate transactions (B), necessarily entails an augment in
prices (P), which is called "monetary inflation." It may be
caused either by government deficit expending covered by
issuing currency, that is, government-backed counterfeiting of
money, or by an increase in bank or commercial credit. The
graveness of a monetary inflation caused by deficit expending
depends on the cause of the budget deficit, which may be either
a transitory increased expenditure, an inflated government
bureaucracy or services that exceed government revenues, or
merely a large budget/GNP ratio.
a. Inflation caused by transitory expenditures.
Israeli examples of monetary inflation caused by transitory
expenditures are those that followed the Iom Kippur and Lebanon
wars. (The first of them was combined with the worldwide "cost
inflation" caused by the raising of the price of petroleum.)
After the cause of the transitory expenditure disappears, it is
relatively easy to disable the remaining self-feeding
inflationary process by means of monetary measures. This
explains the relatively easy success of the Israel National
Unity government in reducing the severe inflation caused by the
military action in Lebanon (1982-86) to a remainder rate of
10-12 percent.
b. Inflation caused by inflated bureaucracy and/or government
services.
All bureaucratic bodies tend to expand, and people demand the
amplification of government services when it is not clear, that
they will be called upon to pay for them. Hence, this kind of
inflation is much more difficult to deal with, on account of
the electoral impact of massive dismissal of government
employees and reduction of services.
The above-mentioned annual remainder rate of inflation of 10-12
percent in Israel, which continues to be more or less stable
from the late 1980s to today (1997), can be attributed to
inflated bureaucracy and services financed by deficit
expending. In the last years, this relatively stable situation
was seriously aggravated by the political motivated raising of
government salaries, when the public favored the opposition.
According to equation S/P=G/H' (1e), such a raising of salaries
(S) exceeding the productivity (G/H') increase would have to
result in an inflationary increase in prices (P). Though the
inflation was restrained by the Bank of Israel raising of the
interest rate, which is a powerful yet harmful means of
controlling inflation that has a double effect:
i) It discourages the use of credit, reducing the quantity
of credit-money and balancing the currency issued by the
government. A similar effect also could be attained by
raising liquidity, (i.e., raising the portion of deposits
that banks must retain in cash.) Both ways harm industry and
commerce, which must pay a high interest rate and cut down
the credit needed for their normal activity.
ii) The high interest rate attracts a flow of foreign
currencies causing revaluation of the national currency, and
favoring import to the detriment of local industry and
export. Imported goods, not balanced by similar amount of
exports, augment the quantity of goods (G) at public
disposition in equation (1e) (S/P=G/H') (11), preventing a
rise in prices (P), yet increasing the deficit in the
balance of payments.
A similar effect of inflation control by increasing G with
imported goods also may be attained by reducing customs taxes.
Therefore, the raising of interest rates combines the effects
of increasing liquidity and lowering customs taxes. In
addition, it provides by means of the attracted flow of foreign
currency for the momentary covering of the deficit in the
balance of payments, giving the feeling of business as usual,
making it even more dangerous.
Returning to the Israel case, the annual rate of the deficit in
the current balance of payments jumped from 1,770 in 1993, to
7,120 million dollars in the first half of 1996 (12). Namely, a
jump from 1.8 to 7.2 percent of the Gross National Product
(GNP). Since the Israeli government budget amounts to nearly
50% of the GNP, an increase of say 20% in government salaries
will result in an immediate growth of nearly 10% in the Gross
National Product (remember that GNP equals Gross National
Income (GNI), as it was shown in Section 3.) The consequent
diminution in the contribution of the harmed private sector to
the GNP will be felt only after a lag that can be more than
one/two years long. In the meantime, even an increase in the
economic activity of the private sector may be perceived as a
consequence of the increased purchase power of government
employees. Therefore, in spite of the disastrous effects of the
high interest rate on industry and export, and the
unsustainable deficit rate in the balance of payments, a false
sensation of "economic growth" and welfare is created.
From a strictly economic point of view the solution is very
easy: Either return salaries to their previous level or dismiss
an equivalent number of government employees. In practice, the
trade unions and electoral demands make both options very
difficult. The only other way to reduce the deficit expending
is to cut down on the goods and services purchased by the
government from the private sector. Namely, to continue paying
employees salaries while restricting their activity. This leads
to a reduction of private gains, which lowers government
receipts and partially balances the decrease in government
expenses and demands new budget reductions.
The return to a normal interest rate is liable to cause a
reversed flow of foreign currency followed by national currency
devaluation, an increase in imported raw material prices, and a
consequent cost inflationary process. Furthermore, since a
large part of the surplus foreign currency has been used in
covering the deficit in the balance of payments, the remaining
reserves may be insufficient to satisfy the demand of foreign
currency, resulting in a total collapse of the economy, as has
happened recently in Mexico and Thailand.
Summing up, the interest rate is a powerful tool for
controlling currency stability when dealing with minimal
inflationary or deflationary deviations. It is a matter of
controversy, if in the case of severe inflation, which demands
a considerably high interest rate over a long period, if the
medicine is not more harmful and dangerous than the disease.
c. Inflation caused by a large Budget/GNP ratio.
Unavoidable incorrect evaluations of future government receipts
and/or expenditures often result in deficit expending. The
larger the Budget/GNP ratio, more significant their
inflationary impact.
The expected 1997 Israel National Budget/GNP ratio is nearly
50% -- more than twice the USA Federal Budget/GNP ratio. The
latter quadrupled from 1934 to 1952, during a period in which
Keynesianism (9) and Marxism, both supporting government
intervention in economy, were on the offensive, while
Liberalism was on the defensive and withdrawing. During this
period, USA federal taxes jumped from 4.8 to 18.9 percent of
the Gross Domestic Product (GDP=GNP excluding income originated
in foreign countries) and remained at this level until
today.(10)
It was alleged that the extreme imbalance in the 1996 Israeli
budget partially originated in an erroneous evaluation of the
expected government receipts.
----
After WW2 a number of factors led many nations in the
developing world and the developed world periphery to a
disastrous level of monetary inflation:
a) The totalitarian ideologies in vogue at the time
convinced rulers that they could and should do all in order
to benefit their subjects. This led to a populist policy of
"concern" for the poor, which favored inflated bureaucracy,
army, and police, and enhanced the power of ambitious
rulers.
b) Keynes' and his followers' theories allowed for deficit
expending in order to prevent economical depression.
Schematically these theories advocated inverting the
classical formula "Capital, Work, Money" into "Money, Work,
Capital." Instead of capital invested in new factories and
jobs resulting in increased production and flow on currency,
money issued would pay for the work, and the latter would
create capital.
Although Hitler succeed in vitalizing the destroyed German
economy by using the above inverted formula, all other
attempts to emulate this performance led to disastrous
outcomes. The cause seems to reside in two factors present
in the German case, yet absent in the others. First, due to
temporary factors the Germany GNP was below its actual
potential. In these circumstances an electric-financial
shock was sufficient to get the German economy moving.
Second, the iron discipline of the Hitlerian regime did not
allow any deviation from the central goal.
c) What makes monetary inflation a favorite of irresponsible
rulers is that it is a hidden tax taken from the workers'
wages without them being aware of the fact. Theoretically it
is taken from anybody who is caught with money in his hands
or accounts. In practice, only wage-earners are the payers
of this tax, since industries and shopkeepers forward it to
the customers by including it in the prices. Workers are not
aware that it is the government that is taking the money
from their pockets and blame the shopkeepers for their
budgetary difficulties.
Cost Inflation.
"Cost inflation" may originate either with salary increases or
by raw material shortage. According to equation S/P=G/H' (1e),
any salary (S) increase that exceeds the increase in
productivity (G/H'), entails the raising of prices (P). It also
requires, in accordance with equation Q V = k P G + S H. (3c),
an increased quantity of money (Q). If the government does not
provide the required additional currency, merchants and
factories are forced to expand commercial credit in order to
avert sales reduction, which results in an augmented number of
promissory notes and post-dated checks that circulate as
currency. Hence, in a "cost inflationary process" the increase
in quantity of money is the consequence and not the cause of
the raising of prices and salaries.
The inflationary increase in salaries may result from either
trade union demands, government populist politics, or
competition between employers in a period of economic expansion
and low rates of unemployment. The latter is the kind of
inflation that can menace a nation, in opinion of economists,
when unemployment is lower than 5 percent. For legal,
political, and psychological reasons wages can easily shift up,
but hardly down, which prevents the market from reestablishing
the equilibrium, after an excessive increase.
An example of cost inflation caused by a shortage in raw
material, was the worldwide inflation of the 1970s, generated
by the petroleum crisis. A fast increase in petroleum demand
associated with political reasons led to a sudden rise in its
price, which affected the cost of production and price of
merchandise. Additional man-hours had to be applied to
searching for new sources and to the exploitation of wells that
were previously non-profitable. It implied a raising of
petroleum marginal cost forwarded to the marginal cost of every
other goods. Perhaps for the first time from the beginning of
the industrial revolution, marginal and actual productivity
(G/H' and G/H) halted their continuous rise, and effected
regression. Salary/Price ratio (S/P=G/H' (1e)) and purchasing
power of the masses fell off followed by consumption
diminution, and general recession. The world faced a new kind
of inflation combined with recession that raised new doubts
about the correctness of Keynes economical theory based on the
experience of the 19th century and the world depression of the
1930s, where recession and inflation seemed never to appear
together.
This sort of inflation differs from those previously discussed,
in that it is of economical nature, i.e., associated with a
change in goods/man-hours ratio and not in a mere change in
money value. Hence, no monetary measure, and no salary/money
adjustment, can return the purchasing value of salaries to
their previous level. The salary indexation, which has some
justification in the previous cases, is here totally
ineffective and prejudicial.
The diminution in the bulk of merchandise involved in
commercial transactions (B) caused by the decrease in
productivity (B/H) balances in the present case the quantity of
money required by the increase of prices (Q V=p B (3a)).
Therefore, the issuing of money is neither the cause nor an
unavoidable outcome of this inflationary process. Nevertheless,
the discontent caused by the diminution of the Salary/Price
ratio, reinforces the demands for salary increase, which in
turn leads to a secondary monetary inflation.
In the normal evolution of the process, workers dismissed from
consumption industries are absorbed by petroleum and affiliated
industries, as well as by industries searching for new sources
of energy and energy-saving methods. Finally, after a period of
depression and unemployment the market is expected to reach a
new state of equilibrium, though at a lower living standard.
Demand Inflation.
Demand inflation, which already has been considered in Chapter
I when dealing with "Saving and Investment," is caused by an
increase in consumption with detriment to saving and
investment. It may be originated by a false illusion of wealth
provoked by inflated value of shares and real estate and/or a
sensation of security derived from full employment.
Consequently, the prices of goods of consumption rise, while
the investment sector shows symptoms of recession.
If this situation continues for a sufficiently long period,
investment workers may be dismissed. In a totally fluid market,
workers would be displaced from investment to consumption, the
increased demand for goods of consumption being satisfied, and
prices restored to its previous level of equilibrium. However,
the time-reaction delay between dismissing from investment to
absorption by consumption industries may cause the recession to
extend to the consumption sector, ending in a global
depression. Such a process may offer a possible explanation for
the world depression of the 1930s that followed the boom of the
1920s.
5. TRADE CYCLES. Keynesianism versus Monetarism
The free-market possesses recuperation mechanisms that restore
it to equilibrium when it is broken. In this aspect it is,
therefore, similar to physical systems, such as pendulums or
strings, which oscillate after deviating from their state of
equilibrium. An alternate series of economic peaks and troughs,
that occurred during the 19th and beginning of the 20th
centuries, suggested the idea that they are the result of
intrinsic oscillating characteristic of free-market, and gave
birth to the Trade Cycles theory. This way of thinking was
reinforced by the contemporary development of the wave theory
in physics, which culminated with James C. Maxwell's (1831-79)
identification of light with oscillations of electromagnetic
fields. From the now obsolete Trade Cycles theory remains the
classification of economic states in boom, recession,
depression, and recuperation, corresponding to the peak,
lowering, trough, and rising portions of a sinusoidal wave.
The worldwide crisis of the 1930s, which followed the boom of
the "Roaring Twenties," strengthened the belief in endogenous
causes of trade cycles and the search for a way to counteract
their harmful effects. It was upon this background that the
theory of the British economist John Maynard Keynes (1883-1946)
(13), founder of the Keynesian school, appeared, advocating
government intervention in economy in order to balance the
effects of the trade cycle. In Keynes opinion, when the market
shows symptoms of recession intensified economic activity of
the government, could cut the oscillating process and prevent
the phase of depression and unemployment.
Keynes' main scientific contribution was introducing dynamics
to the scope of economics thinking. Whereas his predecessors
concentrated their efforts in analyzing states of equilibrium
and the transitions between them, Keynes dared to deal with
changing situations, and their actuating forces. However, the
time factor, of vital importance in dynamic phenomenons, was
not sufficiently understood by Keynes and his followers.
From more recent research on the supposed trade cycles and
their possible causes, serious doubts about their mere
existence appeared. Presently, it seems more likely that the
apparent "oscillations" are caused by fortuitous external
agents, such as wars, drought, technical advances, or even
psychological factors, which unpredictable affect the economy,
rather than being an intrinsic free-market characteristic.
Hence, only government activity synchronized with these
external agents might attenuate their effects. However, the
government only is able to act after the effects are perceived.
Namely, after a lag that may be, in Milton Friedman's opinion,
as long as eighteen months (14). Therefore, any government
tentative of economic intervention would have the character of
mere random disturbances.
For example, let us assume that the market shows symptoms of
recession associated with and unemployment in the consumption
sector. Accordingly to Keynes theory, government must increase
its economic activity in order to reinforce consumption.
However, government activity requires funds that must be taken
either from capital and workers' income by means of increased
taxes, or the issuing of bonds or currency. Whichever the way
of collecting the required funds, it always will be to the
detriment of private saving and investment. Hence, government
intervention will result in investment industry recession,
job-creation failure, and increased unemployment. However, the
firing of investment workers will take place after a sensible
delay during which employers will try to understand the cause
of their difficulties, and to find less drastic solutions.
Hence, in the meantime government intervention can result in a
transitory period of welfare and abundance, inducing a
collective mood of security that allows for spending and the
contraction of debts, disregarding saving and prudence, that
aggravates the coming recession in the investment sector.
In a Keynesian fluid market, in which the lags between causes
and effects are not correctly evaluated, the increased
consumption demand associated with investment recession would
result in a transfer of workers from investment to consumption.
Though, the absorption of the dismissed investment workers may
demand enlargement of existing factories, a task that would
require considerable time, and would be made more difficult by
the reduction in investment resources resulting from the
government deviation of money toward consumption. Consequently,
there could be a considerable lag before the market could
satisfy the demand for goods of consumption and a demand
inflation associated with unemployment can occur. Furthermore,
the diminished consumption of the dismissed investment workers
may extend the recession to the consumption sector, resulting
in a global depression.
Accordingly to Keynes and followers, government must now
resort, in the presence of unemployment, to a new wave of
government spending. Their attitude is based on the assumption
that the unemployment originated in the present insufficient
money circulation, while in fact it is the outcome of excessive
government spending in the past. Clearly, a new wave of
government spending will aggravate the situation by increasing
inflation, causing a new reduction in saving and investment and
increasing future unemployment.
6. EPILOGUE
The ineffectiveness of government intervention intended to
balance economic fluctuations, together with a better
understanding of the role of the time-reaction lags in the
economic processes, has led to the substitution of the
Keynesian theory by Monetarism. The latter theory, whose main
supporter is the American economist Milton Friedman (1912 - ),
limits the role government in regulating economy to the
preservation of currency stability.
The Keynesian school gave legitimation to deficit spending,
budget expansion and widening fiscal policy, and led to
increasing government activity to the detriment of private
initiative. The Keynesian ideas found the ground prepared for
them by the proliferation of totalitarian ideologies during the
first half of the century. The result was an increasing portion
of the Gross National Product ransacked by the governments of
all Western nations.
The American Federal Government receipts from income taxes,
which were in 1936 (when Keynes' main book appeared) only 1.7
percent of the Gross Domestic Income (GDI) (i.e., GNI excepting
income from foreign sources), in 1952 reached 14.1 percent. And
the total Federal Government's revenues rose in the same period
from 4.8 to 18.9 percent of the GDI. From that time to the
present day the total Federal Government's revenues expressed
in percent of the GDI remained more or less stable (15). By
means of issuing currency and bonds the 1994 Federal Government
Budget rose to nearly 22 percent of the GDI (16).
For comparison, the 1997 Israel Budget is expected to amount to
47.3 percent of the Gross National Income (17), i.e., from each
NIS gained by individuals and companies nearly 0.5 NIS is taken
and spent by the Israeli government. To this budget municipal
taxes, government companies and monopolies must be added, which
makes the Israeli economy an approximated realization of the
Marxist dream.
- - - - -
NOTES:
(1) "If we consider as the producer the capitalist who makes
the advances, the word Labour may be replaced by the word
Wages: what the produce costs to him, is the wages which he has
had to pay. At the first glance indeed this seems to be only a
part of his outlay, since he has not only paid wages to
labourers, but has likewise provided them with tools,
materials, and perhaps buildings. These tools, materials, and
buildings, however, were produced by labour and capital; and
their value, like that of the article to the production of
which they are subservient, depends on cost of production,
which again is resolvable into labour. The cost of production
of broadcloth does not wholly consist in the wages of weavers;
which alone are directly paid by the cloth manufacturer. It
consists also of the wages of spinners and woolcombers, and, it
may be added, of shepherds, all of which the clothier has paid
for in the price of yarn. It consists too of the wages of
builders and brickmakers, which reimbursed in the contract
price of erecting his factory. It partly consists of the wages
of machine-makers, iron-founders, and miners. And to these must
be added the wages of the carriers who transported any of the
means and appliances of the production to the place where they
were to be used, and the product itself to the place where it
is to be sold." "The Principles of Political Economy"(1848),
John Stuart Mill (1806-73), Book 3: Chapter 4.
(2) In Biblical Hebrew "to break" and "to buy" are both
expressed by the same word "shabar".
(3) "Macro-Economics", F.S. Brooman, George Allen & Unwin Ltd.,
London (1971).
(4) If this amount includes fixed term deposits, which are not
withdrawable on demand or transferable by checks, they must be
deducted from the aggregate means of payment.
(5) Differentiation must be made between current and fixed term
deposits, as well as between long and short term credits.
(6) In Israel there exists a special form of bank credit, the
authorized overdraft, which must be added to the total bank
deposits when calculating the actual quantity of money at
public disposal. It differs from the habitual forms of credit
in that it is an amount of money at the disposal of the bank
customer without being previously recorded in his account. It
is a potential credit, for which the customer only pays
interest when and for the amounts he actually uses.
(7) B includes every material, virtual, or spiritual value or
service out of money. Hence, V does not include the exchanges
of one kind of money for another, such as the withdrawal of
cash from bank accounts, or the payment of a debt, which
implies the replacement of credit-money by cash or bank
deposit.
(8) Capital's Revenue/GNI ratio in USA during the period 69-93
was lower than 8.5 percent. (From a New York Times article
reprinted by Haaretz 11.8.97.)
(9) Keynes theory is more explicitly exposed in Section 5.
(10) Tax History Project at Tax Analysts. Source: Office of
Management and Budget, Budget of the United States Government,
Fiscal 1988, Historical Tables.
http://www.taxhistory.org/images/Facts%20and%20Figures/gdp.htm
(11) Equation (1e) was established under the assumption of a
closed market in a state of equilibrium. It is valid also in an
open market in a state of equilibrium where imports must equal
exports, and hence G remains unaltered and equal to the
aggregate of local production of goods and services.
(12)Haaretz 15.9.97.
(13) John Maynard Keynes (1883-1946) British Economist:
"General Theory of Employment Interest and Money" (1936).
http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/keynes/
index.html
(14) Milton Friedman (1912 - ) American economist, who has
written among others works: "The Quantity Theory of Money -- A
Restatement" (1956); "A Theory of Consumption Function" (1957),
"The Lag in Effect of Monetary Policy" Journal of Political
Economy, Oct. 1961; "Capitalism and Freedom" (1962), "Free to
Choose" (in collaboration with his wife Rose) (1980). He won
the Nobel Prize in 1976.
(15) Tax History Project at Tax Analysts Source: Office of
Management and Budget, Budget of the United States Government,
Fiscal 1988, Historical Tables.
(16) USA Annual Shareholders' Report
http://www.budget.org/AnnualReport/1994/
(17) Haaretz 10.8.97.