Chapter XXI PRICES AND MONEY

1. “Costs” are Prices

Another strange thing about Keynes’s Chapter 21 is that though it is called “The Theory of Prices,” it is hardly a theory of individual prices at all, or even of relative prices, but merely a theory of changes in the price “level.” Keynes even specifically declares: “The Theory of Prices, that is to say, the analysis of the relation between changes in the quantity of money and changes in the price-level with a view to determining the elasticity of prices in response to changes in the quantity of money...” (p. 296). Now unless one has a correct theory of individual prices and of relative prices one is unlikely to have a correct theory of the price “level” which is merely an average made up of individual prices. But when we try to analyze Keynes’s theory of individual prices and of relative prices, we encounter so many confusions and contradictions that the task of straightening them out becomes next to hopeless.

In a single industry [we are told] its particular price-level depends partly on the rate of remuneration of the factors of production which enter into its marginal cost, and partly on the scale of output. There is no reason to modify this conclusion when we pass to industry as a whole (p. 294).

Let us notice first of all a couple of the minor ambiguities in these two sentences. We have already seen that “a single industry” involves an arbitrary classification without definite boundaries. Notice also that even in speaking of “a single industry” Keynes speaks of its “price-level,” which is already a collective concept involving an average. What he probably meant to say—or in any case what would have been theoretically more defensible—is that “The particular price of a single homogeneous product depends partly,” etc.

But this minor difficulty surmounted, we find that what we have here is a crude Ricardian cost-of-production theory of prices in which the marginal utility of a particular commodity, or the relative marginal utility of two or more commodities, is not even mentioned.

Keynes continues: “The general price-level depends partly on the rate of remuneration of the factors of production which enter into marginal cost and partly on the scale of output as a whole, i.e. (taking equipment and technique as given) on the volume of employment” (p. 294).

Here “the general price-level” is explained by “rates of remuneration” and “marginal costs,” but wage-rates and costs are not explained at all. They are simply taken for granted. Yet wage-rates and costs are prices. Marginally speaking, they are the price of an extra hour’s labor, or an extra unit of raw materials, or an extra increment of equipment, etc.

In modern marginal theory, prices and costs mutually determine each other; there is no one-way causation. Wicksell, endorsing the mathematical formulation of Walras, put it forcibly:

As soon as we have more than one factor of production (e.g. simple manual labor), and in fact we have hundreds of different kinds, the principle that costs of production determine the exchange value of a product can no longer be maintained. These costs become quite simply the prices of the factors of production, which are necessarily determined in combination with the prices of commodities in a single system of simultaneous equations.¹

Relative costs of production may legitimately play a part in modern economics when we are dealing with the problem of relative price formation. Here costs may be said to “determine” prices, not directly, but by their influence on relative supply and hence on relative marginal utilities.

It is true that Keynes finally does bring in the effect of demand on “the general price-level,” but what he discusses is merely the effect of changes in demand:

It is true that, when we pass to output as a whole, the costs of production in any industry partly depend on the output of other industries. But the more significant change, of which we have to take account, is the effect of changes in demand both on costs and on volume. It is on the side of demand that we have to introduce quite new ideas when we are dealing with demand as a whole and no longer with the demand for a single product taken in isolation, with demand as a whole assumed to be unchanged (pp. 294-295).

All that Keynes does at this point, however, is to consider the effect on “the general price-level” of an increase in the money supply. But here his confusions simply increase. He has presented no theory at all, or at best only a circular theory, of what determines a particular price or the relationship of particular prices to each other. But he proceeds to explain why the average of all prices (i.e., the general price-level) rises or falls. (Perhaps what he is really talking about is the average of retail commodity prices, as he seems to consider “costs” and wage-rates to be somehow outside of “the general price-level.”) What makes prices rise, according to Keynes, is a rise in Aggregate Effective Demand, and aggregate or effective demand turns out to be, for all practical purposes, synonymous with the money supply.

Keynes is right in not accepting “the crude Quantity Theory of Money,” but his treatment of the whole subject is superficial and confused. He does draw a distinction between “effective demand” and the quantity of money: “Effective demand will not change in exact proportion to the quantity of money” (p. 296). But two pages later he makes the astonishing statement that “The primary effect of a change in the quantity of money on the quantity of effective demand is through its influence on the rate of interest” (p. 298). This is like asserting that a circuitous detour is the shortest distance between two points. By “effective demand” Keynes seems to mean little more than total monetary demand; therefore doubling the quantity of money, say, directly doubles the “effective demand” because the two terms practically mean the same thing.

Keynes is also right (though not for the reasons he gives) in pointing out that if we begin with a condition of underemployment, a given increase in the quantity of money will probably not raise prices proportionately but will spend itself partly in raising employment. But though he almost invariably assumes a condition of underemployment, he just as consistently fails to recognize or acknowledge the real reason for this underemployment when it exists. That reason is almost invariably the existence of excessive wage-rates in relation to prices. To put the matter in another way, some wage-rates are above the point of equilibrium. If, now, we pour an increased supply of money into the system, and if the effect of this is to raise wholesale and retail prices without raising the excessive wage-rates proportionately, then the result will be increased employment; and the consequent increased supply of goods will make the general price rise lower than it would otherwise have been. But Keynes gets to this conclusion by a set of artificial assumptions and arbitrary reasons that have little relation to economic realities.

2. The Positive Theory of Money

Instead of making a detailed criticism of Keynes’s implied theory of money, it would effect a considerable economy of time and space if I said a few words at this point concerning what I believe to be the correct theory of money. These remarks must necessarily be sketchy; and as they will often give conclusions without the underlying argument, they may sometimes unintentionally sound dogmatic.

The quantity of money is always a relevant consideration in determining the value of the monetary unit, just as the total supply of wheat is relevant in determining the value of a bushel of wheat. But the value of the monetary unit is not necessarily in exact inverse proportion to the quantity of money (as held by the rigid or Mechanical Quantity Theory) any more than the value of a bushel of wheat is necessarily in exact inverse proportion to the supply of wheat.

The inflexible Quantity Theory of Money tacitly assumes that the “elasticity of demand” for money is unity. This proposition has never been proved, and receives little statistical support. The value of the monetary unit is determined not merely by the quantity of money but by the quality of that money. Putting the matter another way, the value of the monetary unit is not determined merely by the present quantity of money but by people’s expectations concerning the future quantity, and by such other factors as the assumed integrity or stability of the issuing government or banks. Hence it is typical at the beginning of any inflation to find that prices rise less than the increase in the money supply, and that in the later stages of an inflation prices rise more than the increase in the money supply.

It must be borne in mind furthermore that an increase in the quantity of money, no matter by how much it may raise the average of prices, never results in an exactly proportionate increase in each price. It is only, in fact, because Keynes and other inflationists tacitly assume that an increase in the quantity of money will raise some prices more than others (particularly retail prices more than “costs” and wage-rates) that they conclude that inflation will cure unemployment.

I have said nothing above about the much-discussed “velocity-of-circulation” of money, and its supposed effect on prices. This is because I believe the term “velocity-of-circulation” involves numerous irrelevancies and confusions. Strictly speaking, money does not “circulate”; it is exchanged against goods. A house that frequently changes hands does not “circulate.” A man can only spend his monetary income once. Other things remaining equal, “velocity-of-circulation” of money can increase only if the number of times that goods also change hands (say stocks or bonds or speculative commodities) increases correspondingly. The annual rate of turnover of demand bank deposits is normally twice as great in New York City as in the rest of the country. In 1957, for example, it was 49.5 in New York and averaged only 23.0 in 337 other reporting districts. This is because New York is the speculative center.

An increase in the “velocity-of-circulation” of money, therefore, does not necessarily mean (other things remaining unchanged) a corresponding or proportionate increase in “the price-level.” An increased “velocity-of-circulation” of money is not a cause of an increase in commodity prices; it is itself a result of changing valuations on the part of buyers and sellers. It is usually a sign merely of an increase in speculative activity. An increased “velocity-of-circulation” of money may even accompany, especially in a crisis at the peak of a boom, a fall in prices of stocks or bonds or commodities.²

3. What Theory of Prices?

Though I shall elaborate upon this at a later point, it follows from the above that inflation is (1) a dangerous “remedy” for unemployment, because the inflation may get out of hand and will in any case create great injustices; (2) an unnecessary remedy for unemployment, which can be cured simply by the appropriate (free market) adjustment and coördination of wage-rates and prices to each other and to the existing money supply; and (3) an uncertain remedy for unemployment, because the unemployment will either continue or be resumed if wage-rates go up to the same extent as prices so that the maladjustment which caused the unemployment is after all not corrected.

I have already pointed out that though Keynes calls Chapter 21 “The Theory of Prices” he defines the theory of prices (p. 296) as “the analysis of the relation between changes in the quantity of money and changes in the price-level.” This, as I have remarked, is merely a theory of changes in a statistical average of prices. It therefore omits any analysis or explanation of (1) what determines any one particular price (say the price of eggs), and (2) what determines the relation of individual prices to each other. But these are the really fundamental problems involved. Until we have solved them we cannot go on to any rational discussion of why individual prices change, and why the “price-level” (which is a purely statistical construct put together from individual prices) changes. But Keynes simply takes these fundamental problems for granted. It is hard to escape the verdict of Hayek:

Although the technocrats, and other believers in the undoubted productive capacity of our economic system, do not yet appear to have realised it, what [Keynes] has given us is really that economics of abundance for which they have been clamoring so long. Or rather, he has given us a system of economics which is based on the assumption that no real scarcity exists, and that the only scarcity with which we need concern ourselves is the artificial scarcity created by the determination of people not to sell their services and products below certain arbitrarily fixed prices. These prices are in no way explained, but are simply assumed to remain at their historically given level, except at rare intervals when ‘full employment’ is approached and the different goods begin successively to become scarce and to rise in price.

Now if there is a well-established fact which dominates economic life, it is the incessant, even hourly, variation in the prices of most of the important raw materials and of the wholesale prices of nearly all foodstuffs. But the reader of Mr. Keynes’ theory is left with the impression that these fluctuations of prices are entirely unmotivated and irrelevant, except towards the end of a boom, when the fact of scarcity is readmitted into the analysis, as an apparent exception, under the designation of ‘bottlenecks.’ ³

Let us look at Keynes’s strange picture of the economic world a little more closely:

But, in general, the demand for some services and commodities will reach a level beyond which their supply is, for the time being, perfectly inelastic, whilst in other directions there is still a substantial surplus of resources without employment. Thus as output increases, a series of ‘bottle-necks’ will be successively reached, where the supply of particular commodities ceases to be elastic and their prices have to rise to whatever level is necessary to divert demand into other directions (p. 300).

Some of the shortcomings in this picture have already been pointed out in the quotation from Hayek above. There are assumed to be, as a usual and virtually a “normal” condition, all sorts of “unemployed resources” kicking around, including, apparently, surplus raw materials, so that for a long time increase in demand does not lead to increase in price. Increasing costs are not regarded as typical but as exceptional, and then only because “bottlenecks” are created. And “bottlenecks” themselves are treated as exceptions, instead of as the outcome of varying degrees of scarcity and varying but inevitable lags in the responsiveness of demand.

This brings us to an aspect of Keynes’s thought that has seldom been recognized, even by his critics. A surprisingly large number of his errors spring, not from his heterodoxies, but from his uncritical acceptance of certain “classical”—or, it would be better to say, Marshallian—doctrines, concepts, or terms. One of these concepts, now used almost universally, is that of the “elasticity”—of demand, supply, price, or what-have-you.

The concept—or rather the term—owes its present great vogue to Marshall. It is a very useful concept, but it can also be a deceptive one, particularly when, as in the last thirty years, a whole literature develops around it that combines oversimplification with a spurious precision. This latter development is mainly the result of the use of the dubiously appropriate term elasticity. I have previously adverted to the misleading quality of this term, but it is now worth scrutinizing even more closely.

Responsiveness, as I shall try to show, is a term that not only expresses more clearly and directly what is meant but avoids most of the pitfalls of elasticity. It is an ironic misfortune in the recent history of economic thought that though Marshall himself suggested this alternative, he immediately dropped it and used the term “elasticity” instead.

We may say generally [he wrote] that the elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price. [His italics. And he continues in a footnote]: We may say that the elasticity of demand is 1, if a small fall in price will cause an equal proportionate increase in the amount demanded: or as we may say roughly, if a fall of 1 per cent in price will increase the sales by 1 per cent; that it is 2 or ¹/₂, if a fall of 1 per cent in prices makes an increase of 2 or ¹/₂ per cent respectively in the amount demanded; and so on.⁴

But there are serious drawbacks to the term “elasticity.” (1) The mechanical analogy on which it rests is somewhat forced and far-fetched, and does not suggest what happens as directly and simply as “response” or “responsiveness” does. (2) It leads easily to the false assumption that the “elasticity of demand” for a commodity is something built into the commodity rather than merely the response of consumers to a change of price. (3) It has led to a literature of mock precision (and at the same time of oversimplification) to which the term “response” or even “responsiveness” is unlikely to lead.

Our present purpose, however, is not to elaborate in general upon each of these drawbacks, but merely to show how Keynes’s thought and writing were vitiated both by his use of the term “elasticity” and by his careless concept of it. 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.

4. Another Digression on “Mathematical” Economics

Keynes devotes a whole section of Chapter 21 to a statement of his price theories in mathematical form. But we have even Keynes’s word for it that we lose practically nothing if we bypass these equations:

It is a great fault of symbolic pseudo-mathematical methods of formalizing a system of economic analysis, such as we shall set down in section VI of this chapter, that they expressly assume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed; whereas, in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep ‘at the back of our heads’ the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials ‘at the back’ of several pages of algebra which assume that they all vanish. Too large a proportion of recent ‘mathematical’ economics are mere concoctions, as imprecise as the initial assumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols (pp. 297-298).

This is admirably said; but Keynes himself does not seem to have realized the full force of it. It is hard otherwise to account for the “maze of pretentious and unhelpful symbols” that he himself uses. Even after he has used them in section VI he declares:

I do not myself attach much value to manipulations of this kind; and I would repeat the warning, which I have given above, that they involve just as much tacit assumption as to what variables are taken as independent (partial differentials being ignored throughout) as does ordinary discourse, whilst I doubt if they carry us any further than ordinary discourse can. Perhaps the best purpose served by writing them down is to exhibit the extreme complexity of the relationship between prices and the quantity of money, when we attempt to express it in a formal manner (p. 305).

Do such symbols and manipulations, however, in fact usually serve this purpose? Or do they not much more frequently deceive the writer who uses them (and many of his readers) into supposing that he has discovered something; that it will now be easy (or at least possible) to ascertain and substitute real numerical values for his algebraic symbols and hence determine real relationships or make precise predictions that apply to the real world?

The majority of Keynesians undoubtedly believe this; and the master has encouraged the belief: “Nevertheless, if we have all the facts before us, we shall have enough simultaneous equations to give us a determinate result” (p. 299). Of course if we have all the facts we shall have all the facts. If we already know the future we can predict it. But when Keynes leads his readers to suppose that they can make real economic predictions or solve practical problems of economic policy if they only pull enough simultaneous equations together, if they only make sure to have “as many equations as unknowns,” he reminds one, by contrast, of the much sounder warning of Irving Fisher. Fisher, though he used even more mathematics in his Theory of Interest than Keynes does in his General Theory, had a much surer sense of the limitations of the algebraic method:

In science, the most useful formulas are those which apply to the simplest cases. For instance, in the study of projectiles, the formula of most fundamental importance is that which applies to the path of a projectile in a vacuum. Next comes the formula which applies to the path of a projectile in still air. Even the mathematician declines to go beyond this and to take into account the effect of wind currents, still less to write the equations for the path of a boomerang or a feather.... At best, science can only determine what would happen under assumed conditions. It can never state exactly what does or will happen under actual conditions.⁵

Keynes’s mathematical equations on pages 304-306 are peculiarly suspect because they are all concerned with “elasticities”—of prices, “wage-units,” output, “effective demand,” employment, etc. Some of these concepts (e.g. “output”) are obviously too heterogeneous and hazy to be capable of statement in useful or valid mathematical form. But my present purpose is simply to ask whether “elasticity” itself is a precise enough concept to justify its use in a mathematical equation.

Marshall himself had great doubts on the matter. After a long section on “elasticity of supply” and “supply schedules,” he writes:

But such notions must be taken broadly. The attempt to make them precise over-reaches our strength. If we include in our account nearly all the conditions of real life, the problem is too heavy to be handled; if we select a few, then long-drawn-out and subtle reasonings with regard to them become scientific toys rather than engines for practical work.⁶

Frank H. Knight points out that:

Serious embarrassment arises from the fact that there is no conceivable way of determining the elasticity of either demand or supply with reference to any particular time period.... The conditions underlying either curve will never actually remain constant.... As to the chance of making any estimate or calculation of elasticity for any real period, the possibilities in the abstract are limited enough on the supply side, but are virtually zero on that of demand.⁷

We may surely carry our doubts further than Marshall carried his. Even to speak of “the elasticity of demand” for a commodity is to imply, as we have seen, not only that this “elasticity” is a quality of the commodity but that there is something fixed or constant about it, at least within a given price range. To speak merely of the response of demand to a change in price is to make neither of these tacit assumptions. We realize then that we are merely speaking of the response of buyers or consumers to a change of price under a whole complex set of concrete conditions at one moment of time, without jumping to any tacit conclusions regarding what the response would be to a still further change of price of that commodity in the same direction, or even to precisely the same change of price of the same commodity under another set of concrete circumstances at another moment in time.

5. “Elasticity” of Demand Cannot be Measured

In spite of many ambitious efforts in recent years,⁸ “elasticity” of demand is not only difficult but impossible to measure. We can collect plenty of statistics, approaching infinity, but we can never be sure which to take and how to interpret them.

To glimpse some of the real difficulties: The closing price of a bushel of ordinary hard wheat at Kansas City on Oct. 2, 1957 was $2.10¼, and x bushels were sold there on that day. On Oct. 3 the closing price was $2.10, and y bushels were sold. On Oct. 3, 1956 the closing price was $2.25¹/₂, and z bushels were sold. Assuming that we knew the values of x, y, and z—that is, the total amount sold at Kansas City on each of these days—the data would still tell us nothing whatever about elasticity of demand. The price of wheat fluctuated greatly on each of these three days. To get an accurate average price a statistician would have to know how many bushels sold at each different price (there is an eighth-of-a-cent difference between prices), and make up a weighted average for the day. But this average would already begin to conceal what the statistician was trying to find out. For a different amount of wheat was sold at each eighth-of-a-cent’s difference. He would have to chart these and draw a (very irregular) curve. This information would in turn be valueless because it would tell us only what went on at Kansas City on three days.

Suppose, disregarding the enormous difficulties and complexities, we could find out and chart the amounts of ordinary hard wheat sold at each different price on every business day of 1956 and 1957 everywhere in the United States; and even that we could do the same for the preceding fifty years. Would we even then be able to measure “the elasticity of demand” for wheat? The figures would still be worthless because the price of and demand for wheat are influenced in the United States (in spite of controls and price supports) by the total world supply and total world demand for wheat. Assuming we could collect world prices and world sales, and translate them in acceptable statistical ways into terms of the American dollar, would we still be able to measure the “elasticity of demand” for wheat?

Putting aside the enormous and practically insurmountable difficulties in the way of collecting and arranging statistics of any real precision (for the “annual” price of “wheat,” as obtainable in any existing statistical compilation, is merely the average of an enormous number of different daily and hourly prices of several different grades of wheat), we come up against the basic insoluble problem. When the price of a commodity changes, and the amount of it that is bought also changes, we are never able to say with confidence whether the amount bought changed because the price was at a different point on the same “demand curve,” or whether the amount bought changed because the demand curve itself “shifted.” And this is true whether we are talking about different prices and different amounts sold from one year to another, from one month to another, from one day to another, or from one hour to another.

What economists do in practice is usually to beg the question. If the price is lowered, and the amount of the product bought is increased, they say this proves that the demand for the product is “elastic.” If the price is lowered, and the amount of the product bought is not increased, they say this proves that the demand for the product is “inelastic.” But if the price is lowered, and the amount sold also declines (the kind of thing that happens on the commodity and stock exchanges every day of the week), they say this proves that the “demand curve” itself has fallen, or, in the professional jargon, has “shifted to the left.”

And when we turn to “elasticity of supply” our difficulties of measurement increase rather than diminish. For both elasticity of demand and elasticity of supply have a time dimension. As applied to supply, this time dimension is somewhat different for every commodity. Yet nothing is more frequent than to find lags in adjustment confused with lack of adjustment. The supply of coffee, for example, is called “inelastic,” when what is meant is that it takes about five years for newly planted coffee trees to mature and bear. Therefore, if there is a rise in the demand for coffee, and a consequent rise in the price, this year’s supply and even next year’s supply may prove “inelastic”; but the supply five years’ from now may prove to be only too responsive to this year’s increase in demand (which may not be permanent).

Again, to take an imaginary commodity, we may find that the “elasticity” of supply in response to an increase in price, as measured in Marshallian terms, is 1¹/₂ the first month (because the increased price brings forth speculative holdings of the commodity), then only ¼ the second month, ¹/₁₆ the third month, zero for the next nine months, and then suddenly “unity” or better, as a new crop comes on the market or a new plant comes into production. But what, then, is “the” elasticity of supply of that commodity?

I have not entered upon this long digression to attempt to discredit the concept of “elasticity” of demand or supply, or demand or supply “schedules” or “curves.” These are useful diagrammatic analogies, concepts, and tools of thought when employed with moderation and humility. But they have become the basis for an enormous (and pretentious and cocky) literature of “mathematical economics” which parades and manipulates a maze of algebraic symbols which are assumed to have “scientific” and even predictive value, but for which it would be impossible in practice to ascertain or assign real numerical values.

One reason for this is not merely that these values cannot really be known, but that they are oversimplified (and hence falsified) even in concept. Demand responds to changes in price. Supply responds to changes in price. But there is no reason to suppose that any scientifically predeterminable response of demand or supply attaches under all conditions to any given change in price. To the practical businessman or entrepreneur this is and must remain a matter of guesswork. He can find out what has happened to that commodity or similar commodities in the past; but this is no sure guide to the future. The mathematical economist cannot give him any sure-fire formula.

Keynes, it is true, has no unique guilt for the mathematical part of the General Theory. His mathematics are comparatively modest in extent. His claims for the usefulness of his equations are far more modest than those of the present school of “mathematical economists.” But it is just as well to point out that nearly all the mathematics employed in the General Theory, insofar as practical application or even theoretical illumination is concerned, is empty and useless.

6. Sacrosanct Wage-Rates, Sinful Interest Rates

Keynes ends Chapter 21 in a burst of pure demagogy reminiscent of Marx. It is impossible to treat this final section as serious economics. It is designed to prove (1) that it would be harmful or dangerous to reduce almost any wage-rate, and (2) that it would be beneficial to reduce almost any interest rate.

The confusions in this section are almost hopeless. Some of them are foreshadowed a few pages ahead: “The cost-unit, or... the wage-unit, can thus be regarded as the essential standard of value; and the price-level, given the state of technique and equipment, will depend partly on the cost-unit and partly on the scale of output...” (p. 302).

Now to say that the wage-unit is the essential standard of value is to say that the price in dollars, and moreover the average price in dollars, of a heterogeneous good or service is the “essential standard of value,” and not the dollar in terms of which the price is expressed. For the “wage-unit,” let us remember, is the “money-wage” of “an hour’s employment of ordinary labor” (p. 41). In other words, Keynes is saying that the dollar in which the price of labor is expressed is not the “essential standard of value,” but that this average price is the “essential standard of value.” Logically, this is something like saying that the foot is not the standard of length, but that the “arm-unit” (the length of the “ordinary” man’s arm) is the essential standard of length. It is like saying that the pound is not the standard of weight, but that the “ordinary” beefsteak (which, say, now happens to average 2½ pounds) is the “essential” standard of weight.

I am not myself arguing that the dollar is the “standard of value” in the United States. All prices are expressed in dollars, and when two or more prices are compared with each other, they are compared in terms of dollars, and are in that sense “measured” in dollars. But the dollar, or any other monetary unit, is not the “standard of value” in the sense that the foot is a standard of length or the pound a standard of weight. For (so far at least as practical life is concerned) the foot and the pound are not relative but absolute; they remain unchanged. But the value of the dollar, or of any other monetary unit, is itself constantly changing. Its value is itself “measured” in terms of its “purchasing power”—i.e., by the varying amounts of goods and services against which it is exchanged. “Economic value,” in short, cannot be measured in absolute terms. Market value can be expressed only as a comparison, as a ratio of exchange. But it is the dollar (or other monetary unit) in terms of which all economic values are commonly expressed.

The dollar, then, is not the “essential standard of value.” But this only multiplies the absurdity of regarding the dollar price of an hour’s “ordinary” labor as the “essential standard of value.” One might say that this was a return to the crude value theories of Ricardo and of Marx. But it is logically even more indefensible, because in regarding “an hour’s ordinary labor” as the “standard of value,” Ricardo and Marx were trying to set this standard in real terms, whereas Keynes rejects the monetary unit as the standard of value and fails to see that its value is inevitably involved in the “essential standard of value” he chooses. For the “wage-unit,” being merely the average hourly wage in terms of dollars, is itself merely the temporary average ratio of exchange between the currency unit and a “labor-unit.”

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.

7. Monetary Inflation Preferred to Wage Adjustment

Section VII of Chapter 21 is chiefly given over to the proposition that whenever there is unemployment “the escape will be normally found in changing the monetary standard or the monetary system so as to raise the quantity of money, rather than in forcing down the wage-unit and thereby increasing the burden of debt” (p. 307). In other words, unemployment should always be cured by further monetary inflation, never by adjusting wage-rates that have got out of line. The piano must be adjusted to the stool, not the stool to the piano.

We have already dealt with the folly of all this, but a further point should be expanded upon here. Keynes speaks of “forcing down the wage-unit.” But we have seen that this “wage-unit” is, in fact, an average of hourly wage-rates. Now this average is a statistical construct, not a concrete fact, and not necessarily a relevant fact. Unemployment at any given time may be cured, not by reducing average wages, but by reducing certain specific wage-rates, and probably by diverse percentages. Reducing these specific wage-rates will, of course, necessarily also reduce the average; but it is the specific adjustments, and not the resulting average adjustment, that are relevant to curing the unemployment.

I have already shown, in the illustration of what happened in twenty-five different industries (pp. 284-285) that it is by widely varying specific changes that wage adjustments are actually made. But we may make the principle clearer by a hypothetical illustration. Let us say that we have two commodities, gadgets and widgets, each of which sells for $2.50. The marginal unit-cost of each consists chiefly of labor cost. At a wage of $2 an hour, say, the total marginal unit-cost of each would be equal to the price, $2.50. But the wage-rate in the gadget industry happens to be $1.40 an hour, and the wage-rate in the widget industry $2.60 an hour. The average wage-rate in both industries together is then $2. This average is not excessive in relation to the demand for, and the price of, each commodity. But this average is no consolation to the widget industry, which cannot make a profit. In a closed economy, and with no acceptable substitute, the widget industry could raise its prices; but this would reduce the demand for its product and hence would create unemployment in the industry. In an open economy—in which, say, the Japanese industry could still sell widgets in New York at $2.50, the American widget industry would have to close down entirely, throwing all previous workers in the industry out of employment. There might continue to be full employment in the gadget industry, which would be able to lower prices and might even expand; but not enough (at least not for a long time) to absorb the unemployment in the widget industry.

The illustration is perhaps lengthy. But it is apparently necessary to spell it out to make clear the meaninglessness of averages and aggregates when we are trying to discuss realistically the maladjustments in the economy which lead to unemployment. Keynes’s insistence on lumped thinking, on dealing with the economy in such (unacknowledged) averages and aggregates and “mixed bags” as “the wage-unit” and “the price-level,” results in systematically missing the very problems to be solved.

8. Those Arbitrary Moneylenders

Keynes’s discussion of interest rates is, as we have seen, even more demagogic than his discussion of wage-rates. “Today and presumably for the future the schedule of the marginal efficiency of capital is, for a variety of reasons, much lower than it was in the nineteenth century” (p. 308). Here is a sweeping generalization based on conditions in 1935, the year in which Keynes was composing the General Theory, and on the four or five years preceding. There is no reason for supposing it to be true. It seems merely quaint in the nineteen fifties, in a world of inflation, full employment, overemployment, and unparalleled capital investment plans everywhere.

The acuteness and peculiarity of our contemporary problem arises, therefore, [Keynes continues] out of the possibility that the average rate of interest which will allow a reasonable level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money.... But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. (My italics, pp. 308-309.)

Here everything that has been discovered about economics since the Middle Ages, when all interest was called “usury” and considered wholly unjustified, is thrown out the window. Interest rates, we are to understand, unlike everything else in the market, are fixed merely by one party to the transaction, by the seller or the lender, by sheer arbitrary determination, custom or extortion. We are back to a crude Exploitation Theory of interest. Everything depends on what lenders will “accept,” and nothing on what borrowers will offer, or why they will offer it. Neither the current yield of direct capital investments nor the expected yield of direct capital investments (the “marginal efficiency of capital”) is supposed to have any influence on the interest rate. The borrowers and the lenders are supposed to be a different class of people (presumably the poor and the rich), and never the same person, say, who is trying to decide whether it is to his advantage to lend his money to someone else for an interest rate, or to invest it directly in some project for a return and perhaps even to borrow more. If A is thinking of buying a stock that is currently yielding 5 per cent a year on its price, it is presumably an outrage for B to ask 5 per cent interest if A wants to borrow the money to buy the stock.

All this is, of course, nonsense. The rate of interest is a market price like any other market price. It is as flexible (on new loans) as any other price (as any historic comparisons will show) and much more flexible over short periods (especially in the downward direction) than wage-rates. Moreover, in the modern capitalistic economy the lenders (owners of bonds, of saving deposits, and life insurance policies) are as a rule not the “rich,” and the borrowers (owners of common stock, of private firms, and of real estate) not the “poor.”

Interest rates are related to other prices and are constantly adjusting to other prices, as other prices are to them. Wage-rates are related to other prices and (when not fixed by government or union coercion) are constantly adjusting to other prices, as other prices are to them. When both adjustments are right, when there is full price, wage, and interest-rate coördination, there is full employment and maximum balanced production.

But Keynes treats both interest rates and wages as if they were completely outside of the price system, or at least as if they ought to be. Government must constantly step in to keep up wage-rates and to push down interest rates. This, of course, is a naked class theory of the business cycle and of unemployment, strikingly similar to Marxist theory. As with Marxism, the tacit assumption is that these government policies are necessary to protect the poor and discomfit the rich. But as also with Marxism, there is the pose that morality has nothing to do with it; that the existing “system” just won’t work and must break down.

The chief difference between Marxism and Keynesism is that for the former the employer is the chief villain, and for the latter the lender, with his nasty and pointless liquidity-preference.

¹ Knut Wicksell, Lectures on Political Economy, I, 225.

² This section is inserted merely to indicate the point of view from which Keynes’s monetary theories are here being criticized. Obviously this is not the place to elaborate a complete positive theory of money and credit, but some positive theory must necessarily be implied in all criticism. The author’s views on monetary theory correspond most closely with those of Benjamin M. Anderson, The Value of Money (1917, 1934) and of Ludwig von Mises, The Theory of Money and Credit (English edition, 1934) to both of which I am heavily indebted.

³ Friedrich A. Hayek, The Pure Theory of Capital, (University of Chicago Press, 1941), p. 374.

⁴ Alfred Marshall, Principles of Economics, (Eighth edition), p. 102.

⁵The Theory of Interest, 1930. (New York: Kelley & Millman, 1954), pp. 316-317.

⁶ Alfred Marshall, Principles of Economics, Eighth Edition, pp. 460-461.

⁷The Economic Organization, (New York: Augustus M. Kelley, 1951), p. 176.

⁸ Cf. e.g, Henry Schultz, The Theory and Measurement of Demand, (University of Chicago Press, 1938).