12. The Purchasing Power Theory—Sense and Nonsense (Translation from German)

When the average businessman thinks about wage problems and a wage policy, as he often must do nowadays, he cannot help being unhappy. On the one hand labor unions and government officials tell him that high wages are essential to maintain demand—and thereby employment—in the American economy; that to avoid or combat depression, wages should go up and/or prices down. On the other hand the businessman—while he is fully aware of the importance of the demand side—knows from experience what rising wages mean for his business. Higher wages do not trouble him much as long as he can be pretty sure that he can raise prices to cover his higher costs. But the average firm—especially the smaller firm—usually compares its wage outlays with existing prices, which it hopes will not recede. It knows that rising wages, unless offset by a rather slow process of improved productivity, can force it out of business.

In this confusing situation, what shall the businessman believe? Shall he follow the so-called purchasing power theory, in which wages are alleged to be the dominant means of maintaining demand? Or shall he rely on his own experience, which has taught him that production can be undertaken only if and when costs do not outrun prices?

AN OLD PROBLEM

Perhaps our businessman can find some consolation in realizing that what faces him has been the dilemma of economic science for hundreds of years. One theory, best known as Jean-Baptiste Say’s “Law of the Markets,” holds that no one should bother about demand, since each product creates its own demand; workers, entrepreneurs, and capitalists receive in the form of wages, profits, and interest so much money that they can always buy the entire output. Hence wages are of concern only as cost factors, not as demand factors.

An even older theory, usually called the purchasing power theory, denies this self-creation of demand. One can produce only if demand for consumption or production purposes is sufficient. It all depends, therefore, on the maintenance of demand. Neglecting more or less the importance of wages as cost factors, the purchasing power theory stresses their importance as a means of sustaining demand. It is consequently inclined to favor higher wages as a means of combating unemployment.

One can say without exaggeration that the history of economics has been the history of the over- and underestimation of the importance of the demand side in comparison with the cost side of the economy. The Mercantilists of the sixteenth and seventeenth centuries were adherents of the purchasing power theory and, incidentally, of monetary manipulation as a means of creating employment. The English Classicists of the eighteenth and nineteenth centuries were strongly opposed to the purchasing power theory and policy. In our century the importance of the demand side was clearly underrated when Britain tried to return to the gold standard after World War I, and when during the Great Depression she stuck much too long to the old parity—in both cases with disastrous effects on her economy. Later, under the influence of certain experiences and of the work of J. M. Keynes and his followers, the pendulum swung to the other extreme.

The demand side is now stressed again to such a degree, especially by the younger generation of economists, that one can almost speak of a purchasing power “myth”; and history seems to be repeating itself in that the adherents of the “myth” seem convinced that they have found an entirely new and revolutionary theory and a panacea for solving most economic disturbances. Apparently they fail to realize that what seems to them modern and progressive is, viewed historically, really antiquated and regressive. For not only has the purchasing power theory—including the oversaving and underinvestment theories—been advanced over and over again (though perhaps not in so complicated a form as by Keynes); but as early as 1742 it was recognized by David Hume and most recently by the so-called neoclassical school in continental Europe that the truth lies not in a one-sided purchasing power theory but in a synthesis of this theory and the classical approach.

THE CASE OF LACKING DEMAND

Let us return to the dilemma of the average businessman. If he has any analytical talents he will soon recognize—and better than many theoreticians today—that difficulties in his business are caused either by lack of demand or by something else.

First we examine the predicaments caused by lack of demand. Our businessman is only too well acquainted with them. He had an especially terrible experience after the crash of 1929. Before the crash, he had been accustomed to being able to sell his products in increasing quantities and/or at increasing prices. During more than eight years of prosperity he proceeded on an ever-expanding scale to enlarge existing and construct new plants and to pile up inventories; each new investment seemed entirely without risk and to assure profit. And he was equally lavish in granting ever higher prices to other entrepreneurs from whom he bought raw materials and half-finished products, and ever higher wages to his employees for their work. But one day he awoke to find that the whole situation had utterly changed overnight; the demand that had held up so many years suddenly collapsed, and with it prosperity and the psychology of prosperity.

What has happened is a repetition on an economywise scale of what happens on the stock market at the end of a boom. When the last bulls have bought, nobody is left on whom the bulls can unload their overbought inventories and their overcostly products. Depression begins, with all its consequences. Nobody wants to buy any more; just as during prosperity everybody awaited an increase in prices and expanding demand, everybody now fears further dwindling of demand and sinking prices. As the French say, “La hausse amène la hausse”—only now “La baisse amène la baisse.” A cumulative psychological process known as secondary deflation starts. Everybody suffers losses, especially those who have invested in new plants calculated for an output at boom rather than at depression levels.

Depressions are part of the so-called business cycles, known since the industrialization of Europe began. Despite all efforts to stabilize the economy they will continue to recur from time to time as long as the economy remains free in the sense that the governing forces are the people’s decisions and the optimism or the pessimism with which they judge the prospects of the future.

Obviously, a depression does not end until fear of vanishing demand is dispelled and hope of recovering demand returns. Our businessman as a member of the economic community postpones buying and investing until that time.

THE CASE OF HIGH COSTS

A quite different situation is no less familiar to our businessman. At any phase of the business cycle and especially when prices have remained on a relatively low level for a certain period without declining, it is not the price-and-demand factor that may hinder our businessman from engaging workers and buying raw material or machines. He may refrain because he considers his costs out of proportion to the prices he can expect. A good example of such a case is the building situation right now. Demand for new housing is assured at a level of rents well above those fixed by the O.P.A. Nevertheless, dwellings are not being built because, compared with such a level of rents and the corresponding prices of houses, costs are too high. This means essentially that wage rates are too high; for the material used for building consists partly of labor and only partly of raw material. Of course, the stoppage in building and the resulting unemployment and the underconstruction of houses is not a market phenomenon in the strict sense of the word. If wage rates were adjusted downwards, underemployment and underconstruction would disappear and, incidentally, aggregate wages would increase. It is just because this is not happening, owing to rigidities and monopolistic manipulation of the labor market, that unemployment and underconstruction persist.

Wages as demand factors obviously have nothing to do with these disturbances. Wages are causative exclusively as cost factors. The fact that they determine demand also is irrelevant. The economy contracts merely because costs are too high. In this case, therefore, the classical approach, which considers wages as cost factors, is correct. The main consequence is that wages can never, without creating unemployment, be pushed above a level corresponding to the productivity of workers who still wish employment.

Unemployment caused by too high wage costs should be called “stabilized” or “voluntary” unemployment. No tampering with demand, no inflationary measure can alter such unemployment for any length of time.

THE UNDERINVESTMENT DISTURBANCE OF DEMAND

As we have seen, two sorts of economic disturbance must be distinguished. For cyclical declines, a purchasing power theoretical approach seems warranted; but in the case of voluntary or stabilized unemployment and underactivity the purchasing power theoretical approach is obviously nonsense and the classical approach valid.

This combination of the classical and the purchasing power approaches represents roughly the synthesis theory achieved in continental Europe during the ’twenties. Distinguishing sharply between cyclical and stabilized unemployment, it refused to recognize the demand side as relevant to the maintenance of full employment, except when a cyclical decline in prices, caused by fear of a further decline in prices, was concerned.

However, during the ’thirties the situation changed. Every time in history that a deflationary process has for any reason lasted very long, the theory has been put forward that the depression is not merely a reaction to a boom, but is the expression of an entirely novel phenomenon—the lack of new investment opportunities. It was contended that owing to the maturity and stagnation of the economy, savings could no longer be absorbed by new investments, and that the resulting “investment gap” created lack of demand of a structural and secular character. My father, who was a banker, told me at the end of the nineteenth century that he feared he would have to give up his business because his main source of income—interest—would soon disappear since nobody seemed to need to borrow money any longer. Yet seldom have investment opportunities been so high as they were during the next few decades!

Similar pessimistic forecasts were made promptly during and after the great depression of the ’thirties. The oversaving underinvestment theories of Keynes and his followers appeared, though such theories had been voiced and subsequently refuted over and over again. Once more—and this time really and irrevocably—the end of capitalistic expansion was assumed to have come. Once more the economy was supposed to be so saturated with capital that not even at the lowest interest rates could opportunities for investment be found—with the resulting “investment gap” and “insufficiency of demand.” Once more a theory born of a special situation appeared to its adherents to have eternal validity. And once more, while the whole community of economists indulges in elaborating further niceties of the theory, the factual situation has, unnoticed by them, already changed and the “new” theory become obsolete. For not deflation but inflation, not lack of demand but high and rigid costs within a basically inflationary situation—these seem to have become the features of our time.

In this atomic age, when investments have reached such proportions that the means of private investors seem insufficient, there is no need to trouble much about the oversaving underinvestment theory. Indeed, the very mention of it seems a joke. One remark, however, may be warranted. The “stagnation theory” assumes that entrepreneurs decline to use their own or borrowed capital because investment would yield a profit incommensurate with the interest lost or paid. However, observation shows that only too many entrepreneurs have ample opportunity to use capital profitably if two conditions are fulfilled:

a. Costs—not of capital, but of labor—are not too high.

b. Prices of finished products do not fall during the production period.

It would be difficult to find an entrepreneur who does not engage in productive activities if these conditions are fulfilled. Of course wages may seem too high only in a broader sense: the use of labor may be too risky or costly for reasons other than the absolute height of the wage rate. When the entrepreneur fears that the government (by taxes) or labor unions (by organized action) are going to take away his profits, leaving him only the chance of losses, he will in the same way desist from productive activity. But this has nothing to do with “lacking investment opportunities” caused by a “saturation of the economy with capital.”

SOME CONCLUSIONS FOR THE PRESENT SITUATION

Some people think that the American economy is headed for a recession of more or less serious proportions. To ward it off, lower prices and higher wages are advocated. If our analysis is correct, such a policy will hardly achieve its purpose.

First, it is unrealistic to pretend that all prices in the United States are fixed arbitrarily by monopolists. There are still free markets, especially for raw materials and foodstuffs, where prices are particularly high—not in spite of insufficient but because of very great demand. To force prices down on these free markets is neither possible nor necessary as long as demand—not least on the part of the government agencies—is great. Under the pressure of demand, prices will remain high. When demand slackens, prices will decline and there will be no problem of the unadjustment of prices to demand.

Prices that are fixed by monopolists or quasi-monopolists would also probably decline as demand receded, even if no outside influence were brought to bear. However, no objections can be raised to a policy that tries to hasten the adjustment.

But how about wages? According to classical theory, wages too have to be adjusted downward when prices decline. Perhaps for monopolies, where wages can still be paid out of profits, this process is avoidable. Many other enterprises, however, do not have enough of a margin, and these will die if squeezed between low prices and high wages.

If at this juncture the general wage level is pushed upward in accordance with the purchasing power theoretical approach described above, there is no doubt about what will happen. The wage earners who remain employed will of course have more to spend if their wages are raised. However, the aggregate purchasing power of the economy cannot be pushed up through the raising of wage rates by political action. Wages will act as cost factors, no matter what is done. The further rise of the already very high break-even points in many industries will bring about a contraction because more and more enterprises will be forced out of business, and unemployment will ensue. If we are really heading for deflation, not inflation—which was the government theory only a short time ago—demand must be supported by radical tax relief measures and ultimately by public works. Both would enhance the aggregate purchasing power of the economy without raising costs. But the raising of wage rates—as against aggregate wages by employing more people—will always be the worst method of increasing purchasing power; for there is no way of evading the fact that wages are the most important cost factor of enterprise. Should a policy of wage-raising really be pursued and the purchasing power theory get the upper hand once more, the recession we may be facing would have a good chance of developing into a serious and protracted depression.

* English version of an article published in the Neue Zürcher Zeitung, August 2, 1947.