The world is a newly affluent place. Economic growth has brought enormous changes to the ways in which the populations of the Western world live. Such change ought to be accompanied by a broad revolution in ideas associated with the management of a national economy and society. Running a rich country is entirely different to running an economy that is struggling to survive; and yet so many of the ancient ideas persist into the present day, entirely inappropriate to the new challenges which society faces. The purpose of this book is to highlight the divide between the old ideas and the current reality and to suggest successors to the current view.
The paradigms on which society's perception of reality are based are highly conservative. People invest heavily in these ideas, and so are heavily resistant to changing them. They are only finally overturned by new ideas when new events occur which make the conventional wisdom appear so absurd as to be impalpable. Then the conventional wisdom quietly dies with its most staunch proponents, to be replaced with a new conventional wisdom. The thesis of the book goes against current conventional wisdom, but it is armed with the evidence of recent events which make the current conventional wisdom increasingly untenable.
Adam Smith, David Ricardo and Thomas Malthus competently described the economic environment they saw around them, one in which the normal state of the average worker was to live on the brink of starvation. Malthus argued that any increase in wealth would be followed by a self-nullifying increase in population, returning the population to its previous desperation. Ricardo held that the benefits of economic growth would ultimately accrue to landlords and entrepreneurs, who would ultimately be able to appropriate all the benefits of increases in production, leaving their workers on starvation wages. Whilst Smith spoke in aggregates, he held a vaguely pessimistic view of who would be the principal beneficiaries of the new wealth, because of the relative bargaining strength of employers and labour: it was not difficult “to foresee which of the two parties must on all ordinary occasions have the advantage in the dispute”; “We have no acts of Parliament against combining to lower the price of work; but many against combining to raise it.”1) No solutions or hopes were offered.
The position was not as unreasonable. Abject poverty was seemingly permanent and endemic; abject poverty in the midst of economic growth did not seem worse than abject poverty amidst economic stagnation and no other alternative was yet perceived.
The latter half of the eighteen century refuted Ricardo's Iron Law (that wages would remain at subsistence levels forever); it was replaced, as competitive theory developed, by the prediction that wages would follow marginal product of labour. This allowed for a scarcity of labour driving up wages, and also for a wage structure based on skill.
The idea that the eternal destiny of the bulk of mankind was bare subsistence slowly died, but the conviction that economic life would remain not very good persisted. As the eighteenth century neared its end inequality spiralled: Marx's harbinger of doom.
The emerging competition theory also presented a rather pessimistic outlook: one of eternal instability. The textbook models prescribed continual bankruptcy and job losses as the normal road by which competitive production remained healthy. Economists' deference for their nobility and value made them no less painful. At every turn, people sought to avoid them, despite economists' paternal assurances that any attempt to do so would dull the system of incentives that made the system work — this pain was fundamental and necessary to the system.
The study of business cycles emerged in the early twentieth century, addressing abiding concerns that serious depressions were part of the natural course of events under a capitalist system. By the 1930s economists still had no answers, rather discouragingly claiming that such depressions would self-correct and any intervention would only prolong the misery.
The central tradition2) had a much greater influence on American economic thinking than any native thinkers. However, those that did exist were generally as or more pessimistic about the future of the economic system than the classical school — somewhat surprisingly, given the greater economic opportunities of the New World and the stereotype of American optimism.
Henry Charles Clay was the only one that could be considered an optimist. He noted the tendency of wages to rise in new settlements as more fertile land could be cleared for agricultural use, although he suspected that America might also ultimately reach a phase in which all land was in use and labour productivity must therefore fall.
Henry George, like Marx, was the founder of a faith. He agreed with Ricardo that increasing population would lead inevitably to more intensive working of land — and thus to a lower return to labour and a higher return to the landlord (increasing rents, falling wages). He also noticed the effect that land speculation (anticipating these rises in rent) had on the economic cycle — real estate bubbles played a central role in many of the American panics that he witnessed. However, he also proposed a solution — he advocated the nationalisation of land (or rather, equivalently, an annual land tax equal to the estimated return of land in its unimproved state). He was pessimistic as to the economic future of society were this not to be achieved.
Thorstein Veblen anticipated an increasing conflict between industry and business — industry had a deplorable instinct to overproduce, undercutting business' attempts to make money. Business always wins. Monopoly triumphs; output is constrained but all wealth flows to the mighty few. Yet depressions are a normal part of the system, they cannot be avoided. Inequality would be enormous and would continue to rise. Yet he held the rich more in contempt than responsible.
However, he believed the cultural consequences of the changes which society were undergoing were far more severe than the inevitable impoverishment of almost everybody. Factory labour undermined the family and church. Bringing workers into close contact with one another, through unions, would lead to the breakdown of law and order — socialism being next to anarchy.
The American tradition also adopted the Social Darwinism of Herbert Spencer (an Englishman), through the work of William Graham Sumner. Spencer, not Darwin, coined the phrase 'survival of the fittest' and provided one of the most politically useful ideologies in history: the destitution, starvation and inability to reproduce of the genetically inferior was a benign force necessary to the improvement of the species. Moreover, any attempt to alleviate this process through charity or government action was not only expensive, but immoral. The doctrine provided previously lacking justification for the inheritance of wealth: if the father was biologically superior, genetics dictated that so would be the son.
Marx had little argument with Ricardo. The worker would remain on the brink of destitution, although less due to his own incessant increase in population and more because permanent unemployment would ensure he had no bargaining power against the capitalist. The result was the same: economic progress would leave the working class behind. Yet it would be exacerbated by inevitable depressions of spiralling power, because the returns to capital would fall away as capital accumulated (which was observed during Marx's time but not in the twentieth century) and because supply would always increase faster than demand. Inequality of wealth and depressions would become worse and worse until the workers would be forced to revolt.
“Nothing has ever been so badly understood as the influence of Marx.” Although he engendered religious faith in millions across the world, it is not often appreciated the extent to which he influenced those who consider themselves non-Marxians. His ideas were remarkably broad and complete, his worldview unified not merely economic ideas but social classes, the state, imperialism and war into a single, coherent whole. His conception of human action as primarily motivated by money sits easily with a modern businessman or right-wing Republican. American liberalism views the concentration of industrial power as benign; American antitrust law takes a much more Marxian stand.
Inequality has traditionally been at the centre of economic discourse, and with good reason. Under the Ricardian system and its variants, economic growth does not offer opportunities for increased income for the average worker, only redistribution promises that possibility. In poorer regions of the world such conditions persist; landlords may be in a position of sufficient power to appropriate any increase in output, thus ensuring an absence of any incentive to economic growth. Whilst Western economists urge increases in productivity rather than redistribution, redistribution may well be a precondition of growth.
Inequality has been justified on many grounds, “principally noted for the absence of the most important reason, which is the simple unwillingness to give up what [the rich] have.” Equality has been argued to lead to uniformity and monotony (the rich sponsor the arts and education), redistribution has a musty association with godless communism, and the original Ricardian defence was that the present system was ultimately inevitable, and any attempt to change it would only lead to short-run inefficiency which would make everybody worse off. The most common justification is that inequality provides an incentive to be richer, an important driver of individual effort and overall economic growth.
Inequality has fallen off the political landscape in the US in recent years. Some measure of increased redistribution has been achieved through the progressive income tax implemented at the end of the Second World War. However, inequality remains acute, and a newfound equity can hardly explain the current détente between the rich and poor. Partly the real power of the rich has diminished — they no longer directly run their own corporate empires, there is no longer a large servile class to staff their households and their ostentation diminished as wealth became more common and vulgar. Partly too, it has been accepted by liberals that the major part of the gains that have been made by the majority of the working class have come through economic growth rather than redistribution — that is not to say that growth is a more important route to working class wealth than redistribution, but it is far less resisted. Although a large part of the working class has become more affluent, it is often not appreciated the extent to which an underclass has remained poor in the midst of these broader gains.
Economic security is a matter of enormous importance and widespread misunderstanding. Economic security means:
The conventional wisdom has long viewed insecurity as a central tenet of the market system — rewards and punishments beget efficiency, so take away or mitigate the punishments and the system is compromised. However, the desire for security seems universal, and hypocrisy reigns to a surprising extent: everybody advocates insecurity for others. Economics professors argue that the threat of unemployment is necessary to maintain incentives to high productivity, and simultaneously that established professors require life tenure in order to do their best work. Business leaders have been the pioneers of modern efforts to mitigate insecurity:
They nevertheless harshly criticise the efforts of labour and farmers to advance their own levels of security.
An interest in security is a luxury that only begins to develop when an agent accrues something worth protecting. In the nineteenth century, the struggle of workers and farmers for survival was so desperate that each had little to lose and little energy available to protect it; security was not then a concern. This explains why business was the first to seek greater economic security — accumulated assets accrued to business before workers or farmers started to become more prosperous. Business' ability to achieve much of this security without government support explains why theirs was not a well publicised battle, and thus why businessmen remain in a better position to condemn others' weak recourse to security — the myth of the entrepreneur, still subject to the unpredictable dangers of shifts in demand, unexpected technological advancement, falls in market prices or bad selection of managerial talent persists despite its gross inapplicability to large industrial corporations. Large corporations simply do not fail any longer.
So, as the lot of workers and farmers improved, so did their concern not to lose jobs and stable commodity prices. The 1930s was the key decade in this process, with new swathes of government intervention to provide social security, pensions and to regulate farm prices to prevent foreclosure. However, accompanying these microeconomic measures, for the first time in the 1930s the case for macroeconomic measures to improve stability became accepted. Unemployment compensation may mitigate unemployment, but far better to eliminate involuntary unemployment by preventing depression; guaranteeing minimum commodity prices never went as far as a healthy economy to maintain farmers' income. Moreover, the consequences of macroeconomic stabilisation far outweigh, in quantitative terms, microeconomic stabilisation, and it is for this reason that the conventional wisdom that instability improves production is plain wrong. Job losses and bankruptcies — the instability that supposedly keep the system running efficiently, in fact cause depression and quantitatively far greater reductions in output than could possibly be attributed to the loss of incentives (the associated phenomenon being unpunished idleness — something which those in higher stations in society have been turning into an artform for a very long time, no less, perhaps, than in universities in which the word “idleness” has now been replaced by “scholarship”). Unfortunately for the conventional wisdom, the recent decades of increased security for all economic agents have also been the most economically successful in history — a fact that is empirically undeniable, but so heretical as to be essentially unspeakable in conservative circles.
The emerging explanation for this increased focus on stability was that the modern industrial economy was becoming increasingly unstable as it evolved. Not so. The Great Depression is often cited as support for this argument — no similar phenomenon existed in the early nineteenth century. This is true, but insignificant — more importantly, in the early nineteenth century workers did not have well-paid jobs to lose as they did in 1930: employment was so barely better than unemployment that unemployment could not inspire the terror or a twentieth century depression. The important development is of something valuable to lose, not of instability. A similar misconception was that the evolution of concentrated markets was an attempt on the part of big business to maximise profits — although this was certainly a component, the desire to increase security for large corporations plays a much larger role in controlling markets than is widely accepted.
Economic stability, unlike economic desires more generally, can be sated. Once a worker has protection against unemployment, old age and sickness, the value of further protections diminishes sharply. Protection from instability can be adequately achieved, and to a large extent has been in the United States (an exception being the lack of health insurance). The only truly significant threat to stability that remains is the threat of depression. As has been mentioned, recessions account for far larger falls in production than could possibly be imagined to result from any loss of incentives.
Although microeconomic measures were originally designed with the recipient in mind, they do generally support macroeconomic stability. Unemployment insurance mitigates the fall of aggregate demand that results from job losses. Pensions provide a stabilising effect by ensuring a substantial component of demand is immune to the business cycle. Farm support similarly ensures demand during a worsening of economic conditions. These roles are little celebrated.
Importantly, increasing output is now the means by which governments maintain economic stability. So long as economic output is held at its full-employment level, all will be safe: workers, farmers and businesses. It may not matter whether increases in production bring products that we need or even want — their production guarantees jobs to those that produce them. Government performance is measured in terms of unemployment rather than industrial output, but successfully achieving full employment (rather than getting incentives right) cannot help but lead to economic growth. In this way, the age old economic concerns of production, inequality and insecurity have been reduced to only one: production. Increases in production, not redistribution, have lead to significant increases in workers' income. And the maintenance of production at a full-employment level is the last remaining task of government to ensure economic security for all.
Some years ago, the Republicans, currently in office and defending their stewardship under heavy opposition attack, were moved to protest that the current year was the second best in history. It was not, in all respects, a happy defence. Many promptly said that second best is not good enough — certainly not for Americans. But no person in either party showed the slightest disposition to challenge the standard by which it was decided that one year was better than another. Nor was it felt that any explanation was required. No one would be so eccentric as to suppose that second best meant second best in the progress of the arts and sciences. No one would assume that it referred to health, education, or the battle against juvenile delinquency. There was no suggestion that a better or poorer year was one in which the chances of survival amidst the radioactive furniture of the world had increased or diminished. Despite a marked and somewhat ostensible preoccupation with religious observances at the time, no one was moved to suppose that the year in question was the best as measured by the number of people who had found enduring spiritual solace. —page 124
Production, measured as GDP or GNP, is now rather casually taken as the preeminent measure of a nation's aggregate success. There are five means by which output can be increased:
1. Unused resources can be activated (idleness eliminated),
2. At a given level of technological advancement, resources can be more efficiently employed (eg appropriate capital-labour combination, appropriate firm size),
3. The supply of labour can be increased,
4. The supply of capital can be increased, or
5. The level of technology can be improved.
It is remarkable that, despite our apparent preoccupation with aggregate production, those involved in theorising about and managing the increase of industrial output (ie economists) are chiefly concerned only with (2), with a peripheral interest in (1) and (4). The explanation for this must be primarily historical: economics developed under conditions in which these were the viable means of enhancing output:
2. Attacking monopolies, tariffs, promoting competition and freeing the movement of capital and labour, in nineteenth century England, were pertinent and effective means of improving the efficient combination of resources and of raising output,
1. Eliminating any level of assistance to the indigent might improve the incentive to avoid unnecessary idleness, and
4. Urging thrift ought vaguely to raise the rate of capital formation.
Whereas the further alternatives were rather more irrelevant:
3. Population advancement, according to Malthus, would lead to further impoverishment — reasonable enough under conditions in which the supply of food was insufficient to cover current needs, and
5. There was no organisational infrastructure, not even corporations, under which systematic research and development could be undertaken; this was simply not a viable alternative.
Yet this picture is anachronistic. Its falsehood is most dramatically illustrated by wartime experience, under which production is of absolute concern, and considerable effort is taken in all of these spheres:
1. Broad economic management ensures there is no unemployment in wartime,
3. Immigrant labour was imported into the US during the Second World War,
4. The sale of War Bonds actively promoted capital formation, industrial investment was directed by government where it was felt insufficient.
5. Substantial resources were applied to the most immediate technological problems facing the economy such as alloy steels, synthetic rubber and shipbuilding.
Whilst, as a nod to the true importance of (2), the antitrust laws, the traditional mechanism for ensuring resource-use efficiency, were suspended during wartime.
This experience highlights what is not being done in peacetime. Particularly, despite the empirical value of technological improvements in economic growth, systematic research and development occurs only in select industries — those with a concentration of large corporations with the resources to invest, and in a few select industries (such as agriculture) in which the government has heavily involved itself. In others — home construction, clothing manufacture, natural-fibre textiles — no firms are large enough to invest in improvements, and none occur. Meanwhile capital accumulation is taken as a measure of economic growth, yet it is never suggested that some intervention ought to be made to improve it. These two: the rate of technological advancement and the rate of productive investment, seem to be the central determinants of economic growth over the long term and yet they are essentially ignored by those charged with managing the economy.
This disinterest in the essential drivers of growth may be justified by our underlying indifference to our level of production. We have proven in wartime that when production is of extreme importance to it, we attend to all means by which it can be improved rationally. Perhaps in peacetime, the commitment to raising production substantially simply isn't worth the effort. And yet even if that is so, the limited extent to which we do selectively try to raise output is steeped in tradition and irrationality.
Another irrationality persists (more in America than elsewhere?): the prestigious usefulness of private-sector output, compared to the burdensome annoyance of public expenditure. Somehow public expenditure can never quite be viewed as a productive and enriching element of national output; it is forever something to be avoided, at best a necessary encumbrance. Cars are important, roads are not. An expansion in telephone services improves the general well-being, cuts in postal services are a necessary economy. Vacuum cleaners to ensure clean houses boost our standard of living, street cleaners are an unfortunate expense. Thus we end up with clean houses and filthy streets.
Production has taken on a preeminent role in our lives, despite being a goal we fail to pursue vigorously or thoughtfully. It is a measure of achievement, though we do not strive particularly hard to achieve. This is not a call to take the problems of production more seriously. It may instead be simply an observation that production isn't important to us. Perhaps we value maximal production primarily for the security that affords us — by maximising production we ensure full employment. Advertising convinces us of the absolute necessity of consuming the goods that we already produce, but not of the need to produce anything currently beyond our means.
[W]e have wants at the margin only so far as they are synthesised. We do not manufacture wants for goods we do not produce. —page 137
Another central, although somewhat implicit, assumption of the conventional wisdom is that consumer demand remains equally urgent at all levels of consumption (or, what amounts to the same thing: that the urgency of consumer demand at different times does not permit scientific comparison). Secondly, and not much discussed in this chapter is the assumption that consumer demand originates deep within the eternal being of the consumer; at any rate, the economist need not concern himself with where they come from — they are assumed to be beyond question or appraisal.
The perception that a given increase in output is equally urgent at all levels of production is rather surprising, given developments undertaken at the end of the nineteenth century by Karl Menger, William Stanley Jevons and John Bates Clark on the concept of diminishing marginal utility, which has itself come to be a central tenet of the conventional wisdom. This development states that as an individual's consumption of any particular good increases, the value of each extra unit of consumption will generally decline. The first loaf of bread will be better appreciated than the second, which will itself be better appreciated than the third. The rather obvious implication of this theory being that viewing economic goods as a whole, each dollar increment of expenditure will reap a smaller and smaller reward until, at some point, further consumption will have a negligible impact on welfare. The central economic problem of mankind would seem to dissolve as production expands — and so it is to be expected that such implications would be attacked viciously by the economic establishment, whose very survival appears to be in the balance.
The fightback comes in two stages. Firstly, and rather weakly, it is suggested that this only applies to an individual good — that agents have an insatiable desire for variety and that an individual can continue to consume new products as his income rises which maintain a constant marginal utility of consumption. Secondly, and not entirely compatibly, the question is proclaimed to be untestable and therefore unscientific. Intertemporal comparisons are held to be inherently illegitimate. Thus if a worker's wage rose from $10 to $20 last year, the benefit to him of that extra $10 of consumption cannot be compared with this year's raise from $20 to $30, simply because they occurred at different times. It is a common mistake of the uninitiated student of economics to suppose that intertemporal comparisons of this type might be valid, and one which the teacher of economics expends some effort in correcting.
Only wayward voices such as Keynes dare to challenge such assumptions. According to him, the needs of human beings
fall into two classes — those needs which are absolute in the sense that we feel them whatever the situation of our fellow human beings might be, and those which are relative only in that their satisfaction lifts us above, makes us feel superior to, our fellows.
assuming no important wars and no important increase in population, the economic problem may be solved, or be at least within sight of solution, within a hundred years. This means that the economic problem is not — if we look into the future — the permanent problem of the human race.3)
Needless to say, this distinction between some class of needs which are inherently satiable and some other, possibly more nebulous class is still regarded as a profoundly heretical suggestion by the conventional wisdom.
The idea that wants do not decrease in urgency as an individual becomes more affluent is flatly contradicted by common sense. However, to overturn a tenet of the conventional wisdom, the idea must be tackled on its own ground. It escapes through the technicalities associated with the validity of comparisons. These are more than powerful enough to protect an element of the conventional wisdom.
Modern consumer demand, at the margin, does not originate from within the individual, but is a consequence of production. It has two origins:
These processes are generally easy for the layman or businessman to discern, rather more difficult for the economist. Economists generally sense the dangers to which such conclusions will quickly lead. This effect — the tendency of wants to rise as production rises, as a consequence of that increased production — will be called the Dependence Effect. It implies that it cannot be assumed that consumers' utility will rise with production: if production increases the wants of the consumer then he may be as well off at any level of production beyond a certain threshold.
Previous chapters explained the final focus on production in economics amongst all else; alongside the observation that maximisation of production is sought chiefly not for the goods it produces, but to obtain full employment. The Dependence Effect further undermines our focus on production, claiming that the demand for this new production is created by the production itself. Although not true of all goods, the demand for many new goods would not exist, were demand for them not to be contrived. The marginal utility of present production, ex advertising and salesmanship, is zero. “Clearly the attitudes and values that make production the central achievement of our society have exceptionally twisted roots.” Perhaps the most striking thing about this conclusion is the completely new array of problems that it poses — very different to those we are accustomed to addressing in economics. “It is a far, far better thing to have a firm anchor in nonsense than to put out on the troubled seas of thought.”4)
It is worth briefly summarising the likely centres of opposition to a challenge to the central role of production as the goal of the economic system. It can be expected to stem from two main sources.
The most obvious is the important business executive. So long as production is viewed as being of great importance by society, producers will be valued. The businessman competes with intellectuals (scientists, writers, professors, artists) for the solemn respect of the community. If production wanes in importance, his position in society will diminish sharply.
The second is American liberalism. Before the Great Depression, American liberals sought redistribution of income, greater economic security and the preservation of rights and immunities of individuals and organisations even in the face of a severe division of wealth. These surfaced in advocation of policies such as progressive income tax, development of public services, protection of public resources, extension of social services, support for farmers and other economically vulnerable groups, support for trade unions and regulation of corporations. However, the Keynesian revolution in the 1930s provided them with a panacea solution to almost all of their problems — the elimination of unemployment by managing (in effect maximising) production achieved everything they wanted to achieve, and more effectively than any of their previous programmes. “Here perhaps was the nearest thing to alchemy that had ever been seen in the field of politics.” Moreover, the public liked it and fiscal management aiming at eliminating unemployment provided the basis for political campaigns throughout the following decade.
The importance of production is already declining in the public perception. Businessmen no longer hold the prestige they once did, and the PR produced on their account increasingly stresses businessmen's image as a statesman, patron of education or civic force. His books are not criticised, but rather patronised by intellectuals. Intellectuals certainly feel no need to prove their credentials in production in the way that businessmen now feel the need to prove their worth outside of that realm. To an extent the ideology of consumption is being rejected by a younger generation with a distaste for ostentatious expenditure, who seek “a degree of shabbiness in attire.”
Production for the sake of security is important. Production for the sake of production is not. Consider the following hypothetical: a presidential candidate has to choose between (a) a substantial nationwide productivity increase that was split equally between step output growth and increased unemployment, and (b) no increase in productivity: every candidate would choose (b).
Spiralling debt creation for consumption is an important part of the contemporary process of want creation. Emulation and advertisement create wants in those with and without the means to pay alike. Consumer debt in America has been rising rapidly since the War, substantially above rises in earnings. Significant numbers of the poorly paid are committed to repaying over a fifth of their income in debt repayment (one in nine households in a low income bracket5) is committed to paying more than 40 per cent). Consumer debt is macroeconomically destabilising — people borrow and spend when the economy is healthy and cut expenditure in order to repay debt when the economy is weak. The consequences of unemployment in a household that has precommitted over 40 per cent of its pre-tax income to debt repayment are severe, for the household but also for the economy more generally. This continual expansion in debt appears to be necessary for consumer demand to keep pace with rising output, but the debt cannot continue to expand indefinitely — there are practical limits to the extent to which consumers can sink into debt. If the ability of advertising to keep demand abreast of production falters, the consequences could be dangerous, and could be significantly magnified by a consequential debt crisis. The conventional wisdom regards the nation's spiralling consumer debt as benign. Unlike in the UK, there is no suggestion that it might be curtailed by legislators. At the same time, government borrowing for investment in public infrastructure is tightly controlled.
Throughout economic history, inflation has generally accompanied economic disaster. Since World War Two, moderate inflation has accompanied relative economic wellbeing. Nevertheless it has been regarded very negatively. But almost nothing has been done to prevent it. One reason for this is the survival of the conventional wisdom that inflations, like depressions are self-correcting (Keynes lampooned the idea that depressions would pass without intervention, inflation has not yet had its Keynes). The memory of depression remains, along with the fear of breaking an economy that is functioning well (or the fear of being blamed for breaking it). Moreover, any serious assault on inflation would likely reduce production, resulting in some degree of unemployment. Whilst the myth of monetary policy offers a hope that inflation can be avoided without this cost, inaction appears attractive.
Inflation is a phenomenon of high production. When supply cannot be easily increased to meet demand, prices are forced upward. However, two distinct areas of the economy can be distinguished. In competitive sectors, in which each individual firm has no influence on the market price, prices will rise immediately in response to an increase in demand. In contrast, in markets containing large firms, each firm will have the discretion as to whether or not to increase prices in response to demand. This creates unliquidated gains for large firms. They could get away with increasing prices and thus increasing short-run profits, but this may or may not be to their long-term pecuniary advantage. The reputation or competitive position of the firm may be hurt. But most importantly, in industries with strong union power, price increases tend to invite new and aggressive wage claims. These permanently increase the firm's costs, even if the price rise can only be temporary. For this reason in particular, it is common for these gains to remain unliquidated until the firm next renegotiates wages with unions. Then, in the aftermath of such negotiations, prices are raise — almost invariably by substantially more than wages (for this reason the 'wage-price spiral should more accurately be called the 'wage-price-profit' spiral, for increasing profits are almost invariably an important part of the equation). This has the happy side effect of enabling the firm to publicly blame the bloody unions for the price rises, for which they generally elicit some degree of sympathy.
Unliquidated gains may persist beyond the peak of demand — and thus it is possible for large firms to raise prices in the face of falling demand, and this will be rational if something changes regarding the relationship between the short-run and long-run maximisation to make the short-run more feasible. However, the freedom to do so is limited. When excess capacity exists in an industry, there is an incentive to undercut one's opponents and thus sizeably increase sales. There is typically a substantial effort to blame unions for the wage-price spiral, but all are equally responsible. The tendency for the firm to raise prices in immediate response to a union deal is entirely down to the details of firm-union negotiation, it does not suggest that the upward spiral 'begins with' or is driven by unreasonable union demands.
A common fallacy should be dispelled. This is that an increase in capacity (and production) is a solution to the problem of inflation. The logic is simple — if there is insufficient capacity to adequately meet demand, then an increase in capacity will reduce the competition for scarce products and upward pressure on prices will be eased. The opposite is true. For one thing, this increase in production will inherently involve an increase in the income of producers, which in turn will feed into demand. But in addition, an increase in capacity requires a further investment in plant, which will feed even further into incomes and put further pressure on existing capacity, because existing industrial capacity must manufacture these new capital goods. An attempt to increase capacity will therefore tend to increase, rather than diminish, the wage-price spiral and inflation.
Inflation affects different groups with in society to different extents. Those with power over prices generally benefit. Concentrated industry can raise its prices, and will often enjoy the benefits of some suppliers who cannot do the same. Competitive industries are less fortunate, being unable to raise their own prices and facing generally rising costs (of machinery, and processed raw materials such as steel). Those on a fixed income, including many white-collar workers and pensioners will be hit by an increase in the cost of living, but will be unable to demand a higher wage, at least not without a substantial lag. Lawyers, doctors and prostitutes are usually excepted:
In 1942 a grateful and very anxious citizenry rewarded its soldiers, sailors, and airmen with a substantial increase in pay. In the teeming city of Honolulu, in prompt response to this advance in wage income, the prostitutes raised the prices of their services. This was at a time when, if anything, increased volume was causing a reduction in their average unit costs. However, in this instance the high military authorities, deeply angered by what they deemed improper, immoral, and indecent profiteering, ordered a return to the previous scale.
This was accomplished under authority delegated to the military authority by the Office of Price Administration (or, more precisely, its predecessor) in which I held the responsible authority. The step, for which I assumed I would be held to account, greatly worried me. Uniquely among acts of public insanity with which I have been associated, it never became a matter of public knowledge.
In a free market, in an age of endemic inflation, it is unquestionably more rewarding, in purely pecuniary terms, to be a speculator or a prostitute than a teacher, preacher, or policeman. Such is what the conventional wisdom calls the structure of incentives. —page 185
Thus, there are two main strategies by which inflation can be controlled. A substantial reduction in aggregate demand will create an amount of slack between capacity and consumption, constraining prices. However, due to unliquidated gains, this slack will generally have to be large in order to be effective, with a concomitantly large level of unemployment. The second strategy is to break the wage-price spiral directly — if this were possible, then inflation could be controlled without any associated reduction in production or employment. Economists have tended to emphasise the former solution, the latter tends to appeal to the layman. “The proper answer is that both are important.”
Monetarism may have been effective in 19th Century Britain. Conditions were favourable. It is also plausible that it was not. The prestige of monetarism took a severe hit with its failure to control the 1920s bubble or solve the Great Depression. Since then it has enjoyed a revival, largely because (a) there is strong consensus in the conventional wisdom that inflation is undesirable (b) effective means of dealing with inflation are dangerous — they risk a reduction in output and increases in employment (or, in the case of price controls, such solutions may even be un-American).
Monetarism lacks the magical effects often alluded to. It can only act by reducing aggregate demand by restricting borrowing. Increases in interest rates discourage borrowing, leading to a reduction in demand; a gap between capacity and demand develops which pushes down competitive prices and restrains oligopolistic prices, since an oligopolistic firm with excess capacity has a temptation to gain market share by undercutting opponents. There is, empirically speaking, no inducement for consumers to save rather than spend.
The restraint of consumer borrowing seems ineffectual. This is because of the mechanisms by which consumers borrow. A numerical example clarifies the point. Consider the purchase of a $1800 car, in 24 monthly payments of $84, representing 6 per cent interest and total interest payments of $216. The effect of an increase of interest rates to 8 per cent increases each monthly payment by only $3 (and total interest costs to $288). In practice, the increase is small enough to be absorbed by sundry inspection and insurance charges: at worst they may add one more monthly payment. In effect, the consumer has a very dull perception of changes in the interest rate, and the task of dulling it further is given to advertising. During the active application of monetary policy in the early fifties, increases in interest rates were often followed by large increases in consumer debt.
Monetarism does not act directly on the wage-price spiral. It acts only by controlling business borrowing for investment. This is often poorly understood. It is not unknown for conservatives to simultaneously call for a rising rate of business investment (and tax incentives to achieve this) alongside tight monetary policy to control inflation. The combination of the two policies is absurd. The myth seems to persist that monetary policy somehow acts directly on prices, the wage price spiral, without touching the volume of producer borrowing, investment and spending.
Monetary policy has a differential impact on different types of business. The circumstances under which monetary control is attempted are those of strong consumer demand. Under such conditions, firms in oligopolistic markets tend to have unliquidated gains. This enables them to pass on the increased cost of borrowing, and this will be especially easy when new borrowing is undertaken for the supposedly laudable goal of investment. Unions and the public understand and accept this motivation for price increases without concomitant wage increases. These firms' capacity to pass on increased costs also make them a safe bet for banks choosing to ration credit (as normally happens under tight monetary conditions). In contrast, those in competitive markets cannot raise prices to meet these costs. They are less likely to secure rationed credit. They cannot resort to bond issues to circumvent rationing. Monetary policy acts primarily on small firms and, for this reason, tends to find approval in larger firms. Severe monetary policy tends therefore to be forcefully resisted by small businesses and farmers.
There is also a potential risk involved. Investment spending is traditionally the most volatile of all demand in the economy. As discussed, monetary policy may well need to be severe in order to begin to bind, and actually become effective in reducing inflation. The effects of an extreme contraction in the money supply on a notably volatile section of demand are unavoidably unpredictable. The economy cannot be 'fine-tuned' in this way. Monetary contraction may be completely ineffective up to a point, and then disastrously over-effective. There is no way of knowing.
Monetarism is not an effective tool. It is blunt, unreliable, discriminatory and dangerous. These lessons have recently been relearned (1968–69) as monetary policy has been used to attempt to constrain inflation resulting from Vietnam spending.
As a means of fighting inflation, monetary policy is typically the weapon of choice of the conservative; fiscal policy of the liberal. Whilst monetary measures have a rather indirect and disputed impact, nobody doubts the efficacy of fiscal measures. Monetary measures tend to have a discriminatory effect, acting more acutely on competitive markets than large corporations, fiscal measures are more nearly equal in their impact. Yet fiscal measures have not been at all effective in curbing the post-war inflation, because they have never been used.
In the US, public expenditure tends to hover at the lower end of that tolerable by the community. There is little or no room for it to be cut (whilst it is often inefficiently administered, cutting budgets is a terrible way of reducing inefficiency: “it is far easier to cut function than waste”). Significant cuts in public spending are politically very difficult.
Tax increases in the midst of inflation, which themselves directly increase prices and business costs, appear rather obtuse to the layman. More importantly, the suggestion of tax increases seems to threaten the tacit agreement that the issue of economic redistribution be ignored. When tax increases are proposed, liberals feel a knee-jerk responsibility to call for them to be progressive and conservatives feel a knee-jerk suspicion that the real goal is to expropriate their wealth for the benefit of others. Finally, there is the ubiquitous conflict with production and employment — whilst some monetarists hope to argue that monetarism can control inflation through some unseen mechanism that does not reduce production, that claim is never made of fiscal control.
The final possibility is to combine wage and price controls with a background fiscal policy. Price controls need only be effective in oligopolistic markets, in which they are much easier to implement anyway — in competitive markets there is no union or corporate power to fuel the wage-price-profit spiral. But such controls would be in stark contrast to all conventional wisdom. By controlling prices, the allocative efficiency of the market is impaired — prices cannot adjust to changing circumstances to redistribute resources. During wartime such allocative efficiency was swamped by much greater increases in output by far more effective means than improved allocation — those typically receiving less attention from economists.
Modern expectations that the economy will be held very near full employment have opened the way for persistent inflation. The conservative (monetarist) response is ineffectual, discriminatory and potentially dangerous. The liberal (fiscal) response is so at odds with the goals of high output and employment that it is not politically feasible. The only remaining alternative (price controls) labours under a large ideological cloud. The way is open for recurrent inflation, which itself has a discriminatory impact on different groups, and exacerbates the other unsolved problem of the affluent society.
The final problem of the affluent society is the balance of goods it produces. Private goods: TVs, cars, cigarettes, drugs and alcohol are overproduced; public goods: education, healthcare, police services, park provision, mass transport and refuse disposal are underproduced. The consequences are extremely severe for the wellbeing of society. The balance between private and public consumption will be referred to as 'the social balance'. The main reason for this imbalance is relatively straightforward. The forces we have identified which increase consumer demand as production rises (advertising and emulation) act almost entirely on the private sector.
The scientist or engineer or advertising man who devotes himself to developing a new carburettor, cleanser, or depilatory for which the public recognises no need and will feel none until an advertising agency campaign arouses it, is one of the valued members of our society. A politician or public servant who dreams up a new public service is a wastrel. Few public offences are more reprehensible. —page 215
It is arguable that emulation acts on public services to an extent: a new school in one district may encourage neighbouring districts to 'keep up', but the effect is relatively miniscule.
Thus, private demand is artificially inflated and public demand is not, and the voter-consumer decides how to split his income between the two at the ballot box: inevitably public expenditure is grossly underrepresented.
Two further reasons contribute to the exacerbation of the social balance. The familiar truce on inequality again discourages any substantial tax increase — it awakens the unresolved and irrelevant ideological battle over wealth redistribution. Secondly, the modern tendency of inflation to remain a normal part of a healthy economy favours the private sector. Public sector wages lag behind those of unionised and white-collar workers whenever significant inflation is present — over time, there is a migration of the more talented and avaricious workers towards the private sector. The relative security of public positions is also declining as unionised and corporate jobs become steadily more secure and resilient to recession. The conventional wisdom refuses to concede that discrimination against public services is an inherent feature of inflation, but this seems undeniable. Throughout much of Europe and South America there has been an historical correlation between inflation and both the strength of communist parties and the frequency of revolution.
It has sometimes been argued that social spending intrinsically robs men of choice. If a man's income is taxed and spent on a school, he is robbed of the free choice to spend it on either a TV or a car. What is ignored is the fact that if he is not taxed, he does not have the choice available to spend his money on his part of a new school. The size of government has also traditionally been seen as an inherent danger — many have always perceived a direct link between the size of government measured by revenue and the loss of freedom, even though it presently appears that government is a distant second to the corporation in its drive to “create, for its own purposes, the organisation man.”
There is a second economic imbalance in the affluent society similar and linked to the social balance. Industrial investment can be divided into two categories. Capital accumulation refers to the increased quantity of capital used in production, enabling greater production per worker. Technological improvement refers to the replacement of old plant with that which is not merely larger, but more efficient due to better design. The free market adequately allocates an efficient level of resources to the former, but in the modern industrial economy, improved design of plant is dependent, more than anything else, on an educated workforce. It is not efficient for any firm to invest substantially in an educated workforce, because without slavery there is no means to prevent the newly educated worker to move to a competitor firm. Education is therefore an external economy. Its benefits accrue to all firms and not sufficiently specifically to any that they will be willing to pay for it. The market cannot therefore allocate an efficient amount of capital to the education of the workforce. Education suffers from all of the usual problems of a publicly provided service — no advertising agency promotes it, the emulation effect is weak and any attempt to pay for it wakens the old antagonisms over the redistribution of wealth.
It is worth noting that this was not always true. As the conventional wisdom was forming, education played little role in technological innovation. Many of the inventions that lead the industrial revolution were made by those with no formal education. Wherever money was available to invest in plant, sufficient entrepreneurship and innovative talent could be found to put it to good use. The need for a highly educated workforce to enable technological advancement is a recent phenomenon.
The problem of human development also applies to one of its principle products: scientific research. Whilst certain areas of applied research and development are heavily provided by the market, others are not. The most obvious is 'basic scientific research', although in fact the long-term development of radically new technologies cannot in practice be financed by the private sector. In America this problem is rather hidden by the fact that such technologies are actively developed by the state through the military-industrial complex — radically new civil technologies such as modern air travel, nuclear energy, communications satellites and electronics could only have been developed with heavy state support first for military applications. “[T]he rate of technical progress in America in recent decades would have been markedly slower had it not been for militarily inspired and for this reason publicly supported research.”6) Additionally, a considerable portion of research in private enterprise is devoted to discovering changes that can be advertised: “[t]he research programme will be built around the need to devise 'selling points' and 'advertising pegs' or to accelerate 'planned obsolescence'.”7)
There are, of course, other reasons to desire improved and increased education unrelated to productivity, as a preferable form in which to enjoy our affluence than the satiation of manufactured wants in the private sector.
If the economy were to be realigned towards education and investment in scientific research, this again ought to have a stabilising effect on the economy. Not only would a further portion of demand be taken out of the capricious hands of consumers and businesses, but the continual expansion of demand would not depend so precariously on the continued creation of new needs, since public wants are not contrived (except for military expenditure).
On the other hand, an education population is not only politically but economically dangerous. A more educated population is likely to be far more difficult to manipulate as consumers. Education undermines the want-creating power of industry.
The conventional wisdom abhors destructive criticism. It is dismissed as a wanton activity. Only 'constructive criticism' is praised, requiring the much harder task of formulating an improved solution before the old can be criticised. At the same time, “[i]n the world of minor lunacy the behaviour of both the utterly rational and the totally insane seems equally odd.” Even if the foregoing analysis is accepted, the obvious solutions are likely to appear feckless, possibly even dangerous. So is the custom. For example, accepting the Keynesian analysis that an economy could reach an equilibrium during a depression with large-scale unemployment was one thing, accepting the Keynesian solution of deficit spending was another thing entirely.
An extremely broad array of policy decisions are cast into doubt by the loss of production as the preeminent concern of the productive system. But more than that, an entire system of morality is at stake. The sin of idleness has been perpetuated by economic reasoning throughout American history. It is difficult to continue to see its danger for the rest of the community when a man's work satisfies artificial wants — or worse, manufactures them. However, joblessness imposes a disagreeably low income, even if there no genuinely productive job can be created. This problem must be solved if the rewards of affluence are to be fully realised.
At present, production must be maximised at all costs in order to ensure economic security by providing jobs for all. In order to manage production rationally, there must be a means of guaranteeing economic security to all, independently of productive employment. The obvious means by which to accomplish this is by changing unemployment compensation. This has been maintained at a level appropriate only for survival, in 1967 only 34.7 per cent of the average wage. Further, it is provided for a limited period, to force those receiving it back into work. There are two problems with this: (1) if economic policy demands that not everybody be in work, then those who are not should be fairly compensated for decisions beyond their control, and do not need a large motivation to get back into work as soon as possible, and (2) it is important from the perspective of maintaining consumer demand at as nearly steady a level as possible that increases in unemployment not lead to a rapid and extreme reduction in demand by the unemployed. There is no longer any great loss to society from those that are unemployed, since the marginal utility of production to society is so negligible. For this reason, it seems rational to encourage those for whom work is either difficult (those with no skills, education or experience, or who are black8)) or unwise (those who are mentally or physically infirm, or women heading households) not to enter the workforce. For those with very few skills or experience, this would free them from work for long enough for them to obtain better education or training. This is likely to lead to an increase in voluntary idleness amongst a minority. Evidence suggests that this effect is likely to be far smaller than the conventional wisdom suggests. It was feared that droves would leave work for unemployment compensation when it was first introduced at a niggardly rate, the eventual numbers who did so were tiny. Although it is certain to happen, its costs are not large; it is likely to cause more of a moral outrage than a significant economic burden.
The best way of restructuring unemployment compensation would be through a negative income tax. Thus, at very low levels of income, individuals would pay negative income tax, ie receive money from government, purely on the basis of their level of income (and probably the number of dependents in their household). As income increased, gradually payments from government would fall away, and soon income tax payments would become positive. There would be no requirements for recipients to jump through hoops or 'actively seek work' in order to receive payments; it would be automatic. The great benefit of this system compared to current arrangements is that there is no disincentive to work — an increase in earnings always leads to an increase in household receipts, which is not necessarily true in present conditions: for the very poor there are often strong financial disincentives to work.
Adjusting the balance of spending between public and private uses is more difficult, because of the inherent preference for private consumption generated by advertising and emulation. However, in practice federal government revenues are rising in line with economic output because of the proportional if not progressive nature of income and corporate tax. The reason that this does not translate into public expenditure rising in line with private output is that military appropriations continue to rise to absorb the excess. This should change.9)
To pay for state and city expenditures a largely increased use of sales tax is proposed. Sales taxes are non-distortionary, and naturally rise in line with economic output. They should encompass all goods, including those traditionally classed as 'necessities' (food and clothing) since in modern times expenditure on food and clothing is often as opulent as any other — food and clothing bought by those in genuine poverty is a tiny proportion of the total and is better addressed by other means. Another benefit of sales tax is that being entirely proportional, it avoids reopening the debate over wealth distribution. This debate has been a central inhibitor of increased social spending for some time, and must now be consciously put aside (particularly by liberals) so that taxation and social spending can be raised without any kind of redistribution — merely because this is the only way in which it can be negotiated in practice. Galbraith does not discuss whether increasing proportional taxation to pay for unemployment compensation, public schools and hospitals will appeal to those who use private schools and hospitals and are unlikely ever to fall outside the top income tax bracket.
Poverty is a different phenomenon in the affluent society. It no longer afflicts the majority, but a relatively small minority. Politically, policies devoted to helping the poor are harshly criticised in any society, but in the affluent society they also tend to lack any significant support — not only are the poor numerically few but also relatively politically apathetic and without influence. This is one reason that poverty, although having been reduced in scale during industrialisation, remains significant for so long during a country's affluence.
It is worth distinguishing two distinct forms of poverty:
Case poverty exists but is relatively less important than insular poverty. However, it is of disproportionate ideological use. It allows society to shift responsibility for poverty to those afflicted.
The solution to these problems is, broadly: to guarantee a decent income to all (for example using the negative income tax) and to restore the social balance by increasing public spending, recognising that localities with more poverty require significantly more investment in all public services (eg education, healthcare, law enforcement) to compensate for households' inability themselves to invest in their children's future — this is required in order to guarantee children growing up in poverty to enjoy the same opportunities to economic success that those born into more affluent families are given. Over the last ten years (to 1968) it has become economically feasible to guarantee a decent income to all those who do not earn it. Policies likely to improve the social balance have a general tendency also to reduce poverty.
In the affluent society, the rationale for the 'just suffering' of those who are not economically productive is gone. In a poor society, the central importance of raising production to the wellbeing of the society might excuse ill-treatment of those who are voluntarily idle; perhaps, even, those who cannot work or are particularly inefficient. “Nothing requires [an affluent] society to be compassionate. But it no longer has a high philosophical justification for callousness.”10)
As productivity increases, the marginal utility of production decreases and, so long as leisure returns a positive marginal utility and work a negative or lesser marginal utility, there will be a tendency for society to work less. This can manifest in one or more of three distinct ways:
This process has long been underway. Society's past productivity gains have mostly been manifested in forms (1) and, to a lesser extent, (2). In 1850 the average American worker worked a 70-hour week, a hundred years later it was only 40 hours. The conventional wisdom is very careful to deny that this is a consequence of the falling marginal utility of goods — various sophistic explanations are given, all of which avoid without really addressing this marginal utility. Work has to some extent become less intense and unpleasant, although again there has been a strong resistance to the making of work more pleasant as a tangible goal — rather, these improvements have been made indirectly by health and safety conditions, through automation of particularly unpleasant tasks, and so on. Examples of (3) are more mixed: although workforce participation by those below 15 and above 65 has fallen drastically, male participation between above the age of ten has remained constant at around 75 per cent for seventy-five years, whereas female participation has risen substantially. This latter trend also reflects the movement of economic production traditionally undertaken within the house (clothing and food manufacture, childcare) into a more formal setting.
There is an important distinction between types of work that is powerfully resisted by the conventional wisdom. This is the distinction between work done primarily for monetary reward, and that which is interesting and possibly creative in its own right, for which remuneration isn't the primary motivation. It would not be thought particularly strange if a college professor, poet, tycoon, advertising man sought therapy on discovering that he no longer found his work rewarding — whereas it may seem rather odd if a factory shift-worker was as surprised to find his labour unfulfilling. There is obvious ideological value in presenting 'intellectual labour' as being as burdensome as physical labour (and in extreme cases even more so11)) in justifying the concomitant wage and power differentials (both under Western capitalism and its Soviet counterpart). The rise of what could be called the New Class, of workers who engage in enjoyable and fulfilling work, is one of the most significant trends of the affluent society. It thinks and acts like a class, indoctrinating its young from the earliest age of the paramount importance of finding an occupation which will be satisfying — which “will involve not toil but enjoyment.” The children of members of the class usually remain within the class one way or another, and when they do not it is regarded as a tragedy.
The New Class is not exclusive and entrance is perfectly feasible. The primary criterion is education. The movement of an ever greater proportion of society into the New Class is a very beneficial effect of economic development, and the further continuation and acceleration of this trend would make a laudable societal goal. The main means by which this might be achieved would, of course, be a heavily increased investment in education. Membership of the New Class affords the opportunity to spend one's working life in relative comfort, engaged in tasks that one finds interesting and challenging. It is reasonable to suppose that everybody would like such an opportunity.
In American society, production is seen as the primary social goal. This is due to the continuing thrall of anachronistic ideas, vested interests in production, the obscurantism of the theory of consumer needs, a mistaken conception of the national security and an unfortunate association under present conditions between production and security for many millions of workers.
A society must survive before it may begin to consider the pursuit of happiness its primary goal. But production is no longer a means to survival, either as it traditionally was, or in its modern reformulation as a war of productive capacity with the Soviet Union. But military production plays an essential role within American society. Many valuable technologies have been developed under military auspices.
This has done more to save us from the partial technological stagnation that is inherent in a consumer goods economy than we imagine. But this is a hideously inefficient way of subsidising general scientific and technical development as nearly all scientists agree. —page 283
Ultimately, the problems with which we are now concerned will be solved. We do not yet know what will replace them — perhaps population increase and a shortage of living space, perhaps natural resource depletion, perhaps occupying minds no longer required for the production of consumer goods. Whatever the next challenge is, we can be confident that the most effective way to prepare for it is to continue to invest munificently in education at all levels.