Money, Banking, and the Business Cycle: Volume II: Remedies and Alternative Theories

By B. Simpson

The business cycle is a complex phenomenon. On the surface, it involves a multitude of mechanisms, such as oscillations in interest rates, prices, wages, unemployment, output, and spending. But a deeper understanding requires a unifying theory to make these various parts whole. Money, Banking, and the Business Cycle provides a comprehensive framework for analyzing these mechanisms, and offers a robust prescription for reducing financial instability over the long-term. Volume II refutes Keynesian and real business cycle theories and provides policy prescriptions to virtually eliminate the cycle. Simpson offers a detailed analysis of several historical monetary systems around the world and shows the causes and effects of fiat money and fractional-reserve banking, as well as a 100-percent reserve gold standard.

• Language: English
• Publisher: Palgrave Macmillan
• Release date: Jul 2, 2014
• ISBN: 9781137336569

Book preview

MONEY, BANKING, AND THE BUSINESS CYCLE

REMEDIES AND ALTERNATIVE THEORIES

Volume Two

Brian P. Simpson

MONEY, BANKING, AND THE BUSINESS CYCLE

Copyright © Brian P. Simpson, 2014.

All rights reserved.

First published in 2014 by

PALGRAVE MACMILLAN®

in the United States—a division of St. Martin’s Press LLC,

175 Fifth Avenue, New York, NY 10010.

Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.

Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world.

Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries.

ISBN: 978–1–137–34077–1

Library of Congress Cataloging-in-Publication Data

Simpson, Brian P., 1966–

Money, banking, and the business cycle : integrating theory and practice / Brian P. Simpson.

    volumes; cm

Includes bibliographical references and index.

ISBN 978–1–137–33531–9 (hardback)

 1. Business cycles. 2. Monetary policy. 3. Banks and banking. I. Title.

HB3714.S56 2014

338.5′42—dc23                                2013044047

A catalogue record of the book is available from the British Library.

Design by Newgen Knowledge Works (P) Ltd., Chennai, India.

First edition: July 2014

10  9  8  7  6  5  4  3  2  1

To Annaliese Cassarino, my wife, and Charles and JoAnn Simpson, my parents

CONTENTS

Preface

Acknowledgments

Introduction

Part I   Refutation of Alternative Explanations of the Business Cycle

1 Underconsumption and Overproduction Theories of the Business Cycle

2 Keynesian Business Cycle Theory, Part Deux: Inflexible Prices and Wages

3 Real Business Cycle Theory

Part II   To Cure the Business Cycle

4 Government Interference, Fiat Money, and Fractional-Reserve Banking

5 The Characteristics and Effects of a Free Market in Money and Banking

6 The Significance of Some of the Historically Freer Banking Periods

7 Gold and 100-Percent Reserves

8 How to Transition to a Free Market in Money and Banking

Epilogue

Notes

Selected Bibliography

Index

PREFACE

It took nine years to complete this book and get it published. It took me about six years to write a very rough first draft, about seven months to write the second draft, and about four months to complete the third draft. Securing a publisher, going through several more rounds of editing, and getting the book finalized for publication occupied the rest of the time. I did not realize how large a task it would be when I started it. It required far more research into more areas than I thought would be necessary. The project grew so much that it eventually became two volumes.

I wrote this book in part because people have a poor understanding of the business cycle. This lack of knowledge has been highlighted since the 2008–9 recession. Wrong explanations have been provided and bad policy prescriptions have been recommended and implemented. The world desperately needs to learn what is required to achieve financial stability in an economic system. The two volumes I have written on the business cycle will enable people to acquire the knowledge they need on this crucial subject. The first volume shows theoretically and empirically what causes the business cycle, and the second volume refutes alternative theories of the business cycle and provides government policy prescriptions, based on the theory in volume one, to solve the problem of monetary-induced recessions, depressions, and financial crises.

Portions of the two volumes of this work, such as the discussions on money, inflation, the causes of the business cycle, particular episodes of the cycle, the invalidity of Keynesian depression and business cycle theory, the invalidity of real business cycle theory, the nature of a free market in money and banking, the benefits of a gold standard, and other topics are appropriate for use as supplemental reading material in courses on macroeconomics and money and banking. The two volumes could also be used as the main textbooks either by themselves or with other, supplemental readings in courses on the business cycle. It would be well worth it to include the two volumes. They will help readers gain an integrated and comprehensive understanding of the business cycle and business cycle theory.

BRIAN P. SIMPSON

La Jolla, CA

January, 2014

ACKNOWLEDGMENTS

There are a number of people and organizations whose help in bringing this project to completion I want to acknowledge. I thank the Social Philosophy and Policy Center—which before it merged with the Center for the Philosophy of Freedom at the University of Arizona was located at Bowling Green State University in Bowling Green, OH—for providing me with a visiting scholar position in the fall of 2008. I thank, in particular, Fred Miller, the executive director of the center. Before my position at the center I was not hopeful about completing the book because of the extensive amount of research I still needed to perform. I was able to complete much of the remaining research at the center.

I also thank National University for providing me with a sabbatical in the spring of 2012. While on sabbatical I was a visiting scholar at the Clemson Institute for the Study of Capitalism at Clemson University in Clemson, SC. I thank the Clemson Institute and its executive director, Brad Thompson, as well. I was able to complete far more work on the project than I thought I ever would while on sabbatical. It was not until I was finished with the sabbatical that I knew I would complete the book.

I also acknowledge my intellectual indebtedness to George Reisman and make a general reference to all of his works pertaining to the topics in this book. I have referenced his works extensively but since I owe so much of my knowledge of economics to this man, I underscore the importance of his influence on my thinking in economics and express my gratitude to him here.

In addition, I thank my beloved wife, Annaliese Cassarino, for all her support. In particular, I thank her for putting up with the long hours I worked to complete this project, especially in the final phases.

Despite the support of other people and organizations in completing this project, I alone am responsible for the views expressed in this book.

INTRODUCTION

This is the second of two volumes I have written on the business cycle. In a sense, the two volumes are a continuation of a previous book I have written titled Markets Don’t Fail! It is thought by many that business cycles—especially recessions and depressions—are inherent features of a free-market economy. It is claimed that a free-market economy is inherently unstable and leads to protracted periods of high unemployment and decreased economic activity. In other words, recessions, depressions, and financial crises are examples of alleged market failure. Government interference through so-called fiscal and monetary policies (among other means) is said to be needed in order to stabilize the market economy. Essentially, this means that the government must manipulate the amount of spending and impose various types of regulations on the economy to stabilize it.

The two volumes that make up this work on the business cycle show that this is not true. They demonstrate that financial crises, recessions, depressions, and the business cycle more generally are products of government interference in the market. Specifically, they are the result of government interference in the monetary and banking system. It is the government’s manipulation of the supply of money and credit through the fiat-money monetary system and fractional-reserve checking system that is responsible for the cycle today. The government is directly responsible for the manipulation of the supply of bank reserves through the fiat-money system and indirectly responsible, through banking regulations, for the ability of banks to manipulate the supply of money and credit through the fractional-reserve checking system.

The two volumes I have written show that Austrian business cycle theory (ABCT) is the only theory that provides a comprehensive and logically consistent explanation of the cycle. ABCT shows how the government’s manipulations cause changes in spending, revenue, profits, interest rates, output, and more. The solution to the problem of financial crises, recessions, depressions, and the business cycle is to abolish the offending government interference. This means a free market in money and banking must be established to eliminate the business cycle.

In other words, financial crises, recessions, and depressions are not a case of market failure but of government failure. They are a case of the government failing to protect individual rights consistently. Violations of individual rights lead to periodic economic crises. If the government consistently protected individual rights, cyclical recessions and depressions would virtually disappear.

In the first volume, I provide the theoretical foundations of ABCT. As a part of that task, I discuss the nature of money, banking, and inflation, with insights on these topics that will be new to many. I also show in volume one how the government’s manipulation of the supply of money and credit creates the cycle. Here is a brief summary of that discussion. When the government increases the money supply at an accelerating rate, it temporarily reduces interest rates and increases spending, revenues, and profits in the economy. When the latter increase unexpectedly, businesses expand their activities and produce more in an attempt to take advantage of the unexpectedly profitable times. This is the essence of the expansion phase of the business cycle.

The contraction ensues when the government decreases the money supply or does not increase it sufficiently. At this point, spending, revenues, and profits fall or fail to rise sufficiently (especially relative to expectations). Interest rates also rise due to the decrease or insufficient increase in the money supply.

In volume one, I also explain the role the fractional-reserve checking system plays in causing the business cycle. Because of this system, most of the new money enters the economic system as additional supplies of credit. This increased credit is what keeps interest rates low, especially relative to the rate of profit, during the expansion phase of the cycle. Likewise, the correspondingly reduced supply of credit brought about by the fractional-reserve checking system during the contraction causes interest rates to rise relative to the rate of profit during that phase. The movements in interest rates and the rate of profit provide two incentives for businesses to expand and contract during those respective phases of the cycle. During the expansion phase, since the rate of profit is high, businesses have an incentive to invest more. At the same time, low interest rates give them the incentive and ability to borrow more to expand. The low interest rates also provide an incentive to take on longer-term investment projects due to the effects of compounding. During the contraction, the low rate of profit gives businesses the incentive to contract. Likewise, high interest rates make it more expensive to maintain their existing activities and provide a motivation to take on investment projects of shorter duration.

After presenting my positive exposition of ABCT, the next task I undertake in volume one is to defend the theory from criticisms. I show that ABCT is consistent with rational expectations (as contemporary economists use that term), that the theory is not overly complex, that it does not exaggerate the role interest rates play in the cycle, and that the creation of mal-investment during the cycle does not depend on the existence of fully employed resources at the beginning of the expansion phase of the cycle. I defend ABCT from many other criticisms as well.

In addition, I extensively apply ABCT in volume one by performing a historical analysis of the business cycle in America from the beginning of the twentieth century up through 2012. I also go back to eighteenth-century France and the Mississippi Bubble to demonstrate the explanatory power of the theory. In my analysis, I show how fluctuations in the rate of change of the money supply drive changes in the velocity of circulation of money, the rate of profit, interest rates, output, and other variables. I do this by presenting and analyzing extensive amounts of data for the period pertaining to America. For the period in France, I use what data are available, as well as historical accounts of the period, to show how ABCT explains that episode.

Where data are available, my analysis in volume one employs a more comprehensive measure of output, as compared to gross domestic product (GDP), to provide a more complete picture of what events are taking place during the cycle. The more comprehensive measure is known as gross national revenue. GDP is deficient as a measure of spending and output because it mainly only measures spending on consumers’ goods. It fails to include most spending by businesses.

In addition, my analysis in volume one utilizes a better understanding of inflation to explain the cycle. It focuses on inflation as an undue increase in the money supply or, equivalently, an increase in the money supply by the government, instead of mere increases in prices. This focus allows for a deeper understanding of the causes of the cycle. Many more insights based on this better understanding of inflation will also be made in the current volume.

My analysis in volume one reveals that variables fluctuate as predicted by ABCT. The data also show changes in the structure of production during the cycle that ABCT predicts. That is, output in industries that are more sensitive to interest rates fluctuates more than output in industries that are less sensitive to interest rates. Through an integration of theory and practice, volume one clearly and convincingly demonstrates the validity of ABCT.

In addition, as a part of my analysis in volume one, I discuss other factors that contributed to specific episodes of the cycle. These include the government controls imposed by Presidents Hoover and Roosevelt during the Great Depression. Such controls took the economy down to unprecedented depths and made the recovery from that devastating episode much more difficult. For example, Hoover’s White House Conferences, where he used the presidency as a bully pulpit to (among other things) get businesses to keep wages high, sent unemployment to levels far above any that have been seen before or since.

The other factors also include, in connection with the 2008–9 recession, the Community Reinvestment Act of 1977 (CRA) that, in essence, forced banks to provide mortgage loans to poor people—people who could not afford to borrow such large sums of money. They include the creation and continued existence of the mortgage-loan giants Fannie Mae and Freddie Mac—huge players in the home mortgage markets that stimulated substantial amounts of irresponsible home buying and mortgage lending. They did so by using their government backing to raise far more capital than they otherwise could have and used these funds to purchase mortgages originated by home mortgage lenders. The CRA, Fannie, and Freddie—as well as other forms of government interference—were partners in crime in generating a massive housing boom in the years leading up to the recession of 2008–9 and made the recession far worse than it otherwise would have been.

My analysis shows that far from being incompatible with ABCT, these other factors are complementary to ABCT in explaining specific episodes of the cycle. However, my analysis also shows that ABCT identifies the primary drivers of the cycle: the drivers that exist in each cycle. The other factors are merely adjuncts to ABCT that appear occasionally in different forms for some cycles.

In volume one, I also address other attempts to explain specific episodes of the cycle. I show that these other attempts do not provide valid explanations. For instance, I show that the Arab oil embargo of the 1970s did not cause the recession that occurred in the mid-1970s. Reductions in the supply of a commodity do not cause changes in the amount of spending that occur in the economy during the cycle and they do not cause the right pattern of fluctuations in industries. For example, ceteris paribus, an oil embargo would create a boom for oil companies not involved in the embargo, as prices rose, and a contraction in industries that use oil as an input. This is not the pattern of fluctuations we see during the cycle.

As another example, I show that the Smoot-Hawley Tariff did not cause the Great Depression. For one thing, the tariff was enacted into law after the depression had already begun. For another, tariffs create expansions in domestic industries protected by the tariff and contractions in import (and eventually export) industries. This is not the pattern of fluctuations we see during the cycle. Further, tariffs do not create the changes in spending seen during the cycle. Such factors as embargos and tariffs can make recessions or depressions worse, but they are not the cause of the business cycle.

The task of this volume is to complete the case for ABCT. To do this, I show that other, prominent theories of the business cycle, such as real business cycle theory and the Keynesian sticky price theory of the cycle, do not provide valid explanations of the cycle. This task is undertaken in part one of this volume.

In part two, I show how government interference in the economy is responsible for the existence of fiat money and fractional-reserve banking. I also show what a free market in money and banking will look like and what it will lead to. The basic result will be a much more stable monetary and banking system. In addition, I provide an investigation into the types of monetary and banking systems that have existed in a number of countries around the world during the last 300 years or so. While not an exhaustive study—whole books have been written on this subject—by analyzing some of what are considered to be the freer episodes in money and banking, I show that a free market in money and banking has not existed. In fact, governments interfered early on in the history of money and banking (even much farther back than the periods I investigate). They did so mainly to finance their own spending.

In the next-to-last chapter, I discuss the benefits of a gold standard and 100-percent reserve banking. I also show that criticisms of gold and 100-percent reserves are not valid. Gold and 100-percent reserves have the ability to essentially eliminate the business cycle and help lead to much higher rates of economic progress. They lead to greater progress because of the stable financial environment they create. Finally, in the last chapter, I show how to transition to a free market in money and banking. The transition can be completed smoothly, without a depression or even a minor financial contraction. As a part of this last topic, I analyze a number of alternative plans to transition to a gold standard.

Let us now begin investigating these subjects with an analysis of the overproduction and underconsumption theories of the business cycle.

Part I

REFUTATION OF ALTERNATIVE EXPLANATIONS OF THE BUSINESS CYCLE

1

UNDERCONSUMPTION AND OVERPRODUCTION THEORIES OF THE BUSINESS CYCLE

INTRODUCTION

There are many theories of the business cycle. Some are better than others but all of them are deficient in some way except Austrian business cycle theory (ABCT). None of the alternative theories provide, as does ABCT, a comprehensive and logically consistent explanation of the business cycle based on the facts of reality. Some correctly identify some aspects of the cycle and may offer valid explanations of some aspects of the cycle, but none of them fully explain the causes of the cycle or the monetary and real changes occurring in the economy as a result of the cycle. I address the main attempts to explain the cycle in this and the following two chapters. I show logically and factually why they do not provide a valid explanation of the cycle. Once this has been done, and if one reads volume one of this work on the business cycle, one will have a complete understanding of the cycle. One will know logically what causes the cycle, will see and understand the causal factors at work in the facts of history, and will understand where alternative theories go wrong.

In the next few chapters, I discuss overproduction and underconsumption theories of the cycle, John Maynard Keynes’s theory of depressions and fluctuations (which is also underconsumptionist), so-called sticky price theory (which is also Keynesian), real business cycle theory, among a few other theories.

OVERPRODUCTION

The overproduction theory of the business cycle originated with socialist thinkers or those who leaned in that direction and was advocated by such individuals as Thomas Malthus, the nineteenth-century Swiss socialist J. C. L. de Sismondi, and Karl Marx.¹ This theory says recessions and depressions occur because capitalism is characterized by periods of too much production. During these periods of excess production, businesses begin to accumulate inventory, cannot sell the inventory at profitable prices, and must cut back on production. The cutback in production leads to workers being laid off, factories being shut down, and causes a general decline in business activity. Hence, recessions and depressions result from overproduction in the free market.

Employment and production increase only after the inventories of businesses have been depleted sufficiently to make production profitable once again. So the economy goes back and forth between these periods of overproduction and production, in an endless cycle.

The specific reasons why it is said capitalists periodically produce too much vary, but it is generally based on the belief that the need and desire for goods is limited and the rapidly expanding production in a capitalist society inherently leads to the supply of goods outstripping the limited need and desire. If the need and desire for goods is less than the supply, then of course the demand will also be insufficient to purchase all the goods produced. Hence, production is periodically reduced back down to the demand for goods in recurring recessions and depressions.

The first and most obvious point to make with regard to this theory of depressions is that there is an inherent contradiction in it. The claim is that recessions and depressions occur because too much has been produced. This implies they are periods of abundance or greater prosperity. If more has been produced than people have a need or desire for, then, in essence, people have grown so rich that they can cut back on production and enjoy the fruits of their labor. Obviously, this is false. Recessions and depressions are periods of greater poverty and hardship, not prosperity. This alone is enough to discredit this theory as a valid theory of the business cycle. However, there is another problem with the theory.

The other problem is with the idea that humans have a limited need and desire for wealth. This idea is false. Humans, in fact, have a limitless need and desire for wealth. This desire is based on the fact that human beings are rational beings—beings that possess the faculty of reason. Reason is the faculty that makes it possible for humans to think at the conceptual level (in terms of principles and ideas). The possession of reason makes it possible for humans to continuously expand the knowledge they possess. It makes it possible for them to progress forward through the continuous acquisition and application of knowledge. This progression is a part of how man improves his ability to survive and flourish; it is a part of man using reason—his basic tool of survival—to continuously improve his ability to further his life and happiness. As a result of the possession of reason and the progression it makes possible, man has a potentially limitless range of knowledge and awareness and thus the potential for a limitless range of actions and experiences based on this knowledge.

One can begin to see the limitless need and desire for wealth in the advance of knowledge and production since the beginning of the Industrial Revolution. One need merely think of the myriad products available today that were not even dreamed of in the mid-eighteenth century: from cellular phones, automobiles, and space travel to air conditioning, life-saving drugs, electronic computers, all sorts of other electronic devices, and many more. The production of and desire for these products represent an enormous increase in the need and desire for wealth. There is no limit to progress as long as man is able to use reason to acquire knowledge and apply it to production.

Even satisfying one of man’s basic needs, such as his need for shelter, implies a limitless need and desire for wealth. Man does not satisfy this need by living in a cave that he happens to stumble upon, like the lower animals might do. Man must grow trees for lumber, build lumber mills, build hardware stores, and produce all the products that these stores sell. He must mine ores and build steel mills to produce steel. He must produce transportation systems to carry building materials to where they are needed. He must produce aluminum siding and stucco, windows, heating and air conditioning systems, appliances, and plumbing systems (including pipes, pumping stations, water purification systems, etc.). The list could go on and on, and this is just with regard to producing shelter to meet his needs and desires.

Even as we grow richer, our need and desire for wealth remains limitless. As beings that possess reason, we have a continuous desire to progress forward economically. For example, if a man owns a car, then perhaps he would like to own a better car. If he has one of the best cars, perhaps he would like several vehicles to fulfill his transportation needs and desires (an exotic sports car, a family car, an off-road vehicle, a truck for hauling items, etc.). If he owns a home, then perhaps he would like a better home. If he has the house of his dreams, perhaps he would like a second home in a beautiful vacation spot. Perhaps he would also like to be able to afford more and better vacations, to be able to spend more time with his family and engage in more and better leisure activities, retire at an earlier age than he can presently afford, provide a better education for his children, and so on. To afford all of these things, a greater productive capability and higher standard of living are required; that is, more wealth is needed. Satisfying our needs and desires requires an ever expanding ability to produce wealth.

Man’s possession of reason vastly increases the scope of his needs and desires. In addition, by enabling him to increase his capacity to produce wealth, it makes it possible for him to constantly improve his ability to satisfy his needs and desires. This is something that is impossible for beings that do not possess reason to do, such as dogs, cats, cows, zebras, chimpanzees, and all the other lower animals. They go through their lives, generation after generation and century after century, performing the exact same tasks in the exact same manner as each previous generation. All they do is eat, sleep, eliminate, and mate over and over again until they die. There is no forward movement with the lower animals. There is no progression of knowledge. Later generations do not build upon the knowledge gained by previous ones. There is no ability or desire to constantly improve upon the satisfaction of their needs.²

The above implies that, in a general sense, there can never be too much production. There is always some use to which man can put greater sums of wealth, if not to improve upon the satisfaction of an already existing need or desire, then to satisfy a different need or desire that has arisen due to the discovery of new knowledge.

The only sense in which there can be an overproduction of goods is in a partial or relative sense: there can be an overproduction of some goods in the economy; however, this implies a corresponding underproduction of other goods. Such a situation implies that the areas of the economy that are experiencing the overproduction will be depressed: prices and profits will be low, workers will be laid off, factories will shut down, and businesses will go bankrupt. However, this implies at the same time that the areas of the economy that are experiencing the underproduction will be booming: prices and profits will be high, workers will be hired, new factories will be built, existing businesses will expand, and new businesses will open. This is not a general, economy-wide business cycle. It is not the boom and bust that is the focus of business cycle theory. It is a boom and bust only within certain industries and will not lead to an overall rise and fall of production in the economy but to a shifting of production from some areas of the economy to others.

To illustrate that there can be no economy-wide overproduction, imagine that production magically doubles overnight in the economy. Imagine that there are twice as many automobiles, computers, cellular phones, homes, clothes, toothpicks, swimming pools, thimbles, and so on produced overnight. Surely it appears that there is an economy-wide overproduction. However, even here there is not. Although it might be true that people do not want twice as many of all products, there are some products of which people want more than twice as many. For instance, most people do not want twice as much table salt, twice as many toothpicks, or twice as much low quality food (such as low quality types of meat). But most people do want twice as many cars, homes, vacations, restaurant meals, et cetera, and if they do not want twice as many of these things, most people certainly want the equivalent of twice as much in improved quality. That is, they might not want two Toyota Corollas but they would like to own a Lexus instead of a Corolla. Further, some of the increase in production could be devoted to the invention and development of new products, unheard of and impossible to produce with the previously lower productive capability. In general, people do not want twice as many staple and low quality goods, but they do want more than twice as many luxury and high quality goods, the equivalent of more than twice as much in improved quality, and the equivalent of more than twice as much in the form of the invention and development of new products.

What this means is, if a uniform doubling in the productive capability occurs throughout the economy, productive resources must be transferred from some areas of the economy to others. Capital and labor must be transferred from the areas in which too much is produced to those in which too little is produced. As stated by the economist George Reisman, The problem in such a case is not any actually excessive ability to produce, but merely the misapplication of an increased ability to produce in an undue concentration on the production of a particular good. The solution is thus simply a better balance in the production of additional goods.³

So the overproduction theory is not a valid theory of the business cycle. It implies prosperity in the midst of poverty. Further, humans have an unlimited need and desire for wealth and therefore economy-wide overproduction is impossible. The overproduction theory is based on the fallacy of composition. Since one industry can be unprofitable due to its overproduction, people think that when virtually all industries are unprofitable it must be from all of them overproducing. What people forget is that when one industry is experiencing lower profits or losses due to its overproduction, other industries are correspondingly more profitable due to their underproduction. This is because the industries are competing with each other. However, at the level of the economy as a whole, there is no competition. Competition only takes place within an economy. Changes in profitability at the level of the economy as a whole, as well as recessions and depressions, occur due to changes in the supply of money and spending.⁴

UNDERCONSUMPTION

Closely related to the overproduction theory of the business cycle is the underconsumption theory of the cycle. This theory has been put forward by Sismondi, Keynes, and others.⁵ Although the details may vary among supporters of this theory, the main claim is that when there is not enough consumptive spending in the economy, goods go unsold, workers are laid off, and businesses shut their doors. In other words, a depression occurs. One reason given why there is not enough consumptive spending is that capitalists might shift their spending from hiring workers to purchasing capital goods (i.e., substitute capital for labor). This means workers will be paid less and thus will allegedly not have enough money with which to consume all the goods produced. Whatever the reason given for the lack of consumption, the result is the same according to supporters of underconsumption theory: economic crisis and depression.

The situation is made worse, according to advocates of underconsumption theory, to the extent that greater savings accompany the lack of consumption because this leads to a greater supply of capital goods and thus a greater supply of goods produced. What this means, according to proponents of this theory, is that the supply of goods increases at the same time that spending for goods decreases and thus the underconsumption depression is exacerbated. As an example of underconsumption theory that focuses on too much saving, here is a quotation from the economist J. A. Hobson and his coauthor A. F. Mummery in John Maynard Keynes’s The General Theory of Employment, Interest, and Money, whom Keynes quotes favorably:

The object of production is to provide utilities and conveniences for consumers, and the process is a continuous one from the first handling of the raw material to the moment when it is finally consumed as a utility or a convenience. The only use of Capital being to aid the production of these utilities and conveniences, the total used will necessarily vary with the total of utilities and conveniences daily or weekly consumed. Now saving, while it increases the existing aggregate of Capital, simultaneously reduces the quantity of utilities and conveniences consumed; any undue exercise of this habit must, therefore, cause an accumulation of Capital in excess of that which is required for use.⁶

Because it is generally claimed that reduced spending and a depression result from too much saving, this theory can also be referred to as the over-saving doctrine. To ensure there is no doubt what too much saving (or too little consumption) leads to, a further quotation from Hobson and Mummery in Keynes’s The General Theory identifies the results very clearly: such undue exercise impoverishes the Community, throws labourers out of work, drives down wages, and spreads that gloom and prostration through the commercial world which is known as Depression in Trade.⁷

There are a number of errors with the underconsumption argument. Let us now look at them. The underconsumption argument makes the false assumption that the demand for goods comes only or mainly from workers and that, essentially, the only demand for goods is that for consumers’ goods. However, the demand for goods by businesses is every bit as much a demand for goods as is the demand for consumers’ goods (whether the demand for consumers’ goods comes from workers or capitalists). Every dollar of spending by businesses for capital goods generates a dollar of revenue for a business, just as a dollar of spending by workers for consumers’ goods generates a dollar of revenue. So, when capitalists spend more on capital goods, whether due to greater savings or a shift in spending from labor to capital, just as much spending is taking place that would have taken place otherwise.

For example, if total spending for all goods in the economy (viz., total sales revenue) is $1,000 and is comprised of $200 of spending on consumers’ goods and $800 of spending for capital goods and there is a shift in spending of $50 from consumers’ goods to capital goods, the same total spending exists. Now there is simply $850 of spending on capital goods and $150 on consumers’ goods. This is true whether the additional money spent on capital goods comes from a shift in spending for labor by capitalists or a shift from consumption to savings and investment by capitalists. For instance, assume further that total wage payments to workers by businesses are $100 in the economic system and that consumption by capitalists is $100. Whether capitalists reduce their own consumption to $50 or their demand for labor to $50, the reduced spending for consumers’ goods is exactly made up for by the increased spending for capital goods. For the sake of simplicity, I am assuming here that wage earners consume with all of their wages and do not save and invest themselves (i.e., are not capitalists themselves).

I must emphasize that in my example I use a realistic ratio of spending for capital goods to spending for consumers’ goods. As I have shown elsewhere, spending by businesses far exceeds spending for consumers’ goods.⁸ So there is a much larger sector of the economy in which spending could easily increase to offset the reduced consumptive spending, since any reduction in consumptive spending would require a much smaller percentage increase in spending by businesses to make up the difference.

The claim regarding spending for capital goods being greater than spending for consumers’ goods is true despite what one might believe based on aggregate economic accounting in the form of gross domestic product (GDP). GDP is a grossly inaccurate measure of gross spending in the economy because it fails to account for most spending by businesses for inventory. It measures only net spending by businesses for inventory and therefore fails to account for a large portion of spending for capital goods.⁹

If spending is shifted from consumers’ goods and/or labor to capital goods, the economy becomes more capital intensive. The ratio of spending on capital goods to consumers’ goods rises from 800:200 to 850:150 or from 4:1 up to 5.67:1. This means more capital goods are produced in the economy relative to consumers’ goods: there is a shift from the production of consumers’ goods to the production of capital goods, since the latter is relatively more profitable. This also means workers have that much more capital to work with and are much more productive. Eventually, due to the greater productive capability made possible by the greater supply of capital goods, there would be both a greater supply of capital goods and consumers’ goods produced.

The demand for consumers’ goods, by itself, does not need to cover the outlays by businesses for factors of production. In each scenario above, the outlays by businesses for factors of production are covered by both the demand for consumers’ goods and the demand for capital goods. That is, in the original scenario, the demand for factors of production is $900 ($800 for capital goods and $100 for labor). The demand for factors of production in the scenario in which $50 of spending by businesses shifts from labor to capital goods is no different: it is $900. The only difference is that now it is comprised of $850 of spending for capital goods and $50 of spending for labor. In the scenario in which capitalists decrease their consumption by $50, the demand for factors of production is now $950 ($850 of spending for capital goods and $100 for labor). In every case, however, costs in the economy, which are determined by the spending by businesses for capital and labor, are covered by the $1,000 of economy-wide demand for goods (i.e., economy-wide sales revenue).¹⁰

Notice also that in the case in which spending by businesses is shifted from labor to capital goods, economy-wide profits do not change relative to the original example: they are $100 ($1,000 in sales revenue minus $900 in costs). This is because economy-wide costs have not changed. Only the mix of costs has changed (i.e., more spending for capital goods and thus greater costs on account of capital goods and less spending for labor and thus lower costs on account of labor).

In the scenario in which the consumption of capitalists has declined, profits are now only $50 ($1,000 in revenue minus $950 in costs). While this decline might seem like it would induce a recession, one need not be alarmed. Such a large shift from consumptive to productive expenditures would only take place if time preference in the economy decreased dramatically, that is, if people made more provision for the future and thus began to save more. Such a change in time preference dictates that rates of return (including interest rates and the rate of profit on capital invested) would have to decline. The causal factor is the change in mentality that reduces capitalists’ time preference. This causes them to save more and reduces the rate of return they require to get them to save and invest. It is not somehow that the rate of return mysteriously falls and capitalists are forced to accept it. The same thing that causes a reduction in rates of return makes capitalists willing to accept a lower rate of return: a lower time preference.

Further, one does not need to be worried about profits falling to zero under the conditions assumed here. This is because profits in an economy with an invariable supply of money are determined by the consumption of capitalists. This value, by its very nature, cannot go to zero. This is because capitalists, like everyone else, must consume something in order to survive. This number, therefore, must have some positive value.¹¹

The large relative change in the consumption of capitalists assumed above, or the large shift in spending by businesses from labor to capital, is extremely unlikely. I use them here only to illustrate my point. That point is that increased saving by capitalists or a shift in spending by businesses from labor to capital does not reduce the ability of the spending for goods in the economy to cover the outlays by businesses to produce those goods. This is because, as stated previously, spending by businesses for capital goods is every bit as much a demand for goods as is spending for consumers’ goods.

The point underconsumptionists fail to understand is that changes from consumptive to productive spending in the economy do not represent a decrease in spending; they represent merely a shift in spending. Therefore, no economy-wide contraction comes about in these scenarios. Consumers’ goods industries contract while capital goods industries expand. In fact, not even all consumers’ goods industries contract since some consumers’ goods can be used as capital goods. For instance, the same number of trucks might be produced and sold but now more are sold to businesses instead of consumers. The key point is that there is no net change in spending and no recession or depression. Indeed, overall production and the standard of living rise because of the greater capital intensity and productive capability in the economy.

In addition, because the shifts in spending relative to the size of the economy tend to be much smaller than I have assumed, any industry-wide contractions and expansions that take place will tend to be much smaller as well. One dollar of spending shifted from labor to capital goods or consumption by capitalists to capital goods in my example is more realistic.

Finally, in the case of shifts in spending from labor to capital goods, while it will reduce overall money wages in the economy (assuming that the same number of workers are employed), such a decline would not constitute a decline in real wages in the long run. This is because capitalists will only be induced to spend more on capital goods and less on labor if it increases productivity and thus reduces costs. There is no reason to shift spending if there is no change in productivity, and there is certainly no reason to shift spending if productivity falls. The rise in productivity increases the rate of economic progress and eventually increases the supply of goods, including consumers’ goods, to the point where, eventually, real wages are higher than they otherwise would have been. So everyone will be better off.¹²

The cause of a recession or depression is not a shift in spending but a decline, less rapid increase, or a less rapid acceleration in spending.¹³ The key is that a decline in total spending (or a decline in the rate of increase or acceleration of total spending) is required, not merely a decline in consumption (i.e., not merely a shift in spending from consumers’ goods to capital goods).

Advocates of the underconsumption theory of the business cycle commit the same error that Keynesians commit in the use of their multiplier. That is, they equate saving with hoarding. This is the only way for spending to decrease in response to greater saving. In fact, virtually no saving takes place in the form of hoarding. Most savings are spent in one way or another: whether they are spent by businesses to purchase factors of production, by those who borrow the savings, by those who receive the proceeds from the purchase of shares of stock, and so forth.¹⁴

The only time people generally save in the form of hoarding is when a recession or depression (or a credit crunch) has already begun. Such hoarding occurs because people become unduly illiquid during inflationary expansions and must scramble to build up money balances when other sources of money begin to dry up (such as selling inventory into a growing revenue stream). This is not a cause of the business cycle (although it can make a business cycle worse).