America's Great Depression (15 page)

One common variant of the underconsumption theory traces the fatal flaw to an alleged shift of relative income to profits and to the higher-income brackets during a boom. Since the rich presumably consume less than the poor, the mass does not then have enough “purchasing-power” to buy back the expanded product.

We have already seen that: (1)
marginally
, empirical research suggests a doubt about whether the rich consume less, and (2) there is not necessarily a shift from the poor to the rich during a boom. But even granting these assumptions, it must be remembered that: (a) entrepreneurs and the rich
also
consume, and (b) that savings constitute the demand for producers’ goods. Savings, which go into investment, are therefore just as necessary to sustain the structure of production as consumption. Here we tend to be misled because national income accounting deals solely in net terms. Even “gross national product” is not
really
gross by any means; only gross durable investment is included, while gross inventory purchases are excluded. It is not true, as the underconsumptionists tend to assume, that capital is invested and then pours forth onto the market in the form of production, its work over and done. On the
Some Alternative Explanations of Depression: A Critique
59

contrary, to sustain a higher standard of living, the production structure—the capital structure—must be
permanently
“lengthened.” As more and more capital is added and maintained in civilized economies, more and more funds must be used just to maintain and replace the larger structure. This means higher gross savings, savings that must be sustained and invested in each higher stage of production. Thus, the retailers must continue buying from the wholesalers, the wholesalers from the jobbers, etc. Increased savings, then, are not wasted, they are, on the contrary, vital to the maintenance of civilized living standards.

Underconsumptionists assert that expanding production exerts a depressing secular effect on the economy because prices will tend to fall. But falling prices are not depressant; on the contrary, since falling prices due to increased investment and productivity are reflected in lower unit costs, profitability is not at all injured.

Falling prices simply distribute the fruits of higher productivity to all the people. The natural course of economic development, then, barring inflation, is for prices to fall in response to increased capital and higher productivity. Money wage rates will also tend to fall, because of the increased work the given money supply is called upon to perform over a greater number of stages of production.

But money wage rates will fall less than consumer goods prices, and as a result economic development brings about higher
real
wage rates and higher real incomes throughout the economy. Contrary to the underconsumption theory, a stable price level is not the norm, and inflating money and credit in order to keep the “price level” from falling can only lead to the disasters of the business cycle.4

If underconsumption were a valid explanation of any crisis, there would be depression in the consumer goods industries, where surpluses pile up, and at least relative prosperity in the producers’ goods industries. Yet, it is generally admitted that it is the 4We often come across the argument that the money supply must be increased “in order to keep up with the increased supply of goods.” But goods and money are not at all commensurate, and the entire injunction is therefore mean-ingless. There is no way that money can be matched with goods.

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producers’, not the consumers’ goods industries that suffer most during a depression. Underconsumptionism cannot explain this phenomenon, while Mises’s theory explains it precisely.5, 6 Every crisis is marked by
mal
investment and under
saving
, not underconsumption.

THE ACCELERATION PRINCIPLE

There is only one way that the underconsumptionists can try to explain the problem of greater fluctuation in the producers’ than the consumer goods’ industries: the acceleration principle. The acceleration principle begins with the undeniable truth that all production is carried on for eventual consumption. It goes on to state that, not only does demand for producers’ goods depend on consumption demand, but that this consumers’ demand exerts a multiple leverage effect on investment, which it magnifies and accelerates. The demonstration of the principle begins inevitably with a hypothetical single firm or industry: assume, for example, that a firm is producing 100 units of a good per year, and that 10

machines of a certain type are needed in its production. And assume further that consumers demand and purchase these 100

units. Suppose further that the average life of the machine is 10

years. Then, in equilibrium, the firm buys one new machine each year to replace the one worn out. Now suppose that there is a 20

percent increase in consumer demand for the firm’s product. Consumers now wish to purchase 120 units. If we assume a fixed ratio of capital to output, it is now necessary for the firm to have 12

machines. It therefore buys two new machines this year, purchasing a total of three machines instead of one. Thus, a 20 percent increase in consumer demand has led to a 200 percent increase in 5For a brilliant critique of underconsumptionism by an Austrian, see F.A.

Hayek, “The ‘Paradox’ of Saving,” in
Profits, Interest, and Investment
(London: Routledge and Kegan Paul, 1939), pp. 199–263. Hayek points out the grave and neglected weaknesses in the capital, interest, and production–structure theory of the underconsumptionists Foster and Catchings. Also see Phillips, et al.
, Banking
and the Business Cycle,
pp. 69–76.

6The Keynesian approach stresses underspending rather than underconsumption alone; on “hoarding,” the Keynesian dichotomization of saving and investment, and the Keynesian view of wages and unemployment, see above.

Some Alternative Explanations of Depression: A Critique
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demand for the machine.
Hence
, say the accelerationists, a general increase in consumer demand in the economy will cause a greatly magnified increase in the demand for capital goods, a demand intensified in proportion to the
durability
of the capital. Clearly, the magnification effect is greater the more durable the capital good and the lower the level of its annual replacement demand.

Now, suppose that consumer demand remains at 120 units in the succeeding year. What happens now to the firm’s demand for machines? There is no longer any need for firms to purchase any new machines beyond those necessary for replacement. Only one machine is still needed for replacement this year; therefore, the firm’s total demand for machines will revert, from three the previous year, to one this year. Thus, an
unchanged
consumer demand will generate a 200 percent
decline
in the demand for capital goods. Extending the principle again to the economy as a whole, a simple increase in consumer demand has generated far more intense fluctuations in the demand for fixed capital, first increasing it far more than proportionately, and then precipitating a serious decline. In this way, say the accelerationists, the increase of consumer demand in a boom leads to intense demand for capital goods. Then, as the increase in consumption tapers off, the lower rate of increase itself triggers a depression in the capital goods industries. In the depression, when consumer demand declines, the economy is left with the inevitable “excess capacity” created in the boom. The acceleration principle is rarely used to provide a full theory of the cycle; but it is very often used as one of the main elements in cycle theory, particularly accounting for the severe fluctuations in the capital-goods industries.

The seemingly plausible acceleration principle is actually a tis-sue of fallacies. We might first point out that the seemingly obvious pattern of one replacement per year assumes that one new machine has been
added
in each of the ten
previous
years; in short, it makes the highly dubious assumption that the firm has been expanding rapidly and continuously over the previous decade.7

7Either that, or such an expansion must have occurred in
some
previous decade, after which the firm—or whole economy—lapsed into a sluggish stationary state.

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America’s Great Depression

This is indeed a curious way of describing an
equilibrium
situation; it is also highly dubious to explain a
boom and depression
as only occurring
after
a decade of previous expansion. Certainly, it is just as likely that the firm bought all of its ten machines at once—an assumption far more consonant with a current equilibrium situation for that firm. If that happened, then replacement demand by the firm would occur only once every decade. At first, this seems only to strengthen the acceleration principle. After all, the replacement-denominator is now that much less, and the intensified demand so much greater. But it is only strengthened on the sur-face. For everyone knows that, in real life, in the “normal” course of affairs, the economy in general does not experience zero demand for capital, punctuated by decennial bursts of investment. Overall, on the market, investment demand is more or less constant during near-stationary states. But if, overall, the market can iron out such rapid fluctuations, why can’t it iron out the milder ones postulated in the standard version of the acceleration principle?

There is, moreover, an important fallacy at the very heart of the accelerationists’ own example, a fallacy that has been uncovered by W.H. Hutt.8 We have seen that consumer demand increases by 20

percent—but why must the two extra machines be purchased in a year? What does the year have to do with it? If we analyze the matter closely, we find that the year is a purely arbitrary and irrelevant unit even within the terms of the example itself. We might just as well take a
week
as the time period. Then we would aver that consumer demand (which, after all, goes on continuously) increases 20

percent over the first week, thus necessitating a 200 percent increase in demand for machines in the first week (or even an
infinite
increase if replacement does not occur in the first week) followed by a 200 percent (or infinite) decline in the next week, and stability thereafter. A week is never used by the accelerationists because the example would then clearly not apply to real life, which 8See his brilliant critique of the acceleration principle in W.H. Hutt,

“Coordination and the Price System” (unpublished, but available from the Foundation for Economic Education, Irvington-on-Hudson, New York, 1955) pp. 73–117.

Some Alternative Explanations of Depression: A Critique
63

does not see such enormous fluctuations in the course of a couple of weeks, and the theory could certainly not then be used to explain the general business cycle. But a week is no more arbitrary than a year. In fact, the only non-arbitrary time-period to choose would be the life of the machine (e.g. ten years).9 Over a ten-year period, demand for machines had previously been ten and in the current and succeeding decades will be ten plus the extra two, e.g., 12: in short, over the ten-year period, the demand for machines will increase in
precisely the same proportion
as the demand for consumer goods—and there is no ramification effect whatever. Since businesses buy and produce over planned periods covering the lives of their equipment, there is no reason to assume that the market will not plan production accordingly and smoothly, without the erratic fluctuations manufactured by the accelerationists’ model. There is, in fact, no validity in saying that increased consumption
requires
increased production of machines immediately; on the contrary, it is increased saving and investment in machines, at points of time chosen by entrepreneurs strictly on the basis of expected profitability, that
permits
future increased production of consumer goods.10

There are other erroneous assumptions made by the acceleration principle. Its postulate of a fixed capital–output ratio, for example, ignores the ever-present possibility of substitution, more or less intensive working of different factors, etc. It also assumes that capital is finely divisible, ignoring the fact that investments are

“lumpy,” and made discontinuously, especially those in a fixed plant.

There is yet a far graver flaw—and a fatal one—in the acceleration principle, and it is reflected in the rigidity of the mechanical model. No mention whatever is made of the price system or of 9This is not merely the problem of a time lag necessary to produce the new machines; it is the far broader question of the great range of choice of the time period in which to make the investment. But this reminds us of another fallacy made by the accelerationists: that production of the new machines is virtually instantaneous.

10The accelerationists habitually confuse consumption with production of consumer goods, and talk about one when the other is relevant.

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entrepreneurship. Considering the fact that all production on the market is run by entrepreneurs operating under the price system, this omission is amazing indeed. It is difficult to see how any economic theory can be taken seriously that completely omits the price system from its reckoning. A change in consumer demand will change the
prices
of consumer goods, yet such reactions are forgotten, and monetary and physical terms are hopelessly entwined by the theory without mentioning price changes. The extent to which any entrepreneur will invest in added production of a good depends on its
price relations
—on the differentials between its selling price and the prices of its factors of production.

These price differentials are interrelated at each stage of production. If, for example, monetary consumer demand increases, it will reveal itself to producers of consumer goods through an increase in the price of the product. If the price differential between selling and buying prices is raised, production of this good will be stimulated. If factor prices rise faster than selling prices, production is curtailed, however, and there is no effect on production if the prices change
pari passus
. Ignoring prices in a discussion of production, then, renders a theory wholly invalid.