From Theory to Practice
In the domain of the physical sciences the individual who deals with specific everyday problems is not ordinarily called upon to develop the underlying theory before he tackles the job immediately at hand. The engineer who is commissioned to design a structure to meet a particular need, the bridge that we have been using as a typical engineering problem, for example, merely reaches for his handbooks and plunges into the details of his task, secure in the knowledge that the principles outlined in his works of reference are accepted by all those who labor in his field, and represent the most advanced thinking of a science that consolidates its gains as it goes along and moves ever forward toward the ultimate truth. He does not need to concern himself about where to find the basic data that he requires, for he knows that, except for minor details, he will get the same information from every source. If he prefers one handbook to another, it is not because the contents differ, but because the arrangement of the material is more to his liking.
This does not mean that the engineer’s ultimate results are immune to controversy. From his reference material he can determine the strength that his bridge members must have in order to withstand the stresses to which the structure will be subjected, and the community would never consider making any reduction in the beam sizes or ordering tension members to be redesigned as compression members, The citizens recognize that the basic engineering principles are valid and binding, and that they must be adhered to, no matter how much someone might like to deviate from them in order to reduce the cost or change the appearance of the structure. But the purely theoretical bridge that emerges from the engineer’s calculations cannot be built. The actual structure must have a definite form, it must be built of some specific materials, and it must have a particular location, none of which can be drawn from a textbook, and all of which are subject to controversy and differences of opinion.
Theory merely requires that a particular bridge member have a certain specific strength. It does not tell us whether the member should be made of wood, steel, concrete, aluminum, or any other material that can meet the requirements. The choice between these alternatives, as well as the choice of location and other similar decisions must be made on the basis of cost, appearance, convenience, or other considerations outside the realm of science. The engineers can and do evaluate these items according to their best judgment in the course of preparing their recommendations, but, as pointed out earlier, it is entirely in order for the community to disagree with them as to the relative weight that should be assigned to the different considerations that are involved, and to alter the plans accordingly. For instance, the engineers may recommend the use of steel on the basis of lower cost, but the community would be justified in ordering a change to reinforced concrete if the citizens concluded that the appearance of a concrete structure would be more in harmony with the surroundings, and for that reason would be worth the additional cost.
One of the major reasons why economics has never fully emerged from its infancy is that the important distinction between these two kinds of issues has not been recognized either by the economists or by laymen. In economic life, as in the physical world of the engineer, our everyday contact with practical problems involves the making of decisions between various alternatives, all of which may be theoretically sound. Questions of tax policy, for example, are generally analogous to the selection of materials for bridge construction. We cannot argue that an excise tax will not raise revenue, any more than we could contend that it is impossible to build a bridge of aluminum. If we are opposed to the tax we must base our argument on some other contention, perhaps that the additional revenues are not necessary, or that some other method of taxation would be more advantageous. But in economic affairs there has been a general failure to realize that there are also many economic issues that are governed by fundamental principles which are beyond our control and are no more subject to alteration by majority vote than the sizes of the bridge members.
This lack of recognition of the necessity for conforming to basic economic laws is responsible for the collapse of many a well-intentioned socio-economic program. Just as a bridge constructed in defiance of the basic principles of mechanics soon becomes a pile of wreckage, so any economic program formulated in defiance of, or in ignorance of, the basic principles of economics, also goes down in failure, regardless of how commendable the motives of its sponsors may be.
As stated in Chapter 3, the two major economic problems for which economic science can be expected to provide solutions are unemployment and economic stability. Contrary to the prevailing opinion of the economic profession, we find that there is no necessary connection between these two problems, and that each can, and should, be treated independently of the other. The entire employment study, including both the theoretical development and the identification of available practical methods of applying this newly developed theoretical understanding has therefore been separated from the remainder of the work, and has been published under the title The Road to Full Employment. This present volume is concerned with all of the other aspects of the operation of the economic system, but the concluding chapters will concentrate mainly on the second of the two major problems: how to stabilize business conditions and avoid booms and recessions.
This is a practical, not a theoretical problem, and it is analogous to the tasks of the engineer rather than to the work of the pure scientist. If it were a physical problem, the engineer who attacked it would have no concern about the theoretical fundamentals; he would find adequate sound and tested theory available at his elbow. But economics provides no such background of established and accepted theory. Instead of giving us substantial agreement among all reference books, such as we find in the engineer’s library, the literature of the economic profession is notorious for the diversity of its views. “Economists are still of many schools and clash heatedly on a thousand issues.”173 reports Arthur F. Burns.
In large part, this lack of agreement stems from the absence of any definite correlation between the hypothetical economic world of the academic theorist and the real economic world in which we live and go about our daily tasks. “For the purpose of academic theorizing,” says Jacob Viner (who was not a zealous critic of the economic profession, as his words might suggest, but a prominent member of the economic Establishment), “the premises the theorist starts from may without serious penalty be arbitrarily selected, narrowly restricted in range, and purely hypothetical in nature.” In the same connection he admits that “for purposes of teaching, or of acceptable writing for his restricted audience of fellow theorists, his conclusions are of little importance; and what matters above all is the rigor and elegance of his manner of reaching them.”174
But these theorists who are interested primarily in elegance of treatment, and regard conclusions applicable to real economic problems as unimportant trivia are at present our only source of economic theory. And they cannot give the public official or businessman who needs answers to concrete practical problems the kind of help that is needed. Again quoting Viner:
The theorist’s habitual methods of analysis are such as to lead to “right” or “wrong” answers to manufactured problems, the premises and the criteria of rightness being so chosen as to make this not only possible but necessary. For the policymaker, however, the problems are for the most part not of his own devising, but are presented to him by outside forces, in vague and ill-defined fashion, and what he asks of his advisors consists as much of help in determining what the problems are as of help in finding solutions for them. The theorist here is likely to find himself uninformed and unskilled.”174
The first task of the present project has therefore been to supply the practical, usable, economic theory that we cannot get from the theorists to whom Viner refers-to sift the great mass of material available in the economic literature, separate the grain from the chaff, and build from the ground up the sound theoretical structure that is essential for any real progress toward the defined goal. The results of this effort constitute the preceding 20 chapters of this work. No answers to practical problems were developed in those pages, although the solutions for many of our present difficulties are clearly foreshadowed by the theoretical relations and principles that were there formulated. The work up to this point has been confined to producing the equivalent on a limited scale of the engineer’s handbooks: a compilation of pertinent rules and principles that will form the background for our approach to the problems at hand. The most important of these are the General Economic Equation, and the seventeen Basic Principles, which are here recapitulated for convenient reference.
THE GENERAL ECONOMIC EQUATION
THE BASIC PRINCIPLES
GOVERNING PRIMARY ECONOMIC PROCESSES
PRINCIPLE I:Purchasing power is created solely by the production of transferable utilities, and it is not extinguished until those utilities are destroyed by consumption or otherwise.
PRINCIPLE II:Only goods can pay for goods.
PRINCIPLE III:Purchasing power and goods are simply two aspects of the same thing, and they are produced at the same time, by the same act, and in the same quantity.
PRINCIPLE IV:Exchanges between individuals or agencies at the same economic location (the same location with respect to the economic streams) have no effect on the general economic situation.
PRINCIPLE V:The income to the producer from goods produced is exactly equal to the expenditures for labor and the services of capital. The net result to the producer is zero.
PRINCIPLE VI:The circulating purchasing power arriving at any point in the stream is equal to that leaving the last previous processing point, plus or minus net reservoir transactions.
PRINCIPLE VII:Except as modified by reservoir transactions, the purchasing power (money or real) available in the goods market is equal to the purchasing power expended in the production market.
PRINCIPLE VIII:Any net change in the levels of the consumer purchasing power reservoirs results in a corresponding change in the money price level in the goods market, except insofar as it may be counterbalanced by a net change in the levels of the goods reservoirs.
PRINCIPLE IX:The market price levels are independent of the volume of production.
PRINCIPLE XAny net flow of money from the consumer reservoirs to the purchasing power stream, or vice versa, causes a corresponding change either in production volume, production price, or both
PRINCIPLE XIArbitrary increases or decreases in wage rates have no effect on the volume of production or the ability of consumers as a whole to buy goods.
PRINCIPLE XII:Voluntary market price changes by producers have no effect on the volume of production or the ability of consumers as a whole to buy goods.
PRINCIPLE XIII:All consumer purchasing power must be used for the purchase of goods from producers; it cannot be used for the purchase of goods already in the hands of consumers, or for raising the prices of such goods.
PRINCIPLE XIV:The quantity of money existing within an economic system has no effect on prices or on the general operation of the system, except insofar as the method by which money is introduced into or withdrawn from the system may constitute a purchasing power reservoir transaction.
PRINCIPLE XV:Credit can make goods available to one individual or group of individuals only by diverting them from other individuals.
PRINCIPLE XVI:The cost of the services of capital is fixed by competitive conditions independently of productivity.
PRINCIPLE XVII:Average real wages are determined by productivity, and are equal to total production per worker less the items of cost that are determined independently of productivity: taxes and capital costs.
Here in these seventeen basic principles and the General Economic Equation are the teachings of economic science as they apply to the subject matter under consideration. These principles rest firmly on solid facts, not on assumption, speculation, or guesswork, and they have been derived from those facts by processes which are logically and mathematically exact, even though extremely simple. Because of their factual nature they are specific. In their statement there is none of the hedging or evasion that characterizes much of the usual treatment of economic subjects. All relations are set forth in positive terms, not as “tendencies” or “propensities.”
In addition to being specific, these principles are universal. Unlike many of the conclusions of conventional economics, they are not limited to any particular economic system or to any special set of conditions. They governed the Cave Dwellers in their strenuous efforts to earn their living at the dawn of history, and they will apply with equal force to the streamlined multi-cylinder economic machine of the far distant future. They govern economic processes, not merely the systems of which these processes are constituent parts, and they are applicable to the processes wherever and under whatever system they may appear. The familiar contention that a socialistic economy is subject to a set of principles that differ from those which rule our individual enterprise system is as absurd as if we were to contend that the laws of physics applicable to a concrete bridge are not the same as those which apply to a steel structure.
It is true that some of the basic principles may have no practical application in certain economic organizations. The economic laws governing money and credit, for instance, are meaningless in a barter economy, but they are on the economic statute books just the same, and they are immediately and fully applicable whenever money or credit is introduced. The oft repeated statement that “no theoretical conclusions (in economics) are valid for all times and places” is merely an excuse for the failure of poorly constructed theories to cover their entire field. Basic principles that are not equally valid for all economic systems and for all times and places are either incomplete or erroneous.
Next we note that these principles of economic science are mutually consistent, a feature in which conventional economic theory is weak. Indeed, the lack of integration of economic theory is one of its most outstanding defects. Each individual aspect of economic life has been treated separately as if it were contained in a special watertight compartment of its own. Microeconomics is at odds with macroeconomics. Supply and demand reasoning, for example, has been applied without regard for the limitations on total effective demand that are imposed by the current volume of production, with the very serious consequences that were discussed earlier. The resulting inconsistencies are largely responsible for what Keynes called “the deep divergences of economic opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory, and will, until they are resolved, continue to do so.”175
Last, and most important, these principles of economic science are in full accord with all of the facts and statistics that are being complied in every increasing volume by governmental and private agencies, facts and figures which completely riddle many of the theories that are being advanced under the banner of one or another of the current orthodoxies.
As statements of fact, these principles are completely independent of our approval or disapproval. Some of them conflict very definitely with widely held views as to what ought to be, but we invite nothing but trouble if we refuse to recognize facts that are distasteful and persist in patterning our actions on false assumptions. The facts are not hard to find, There is some excuse for errors and misconceptions in a field such as the study of atomic structure where no means of direct observation are available and the data obtained by indirect means are incomplete and rather uncertain. But most economic facts are readily accessible. Unfortunately, too many economists simply refuse to look at them.
“Certainly one of the most striking features of economic thought at the present time,” A. B. Wolfe wrote in an assessment of the situation that is equally valid today, “is the prevalence of sheer mathematical logic without a shred of factual data,”176 and he quoted the opinion of Wesley C. Mitchell that “much of our pure economics is little more than a futile indoor sport.”177
Not all of the professional economists are satisfied to accept this state of affairs in which the theory of their discipline is almost entirely divorced from the realities of life, and is only a species of mental gymnastics. Critics within the ranks are plentiful, and the need for a more fruitful approach to economic problems is freely expressed. But these dissenters are too close to the picture to see it in the proper perspective. They are unable to recognize that something more than reconstruction of their theories is necessary; that what is needed is major surgery, the complete separation of the scientific aspects of economic from the sociological aspects, and the development of a true economic science.
The new economic science based on the findings of this present work has furnished the exact, consistent, and universally applicable set of basic principles that has been recapitulated in this chapter. Here in concise form is the fundamental knowledge that is needed in order to lay out a workable program for reaching our economic objectives. With this information at hand we are now ready to take up a consideration of the practical aspects of the various problems. In the pages that follow, the measures previously proposed for the improvement of general economic conditions will be analyzed, and the possible contribution that each is capable of making toward economic stability will be determined. Some additional measures of an appropriate character suggested by the facts brought out in the analysis will also be presented and discussed. On the basis of this study a complete program for business stabilization will be recommended-a program which will eliminate booms and recessions and will permit the economy to operate on a permanent high level.
The conclusions reached in this study do not constitute an economic “plan” in the usual sense. There has been such a deluge of “plans” in recent years that the ordinary citizen is beginning to show signs of alarm when an advocate of a new scheme of this kind appears on the horizon. The primary purpose of this work is to identify and define the requirements that an economic plan of any kind must meet in order to accomplish the purpose for which it is designed. In essence, therefore, it is not a plan, but a yardstick for judging plans.
Of course, in order to follow up the theoretical findings to their logical conclusions, the yardstick is actually utilized so that the final recommendations can be made explicit and in detail, but it should be understood that no claim is being made that these are the only measures that will attain the desired results. In most cases several alternative measures are identified as suitable for the particular purpose in view, and the final recommendation is merely a matter of choice among these alternatives. It is also possible that other practical measures which meet the theoretical requirements laid down in the earlier chapters still more satisfactorily than those recommended will ultimately be devised.
Inasmuch as this study was undertaken on the basis of the reasonable premise that the precise and well-developed methods of the physical sciences would be able to accomplish results beyond the reach of the less accurate tools of the socio-economist, there is no occasion for surprise when we actually do find simple and obviously correct answers to some of the major problems that have baffled the economic profession. What has been astounding, however, is the way in which these answers stand out in bold relief as soon as we make a careful and systematic survey of the pertinent facts in their proper economic setting, even before we have had an opportunity to enter into any exhaustive analysis.
So it is with the study of depressions. As soon as we started to set down an accurate description of the operation of the economic system, preparatory to beginning analysis, it was apparent that the flow of purchasing power around the economic circuit is continually being modified by transactions involving inputs into and withdrawals from certain reservoirs along the line. Immediately it became clear that this is the key to the whole problem. Of course, considerable spadework was required in order to clarify the details of the operation of the price mechanism and the characteristics of the business cycle, but the cause and cure of depressions were already evident before the quest had hardly started.
It is evident from the information developed in the foregoing pages that the cause of economic instability in all of its manifestations-money inflation, deflation, booms, recessions, depressions, and the business cycle in general-is an artificial variability in the flow of the circulating medium due to irregular inputs into and withdrawals from the money and credit reservoirs. The obvious remedy is to take compensatory actions which will counterbalance the net excess of the reservoir transactions and will maintain a flow of money purchasing power into the markets which will always be equal to the amount generated by the production of goods. Each of the various practical means of accomplishing this result will, however, have some collateral effects on the economy that will need to be taken into consideration in making a selection from among the available methods, and there are also certain basic points that should have special attention in this connection.
First, it should be clearly understood that the business cycle is simply an alternation of money inflation and deflation. It consequently follows that any measure which is effective against money inflation is a measure that can be used to control the cycle. Complete stabilization requires control of deflationary as well as inflationary tendencies, but the anti-inflationary measures can usually be reversed for this purpose.. It should also be recognized that the collateral aspects of these measures are irrelevant from the control standpoint. The objective is a regulation of the flow of money purchasing power, and the nature of the tool utilized for this purpose is immaterial. Monetary measures, fiscal measures, direct control measures, control of foreign transactions, are all tools that are available for use, but none of these has any unique feature that is indispensable. Fiscal measures, such as variable tax rates, could be used for the purpose, in which case none of the others would be required. Or a program of some other kind could be adopted, in which case the fiscal measures would be unnecessary. The only requirements are: (1) that we know exactly what kind of a control over the money purchasing power stream is needed, (2) that we have some effective method of exercising such control, and (3) that we have adequate facilities for measurement and monitoring, so that the compensatory action can be applied in the exact amount required.
But even though the collateral aspects of these various possible control measures are irrelevant from the standpoint of the control operation itself, they may be very important in other respects. The whole benefit of the stabilization program would be lost if adverse side effects of the control measures are as serious as the economic instability itself, or if these measures have some features that are highly objectionable to the public at large.. The task of the practitioners of applied economic science, the economic engineers, we might say, is to analyze the various possible measures that have been suggested, or that they may be able to devise, and to determine which of these is capable of accomplishing the desired objectives with the least disruption of other economic relationships.
While we are recognizing that money inflation, deflation, and the business cycle in general are all one problem and can be controlled by one suitable measure or set of measures, it is equally important to realize that employment is a separate and distinct problem that must be handled by measures of a totally different character. It is true that under existing conditions the business cycle has an effect-sometimes a very drastic effect-on employment. But our findings are that there is no necessary or direct connection between the two. A failure to recognize this fact is to a large extent responsible for the conspicuous lack of progress toward solution of these two serious problems. The discussion of economic controls in the remainder of this volume will be confined to matters having a bearing on the stabilization question. Some of the proposals that will be discussed also have other aspects that relate to employment rather than business stability, but these issues were considered in detail in The Road to Full Employment.
Inasmuch as the findings of this work with respect to employment are in direct conflict with current economic thought, which regards unemployment as the essence of the depression, and may also seem to conflict with the undeniable fact that depressions do generate unemployment, it may help to clarify the nature of these findings if we compare the control of the business cycle with an analogous task in the physical field: control of humidity. It is generally understood that the relative humidity in a dwelling is an important factor in the comfort of the inhabitants, and where possible variations are great some control measures are desirable. In studying this situation we find that there is a definite correlation between humidity and temperature; that is, an increase in temperature decreases the relative humidity, and vice versa. This is the same kind of a correlation as that which exists between the business cycle and employment. When the business cycle (analogous to temperature) is in the rising stage, unemployment (analogous to relative humidity) decreases. In the downward stage these trends are reversed. It follows that If we wish to keep the relative humidity at some suitable level, we could accomplish this by controlling the temperature. We would then be doing essentially the same thing that is now being done in the economic field, where the current approach to the unemployment problem relies almost entirely on inflationary measures for stimulating business activity.
In the physical situation it is easy to see that this problem of controlling the humidity by varying the temperature would be absurd. When the room is cold and clammy, an increase in the temperature is quite appropriate, since this brings both temperature and humidity into the desired range, but applying the same corrective in a hot and humid situation would create a high temperature problem worse than the humidity. In this case it is obvious that although humidity can be controlled by regulating the temperature, this is a very poor way of accomplishing the desired result. The efficient and effective method is to keep the temperature at a comfortable level, and to control the humidity independently by adding or withdrawing moisture.
Similarly, in the economic situation we can reduce unemployment by means of money inflation, but here again this is a very poor way of accomplishing our purpose, as money inflation has some very undesirable effects. Furthermore, an inflation of this nature must inevitably be followed sooner or later by deflation, so that in the long run the beneficial effect on employment will be nullified.. As in the physical situation, the efficient and effective procedure is to set up two separate controls, maintaining market prices at the equilibrium level by stabilizing the flow in the money purchasing power stream, and controlling employment independently by purely employment measures.