Wages, Prices, and the Demand for Money: Keynes Got It All Wrong
Markets clear. Or so was the accumulated wisdom in the half century before John Maynard Keynes. The British economist proposed a novel theory of economics in 1936 based on the opposite premise: markets don’t clear. While Keynesian theory is quite complex and his book widely regarded as unreadable, in his system, chronic idleness of useful resources is the rule. In Keynes’s world, the market can find a market-clearing price through decentralized adjustments for most preferences among most goods. But two particular preferences are problematic in that the price system does balance supply and demand. The two troublemakers are time preference and the reservation demand for money. Those two bad actors cause the market process to fail for everyone else.
The British Austrian school economist William H. Hutt was an underappreciated critic of Keynes. In Hutt’s The Keynesian Episode: A Reassessment, he distilled the obscurantism of “the new economics” into a series of clear propositions. When reduced to its essence, Keynesian economics is compelling in its absurdity. In Keynes’s version of reality, there are Good Preferences and Bad Preferences. The bad ones are so troublesome that an increase in either one can cause entirely different useful resources to lose the ability to command a money price altogether. The effect is so strong that a productive worker may become idle, not due to his own lack of skill or sloth, but due to someone else’s attempt to save. When a resource is stuck in this idle state, the owner and buyers cannot find a common ground.1
Time preference is the lower valuation that people place on a good in the future compared to the present. Time preference frustrates market clearance through the paradox of thrift. According to this construct, attempts by all savers in the community to save more in aggregate fail. Their attempts do not result in greater realized savings. It works this way: saving reduces spending on consumption but somehow leaks demand out of the system instead of creating a demand for something else (such as capital goods). Wikipedia explains: “[A]n increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower total saving.”
Prior economic teaching had identified time preference—the choice between provision for present needs and future needs—as the originating cause of interest. Reservation demand is the demand that the owner of a good exercises by not selling it or by holding out for a higher selling price. This preference itself is largely irrational, driven by what Keynes saw as an excessive and irrational preference for liquid assets. Interest in Keynes land is entirely caused by the reservation demand for money.
Saving and investment in the Keynesian story are unrelated activities—not two sides of a single market. Because investment is interest rate sensitive, an increase in the reservation demand for money can cause the interest rate to be too high, attracting more savings which are not realized as investment. Investable resources thus remain unused.
Hutt took the other side of this. To his thinking, “time preference and so-called liquidity preference are no different in principle or in practice from all other economic preferences.”2 He asks this:
Why should two particular expressions of preference concerning ends, namely, that between the present and the future (thrift), and that between the services of money (liquidity) and all other services, or the response to those preferences in the form of certain ways of using the scarce means available, give rise to unemployment?3
Hutt—and Keynes—were largely dealing with the problems of surplus labor in 1930s Britain, in which the sellers of labor were represented by labor unions (or simply unemployed people with unrealistic wage expectations). Hutt wrote many times about the problem of surplus, whether unemployment in labor markets, inventories, or capital goods. He placed the responsibility for chronic surplus largely on sellers who would not lower their asking price. In most cases of surplus, the seller was usually asking for a price above what potential buyers would or could pay. While there are buyers making an offer in almost any market, for anything that is useful, if the buyer does not agree, then no exchange will take place.
Hutt thought that where there is a surplus, it was the seller who needed to come down to meet the buyer, rather than the buyer offering more. The business firm works on behalf of the consumer. They will make a wage offer based on the contribution of the worker toward the price the consumer is expected to pay for a product. Under depressed conditions, the consumer may be willing to pay less. Entrepreneurs may be even more cautious about the selling prices they expect. But, at some price, said Hutt, “there is always complete absorptive capacity for all potential productive services which have value.”4 The wage expectations of unemployed labor
Article from Mises Wire