THE KEYENSIAN SYSTEM, THE ECONOMICS OF ILLUSION…..?

BY: MISES

uite briefly the essence of the late Lord Keynes’s work The General Theory of Employment, Interest, and Money is: employment fluctuates with the intensity of effective demand, which depends, given a certain propensity to consume, upon the amount of investment — the spending of purchasing power for the purpose of adding to capital equipment. Investment in turn fluctuates — productivity of capital remaining the same — with the interest rate at which loanable funds are offered. Therefore, employment can be created by reducing the interest rate, provided entrepreneurs are willing to pay any interest at all; if they are not, the state must take over their investment activity, directing into circulation the purchasing power that private entrepreneurs would otherwise spend. An easy-money policy and — if that does not suffice — government deficit spending — monetary measures in a wider sense — can guarantee full employment.

Obviously an adherent of the pre-Keynesian approach would call this whole line of thinking an illusion. But it is perhaps less obvious that it represents not only illusionary economics but an “economics of illusion” in a very specific sense. For it presupposes an economy whose members do not see through the changes brought about by monetary or fiscal manipulation — or, as some might say, the swindle. Above all, it presupposes that people are blinded by the idea that the value of money is stable — by the “money illusion,” as Irving Fisher called it. In all this we are not saying anything new; fundamentally, we are merely stating the approach of the classical economists.

The Classical Economists and the Money Illusion

It is usual nowadays to characterize classical economists as antiquated halfwits whose “teaching is misleading and disastrous if we apply it to the facts of experience.”[1] This characterization could perhaps be applied more justly to Keynes’s own theory. It is certainly not just when applied to the classical economists, who were familiar with the effects of manipulations that increase the supply of money. They were well aware that booms can be provoked and prolonged by inflation. Their vehement protests were founded on very extensive experience and acquaintance with the monetary depreciation, debasement of coins, and bank-note experiments of the Mercantilist and post-Mercantilist periods. No classical economist denies that, in the first stage of an inflation, prosperity spreads as if by magic. Yet this prosperity is unreal; nowhere is it depicted more brilliantly than in the second part of Goethe’s Faust. Prices rise faster than costs and profit margins are widened, rendering new enterprises profitable. For the following reasons, however, the stimulus soon loses its force: On the one hand, prices break after a certain time unless new doses of the inflation poison are injected (and if they are, the experiment ends with the destruction of the currency). A rise in prices leads entrepreneurs to expect further rises. Consequently, they make new investments and build inventories, which in turn operate to boost prices further. The moment the stimulus of rising prices is exhausted, the cumulative boom spiral reverses its direction. Since there is no new stratum of buyers on whom the bulls can unload, the downward movement gains momentum. The English economist, A.C. Pigou, gives a penetrating description of the process in his Industrial Fluctuations (London, 1927). In an economy dependent largely upon exports, prices collapse even earlier: under the impact of the rising domestic price level, the balance of payments deteriorates, and the outflowing gold causes a deflationary process within the country, as David Ricardo described clearly in his 1810 pamphlet, The High Price of Bullion.

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