Monetery system

http://goldcoinblogger.com/fiat-monetary-system-revealed/

By Peter Costa

For over 3000 years from the formation of banking to the creation of currency there have been 2 systems that have ruled. One of these systems has been beneficial to a small group who has sought to control the money supply while the other has been beneficial to the whole. Civilization has gone back and forth between these 2 systems for centuries and a great deal of time and energy has been spent keeping it beneficial to a small group. After diligent research I have come to see that practically every economic catastrophe happening globally right now can be traced to the current monetary system every developed nation operates from.

The 2 systems we have gone back and forth from for centuries can be broken down into a backed monetary system and a fiat monetary system. All monetary systems that have ever existed have been either one. A backed system is when a monetary exchange is backed by something such as gold or precious metals thus limiting the expansion of the money supply. With a backed system it is difficult for the money supply to expand rapidly because it is based on the reserves that are held. When a system is backed and has limitations to the expansion of money it becomes beneficial to the whole and can create a lot of stability in the economy. When a monetary system is backed it makes it very difficult to manipulate the money supply. A fiat system is exactly the opposite of a backed system this is a monetary exchange that is backed by absolutely nothing. In a fiat system currency is typically issued by a ruling entity such as the government and is backed up or enforced by jail time or fees if not accepted. Normally this exchange is paper money or some other form of portable currency that is hard to replicate or forge. With a fiat system the money supply can be expanded as often as needed because there is absolutely nothing backing it. This type of system is typically manipulated and beneficial to a small group rather than the whole. Throughout history fiat systems have failed and have never worked. Fiat systems have been the catalyst for the rise and fall of many great nations.

The current system most developed nations are on right now including the United States is a fiat system. A majority of the currencies being issued today are backed by absolutely nothing. When you boil it down they are useless pieces of paper that are on a path of no return and will soon be used as nothing but paper to light a fire. The Wymore Republic and Former Soviet Union have been the most recent prey for this type of a system and the whole global economy will soon follow. For a fiat monetary system to properly exist there needs to be a central banking system put into place. A central banking system is setup where you have an entity such as the Federal Reserve commonly known as a central bank, print up the countries money and all banks in the nation are attached to this one reserve. The alarming thing with this setup is that the central bank is never owned by the government it is typically owned by bankers or private investors. This system is beyond faulty and can create a lot of volatility in an economy and cause everything from depressions to recessions. The most detrimental part of this setup is that it promotes fractional reserve banking. Fractional reserve banking is when a bank loans out more money than they have in deposits. As recent as the Clinton administration days banks were encouraged to loan out more money than they had and were given a 1 to 9 ratio. How a 1 to 9 ratio works is for every $1 a bank receives in deposit they are allowed to loan out $9. Ever since banking was formed this has been a standard practice between banks. On a backed system it is harder for banks to indulge in this type of practice because if word got out depositors would take all their funds from the bank causing a bank run. A fiat system with a central banking system put into play protects banks from this threat because it acts as a reserve and has all banks in the nation attached to it. If there were any threat of depositors taking out large sums of money they would simply cover that bank. This in itself is the recipe for economic instability and an eventual currency collapse because it allows banks to artificially inflate the money supply.

Now that you understand how the system works let me explain what this type of system enables. For decades now the United States has been on a fiat monetary system. In this type of a system the name of the game for banks is to get as much money out into the economy in the form of loans as they can. Many companies have understood this and have used it to their advantage. Companies have been lining up at banks to receive loans for their companies. With these loans they create companies, include the citizens of the United States in the workforce and start to become an asset or liability on the banks balance sheet. As the years go on these companies run out of money and keep going back for more loans so that they can pay off the outstanding ones. Due to banks wanting to keep money out in the economy they continue lending these companies money giving them enough to pay back interest on the loans and survive for a little longer. Before you know it these companies get to a level where they are “too big to fail” and if they were to go bankrupt they would take the bank down with them. So companies start spending lavishly and keep going back to the banks when they run out of money. This is why companies like AIG and countless others have been able to continue to exist. They have borrowed so much money from the banks and if they were to go bankrupt they would take the bank with them. This exact same scenario has been replicated with individuals through mortgages. Countless banks in attempt to keep money out in the economy have taken individuals who should not have mortgages and approved them. When the individual can no longer make payments they apply for another loan or restructure their mortgage driving them deeper into debt. As long as the money continues to stay out in the economy the bank is satisfied. The problem with this whole type of practice is that sooner or later it all falls apart because everything has a breaking point. This exact scenario has been the catalyst for our current economic state. All that is unfolding right now was lead by subprime mortgages faltering where scores of individuals could no longer afford their mortgages and had to walk away. Once this happened the bank’s game of artificially expanding the money supply was up. With so many people defaulting on their mortgages banks were no longer able to loan money freely which leads to more loans defaulting and sooner or later it all unravels into what we are currently experiencing.

The jig is up and banks are being forced to close their doors for business. Now you can start to understand why over 195 banks have failed in the last 2 years and why 26 have already filed for bankruptcy in 2010. In addition there are 500 more banks on the troubled list that will soon face a similar fate. One of the biggest banks in the country is on the list which is Citigroup who have over $1 trillion in assets. Effective April.1st, 2010 Citigroup is going to need 7 days notice for anyone making a withdrawal from a saving, checking or money market account. The scary thing is this is already effective in Texas and they have been warning depositors about this since the start of the 2010. This is only the beginning and many more banks will follow suit as more loans default and depositors want to withdrawal their holdings. The only problem with this whole thing is that it is not the banks that suffer from this practice it is the people. Like these large companies that have become too big to fail many of the banks have become too big to fail. We are now in a situation where if certain banks were to fail our currency would collapse. That is why banks will now start exercising the right to take up to a week to provide you with money from your accounts because the government has no choice but to bail them out in hopes that this will all turn around. So far out of $600 billion plus used to bail out troubled banks $537 billion of it has been handed out in executive bonuses. “The banks have no remorse for the current economic crisis and are going to guarantee hyper inflation in the coming times which will lead to a currency collapse” stated Ronald Fricke president of Regal Assets in response to the current banking crisis. As we print more money to solve these situations it only devalues the dollar guaranteeing inflation. If things continue to escalate we will face hyper inflation which if not handled correctly could render our currency useless. As you are probably starting to understand this economic crisis is so inner woven.

As much as it pains me to say this, at this point it may be better off for the United States if the currency collapsed rather than continue to bail out the banks. This would free us up from the web our banks have spun and allow us to start off anew. There are too many things holding back any kind of economic recovery and as Obama put it when he first stepped into office this thing is much deeper than anyone could possibly imagine. The only system that has ever offered stability and the only time period where the United States deficit was completely paid off is on a backed system. All the way up until 1933 the United States was on a backed system and with manipulation from the certain parties we were transferred over to a fiat monetary system. When this system gives way and a new one is introduced rest assured it will be a backed system. If you look around you will already see this beginning. A currency collapse is inevitable in the United States and for the first time in over 30 years countries have started to buy gold in an attempt to back their currency. China is leading the way and plan to purchase over 6000 metric tons in the next 3-5 years. This alone is going to cause the demand for gold to sky rocket thus making it more and more difficult to acquire. If you have not already started backing your green back with gold now is the time.

Inflation

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Inflation is a general rise in prices across the economy. This is distinct from a rise in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices and preferences, and changing costs.
inflation is a general rise in prices across the economy

If the price of one item - say a particular model of car - increases because demand for it is high, we do not think of this as inflation. Inflation occurs when most prices are rising by some degree across the whole economy.
the inflation rate

We often hear about the rate of inflation being 2.0% or 2.7% or some other number. The inflation rate is a measure of the average change in prices across the economy over a specified period, most commonly 12 months - the annual rate of inflation. We typically hear about the annual inflation rate for a particular month. If, say, the annual rate of inflation in January this year was 3%, then prices overall would be 3% higher than in January last year. So a typical basket of goods and services costing, say, £100 last January would cost £103 this January.
price indices

There are a number of different measures of inflation in use today. The most familiar measure in the UK is the Retail Prices Index (RPI). But monetary policy is now based on the Consumer Prices Index (CPI). Both measure the prices of products and services that consumers buy. A price index is made up of the prices of hundreds of goods and services - from basic items like bread to new products, such as PCs. Prices are sampled up and down the country every month; in supermarkets, petrol stations, travel agents, insurance companies and many other places. All these prices are combined together to produce an overall index of prices.

The goods and services included in the index are chosen and weighted on the basis of the spending patterns of UK households - for example, if gas bills account for around 1% of consumers' total spending, then gas prices will account for about 1% of the index. The percentage weights are revised annually to reflect changes in spending patterns. Sometimes new goods and services are added and sometimes they are taken out. A few years ago, men's cardigans were removed - not many men wear cardigans these days!
the inflation rate is a measure of the change in prices over a specified period

Until December 2003, UK monetary policy was based on a measure of inflation called RPIX. RPIX inflation is almost the same as RPI inflation but it excludes one component - namely mortgage interest payments.

But on 10 December 2003 the Chancellor of the Exchequer announced that in future monetary policy would be based on a new measure of inflation - the Consumer Prices Index. This is explained under the heading 'The current inflation target' in 'Policy Framework'. More information and data on the measures of inflation are provided in other sections.
changes in the inflation rate

Any individual price change could cause the measured rate of inflation to change, particularly if it is large or if the item has a significant weight in the price index. But we are more interested in the general increase in prices rather than individual price changes. A large rise in the price of petrol, for example, might affect the overall rate of inflation. But unless this price carried on rising, the annual rate of inflation would eventually fall back again - the example in the box below explains this, if you want to know more.

Events affecting a range of prices can also result in a change in the inflation rate. For example, a rise (or fall) in oil prices might affect the price of other goods if producers pass on the increase (or decrease). But, again, unless the oil price continues to rise (or fall), this influence on the inflation rate will eventually wear off after a time.

A change in price
If petrol prices had been 50p a litre for some time and then they increased in, say, February 2011 to £1 a litre while no other prices changed, the annual rate of consumer price inflation would increase. If petrol prices remained unchanged after that, the annual rate of inflation would then fall back in the following February 2012. That is because the annual rate of inflation in say February 2012 measures the change in prices between February 2011 and February 2012, during which time the price in our example has stayed the same at £1 a litre - the rise in petrol prices recorded in February 2011 drops out of the calculation. So, although the price of petrol remains at the higher level, annual inflation is not higher after a year or more.

Similarly, if the value of the pound falls against other currencies - ie the exchange rate depreciates - the price in the shops of some imported goods might rise. But only if the exchange rate keeps falling will this influence on inflation continue.

Price changes like those described can have other indirect effects on inflation. But individual price changes in themselves do not have a lasting impact on the inflation rate.

The rate of inflation in a particular month will depend on movements in all prices. But we need to distinguish between individual price changes - which might change the measured rate of inflation for a period - and the notion of inflation as an ongoing, general increase in prices.
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The measured inflation rate at any point in time will be made up of an array of individual price changes. But the amount of inflation in the economy is about more than just the sum of all individual price changes. Something more fundamental determines the amount of inflation in the economy - whether it is 1%, 10% or 100%.

demand...

One of the underlying causes of inflation is the level of monetary demand in the economy - how much money is being spent. We can demonstrate this by considering what happens when the prices of some products are rising. Imagine the price of cinema tickets has risen. If consumers want to buy the same amount of all goods and services as before, they will now have to spend more - because the price of one of the products they consume has risen. This will only be possible if their incomes are rising, or alternatively if consumers are prepared to spend a bigger proportion of their incomes and save less. But if total spending does not rise, then higher prices will mean consumers either will have to buy fewer cinema tickets or buy less of something else. Any fall in demand for goods and services will put downward pressure on prices. So although higher costs or other factors might cause some prices to rise, there cannot be a sustained rise in prices unless incomes and spending are also rising.

On the other hand, if the price of some goods falls, people will need to spend less to buy the same amount of all goods and services as before. But if people still earn the same, they will have the same amount of income as before. So they will be able to buy more of those goods or of something else. Demand in the economy will rise and this, in turn, might cause some prices to rise.

Of course, this process takes time. And the situation will be complicated if some people's incomes are affected by the falls in prices - say because lower import prices cause firms competing with imports to lose sales and reduce the number of people they employ. However, it demonstrates a key feature of inflation - that it relates to the amount of demand in the economy.
the underlying causes of inflation relate to the amount of demand in the economy

... and supply

But inflation is not just about demand in isolation. Inflation reflects the amount of demand in the economy relative to the available supply of goods and services - in other words, the amount of money people are spending relative to what can be produced.

Inflation tends to rise when, at the current price level, demand for goods and services in the economy is greater than the economy's ability to produce goods and services - its output. One of the original descriptions of inflation remains valid - that 'too much money chases too few goods.'
the gap between demand and supply

How much the economy is able to produce will reflect the rise of the working population. Increases in output will also depend on factors that enable more output to be produced from available resources - in other words, productivity increases. The amount the economy is able to produce, ie supply, might increase due to the introduction of new technologies, extra investment in new equipment, improved methods of production and distribution or by enhancing the skills of the workforce. These things can all lead to higher productivity.

There will be some price level at which there is a broad balance between the demand for, and supply of, goods and services. At this point there tends to be no upward or downward pressure on inflation. Firms will be working at their normal capacity - producing everything they can in the most efficient way with their existing resources.

too much demand...

But what happens if there is an increase in demand for some reason, for example due to a reduction in income tax, or because consumers suddenly feel more optimistic and start spending more money rather than saving?
when demand rises above what firms can produce at their normal level of operation there tends to be upward pressure on costs and prices

Firms can usually increase production to meet higher demand. But this may only be possible by incurring higher costs. For example, it might be necessary to introduce overtime working or hire extra people. If many firms are trying to recruit extra people in order to produce more, wages might start to rise. And firms might have to pay more for additional materials or run their processes and machinery in a less efficient way.

So to produce more, firms increase their demand for resources and this may result in upward pressure on production costs and prices - for example, the price of bricks and the wages of bricklayers might rise if there is high demand for the construction of new buildings such as houses or offices.

At the same time, imports are likely to rise and the gap between what the country imports and exports - it's trade balance - might widen. Higher prices in general might lead people to demand higher wages so they can still buy the same amount of goods and services. An increase in wage costs might then feed through to a further rise in prices. The inflation process can then continue until prices have risen to such a level that demand is once again equal to supply.

... too much supply

The opposite to this is when there is slack - ie spare capacity - in the economy. That is when the amount that can be produced is greater than demand. In this situation, there tends to be downward pressure on costs and prices.
inflation is usually generated by an excess of demand over supply

To contain inflationary pressures in the economy, demand needs to grow roughly in line with output. Output grows over time at a rate which largely depends on factors which increase productivity. If demand grows faster than this, unless there is spare capacity in the economy - such as after a recession - inflation is likely to rise.

We say more about demand, output and inflation in 'Inflation' under the heading 'What is monetary policy for? in 'Inflation Outlook' under the heading 'Assessing economic conditions' and in 'The Economy' under the heading 'Demand and output'.
inflation expectations and monetary policy

Even when demand and supply (output) are roughly balanced, inflation will not necessarily be zero or indeed particularly low and stable. When firms and employees negotiate wages and when companies set their prices, they often consider what inflation might be in the period ahead, say the next year. Expected inflation matters for wages and prices because future price rises reduce the amount of goods and services that today's wage settlement can buy. So, if inflation is expected to be high, employees might push for a higher wage increase.
if people expect inflation, their behaviour can lead to inflation

If wage settlements build in these expectations, then firms' costs increase, which in turn could be passed on to customers in higher prices. So if people expect inflation, their behaviour can lead to inflation.

What determines the expected rate of inflation? The simple answer is monetary policy and how much people believe in the ability and commitment of the authorities - the government and the central bank - to achieve their inflation objectives. People have to believe that there will be low inflation before they stop building expectations of high inflation into their decisions. The authorities have to demonstrate that they will not allow inflation to rise - that they will act to ensure demand does not rise too much ahead of output.

The ultimate cause of inflation can really be said to be central banks, like the Bank of England. Their behaviour and actions determine whether inflation is allowed to rise or is kept low - in other words, whether they allow prices to rise unchecked by monetary policy, or whether the central banks seeks to influence the amount of money in the economy by changing interest rates.

To keep inflation low, we want to ensure that the growth in demand does not get ahead of the growth in what the economy can produce. We want output to rise, but at a steady rate across the economy as a whole and not so fast that the resulting demand for resources generates upward pressure on costs and prices.
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price stability

The broad aim of monetary policy is to achieve stable prices. Price stability means that changes in the general level of prices across the economy are relatively small and gradual - in other words, prices do not rise by much from month to month and from year to year. In practice, price stability equates to low and stable inflation.
the broad aim of monetary policy is to achieve price stability

A quote from Alan Greenspan, a former Chairman of the US Federal Reserve - the central bank of the United States - is one of the most apt.

"For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household decisions."

The goal of price stability has become widely accepted as the appropriate objective of monetary policy, and is now one of the primary considerations of central banks around the world. This consensus reflects an understanding of how the economy works and a practical experience of the ineffectiveness in effectiveness of using monetary policy to achieve other economic objectives.
monetary policy, prices and output

The effects of monetary policy - interest rates - are ultimately seen in prices. A change in interest rates feeds through the economy, influencing demand, costs and then prices. This process is explained in 'Inflation' under the heading 'How do interest rates affect inflation?'. Boosting demand, by lowering interest rates, may cause output to rise at a faster rate for a time. But monetary policy does not have a lasting impact on output.

Suppose the Bank of England printed double the amount of money in the economy and left it on street corners for people to help themselves. People would go out and spend more. But the economy cannot simply produce twice as much. Firms would try to increase output to meet the extra demand and imports might rise. But the extra demand for resources would force costs and prices higher. In the same way, changing interest rates will result in changes in demand in the economy. But, overall, it cannot affect what the economy is able to produce, other than in the short term as output responds to fluctuations in demand.

Some of the mistakes in economic policy in the past resulted from a belief that it was possible to raise output and employment permanently by accepting a degree of inflation - there was an assumed trade - off between inflation and unemployment. But efforts to exploit this it, by trying to boost demand through higher government spending or lower interest rates, led to increasing rates of inflation - they revealed that, in the long run, there was no such trade-off.
there is no general, lasting trade-off between output and inflation

There is, however, a recognised trade-off between output and inflation in the short term, ie a few years. This is very important to the workings and conduct of monetary policy. In the short term, if demand and output are growing too quickly, increasing interest rates can reduce output growth back to a level which does not result in inflationary pressure.
the effects of monetary policy are ultimately seen in prices

Conversely, reducing interest rates can increase output growth. But, in the longer run, there is no lasting trade-off between output and inflation. Changes in interest rates affect prices only.

The role of monetary policy is restricted to influencing the level of demand in the economy in order to control inflation. Changes in monetary policy do affect output and employment in the short term. But these influences do not last.
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the value of money

Ensuring that prices are fairly stable amounts to trying to maintain the value of money, ie ensuring that what £1 buys today will be roughly the same as what it will buy tomorrow or next month. If people expect the value of their money to fall, this undermines the role of money as a measuring rod for the value of goods and services in the economy. It no longer acts as a standard and stable measure of value, because its own value is falling and uncertain.

At worst, when confidence in a currency deteriorates completely, money can stop being used as a means of exchange. When prices were rising rapidly in Germany in the 1920s, people had so little confidence in their currency that they demanded to be paid several times a day, so they could quickly spend their wages before they fell in value.

In the UK in the 1970s, the annual rate of inflation was more than 20% for a time - what £1 would buy was reduced by over a fifth in one year. In response, people sought wage increases to compensate them for this decline in the value of money. This placed further upward pressure on prices - creating what is known as a wage-price spiral.
the role of prices

Uncertainty about the value of money - the future prices of goods and services - can be damaging to the proper functioning of the economy. Prices are at the core of a market-based economic system. They help to determine what goods and services are demanded and what is supplied. When prices across the economy are fairly stable, specific changes in the prices of individual goods and services allow firms and individuals to make decisions about how much to consume, how much to produce and invest, and how much to save or borrow. These price changes are reasonably clear to see; they are not obscured by a general rise in prices.

But when the prices of most goods and services are rising, it is more difficult to know which items are rising in price relative to others. For example, if the demand for organic vegetables is high and prices are rising, this should be a signal to other companies to increase supply to this market. But if prices in general are rising, it might not be clear whether the higher price is part of this general increase or specific to an individual product.
economic stability

When inflation is high, it also tends to be more variable and uncertain. Many of the costs of inflation are associated with its uncertainty.
price stability is important because high and volatile inflation creates economic instability

Savers and lenders might want some insurance against the uncertainty of the future value of their money, ie a higher rate of interest for lending their money. This will mean higher borrowing costs for individuals and firms. And uncertainty about prices and the value of money might discourage firms from making long-term investments.

One of the main consequences of high inflation has been greater instability in economic conditions as a whole - periods when demand and output have been growing strongly but then fallen sharply. These episodes are commonly referred to as boom and bust cycles.

In the past, when demand rose much faster than output and inflation increased, sharp increases in interest rates were necessary to bring demand back into line. This often resulted in large falls in output - ie a recession - as the imbalance in the economy was abruptly corrected. One of the costs of unsustainably high output growth - an economic boom - and the resultant upward pressure on costs and prices, has been large falls in output and employment. These falls were probably greater than would have been the case had demand and output grown in a steadier and more balanced way.

One such episode in the United Kingdom was during the late 1980's and early 1990's. Interest rates were increased to as high as 15%. With consumers and companies burdened by high levels of debt, higher interest rates led to a large contraction in demand and resulted in falling output and employment in the early 1990s. The boom was followed by the bust. These episodes inevitably affect individuals' and firms' behaviour. Firms find it more difficult to plan ahead when there is uncertainty about demand, prices and interest rates.

Until the first quarter of 2008, output had grown for the longest continuous period since the mid-1950s - when current statistical records began - and inflation had been relatively low over the previous decade. But the sharp rise in energy and food prices pushed CPI inflation well above target to a peak of 5.2% in September 2008. Output growth also began to falter in 2008 and by 2009 Q3 it had fallen by 6.4% from its peak in 2008 Q1.

Monetary policy is aimed at achieving price stability. But the goal of price stability is not an end in itself. Stable prices are a necessary condition for the economy to grow in a stable and sustainable way, and for the effective functioning of prices and money in the economy.
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Monetary policy aims to influence the overall level of monetary demand in the economy so that it grows broadly in line with the economy's ability to produce goods and services. This stops output rising too quickly or slowly. Interest rates are increased to moderate demand and inflation and they are reduced to stimulate demand. If rates are set too low, this may encourage the build-up of inflationary pressure; if they are set too high, demand will be lower than necessary to control inflation. How does this work?
the official Bank Rate

Monetary policy operates by influencing the price at which money is lent, ie the cost of borrowing and the income from saving.
the MPC sets the interest rate for the Bank of England's own financial market transactions

In the UK, the Monetary Policy Committee (MPC) sets an interest rate for the Bank of England's own market transactions with financial institutions - the rate at which the Bank will make short-term loans to banks and other financial institutions. This rate is known as the official Bank Rate.
from the official Bank Rate to inflation

Changes in the official Bank Rate then affect the whole range of interest rates set by commercial banks, building societies and other financial institutions for their own savers and borrowers. It will influence interest rates charged for overdrafts and mortgages, as well as savings accounts. A change in the official Bank Rate will also tend to affect the price of financial assets such as bonds and shares, and the exchange rate. These changes in financial markets affect consumer and business demand and in turn output. Changes in demand and output then impact on the labour market - employment levels and wage costs - which in turn influence producer and consumer prices.
the effects on demand

When interest rates are changed, demand can be affected in various ways.

Spending and saving decisions
A change in the cost of borrowing affects spending decisions. Interest rates will affect the attractiveness of spending today relative to spending tomorrow. An increase in interest rates will make saving more attractive and borrowing less so. This will tend to reduce current spending, by both consumers and firms.That includes spending by consumers in the shops and spending by firms on new equipment, ie investment. Conversely, a reduction in interest rates will tend to increase spending by consumers and firms.

Cash flow
A change in interest rates will affect consumers' and firms' cash flow, ie the amount of cash they have available. For savers, a rise in interest rates will increase the money received from interest-bearing bank and building society deposits. But it will also mean higher interest payments for people and firms with loans - debtors - who are being charged variable interest rates (as opposed to fixed rates which do not change). These include many households with mortgages on their homes. These fluctuations in cash flow are likely to affect spending. Lower interest rates will have the opposite effects on savers and borrowers.

Asset prices
A change in interest rates affects the value of certain assets, such as house and share prices. Higher interest rates increase the return on savings in banks and building societies. This might encourage savers to invest less of their money in alternatives, such as property and company shares. Any fall in demand for these assets is likely to reduce their prices. This reduces the wealth of individuals holding these assets, which, in turn, might influence their willingness to spend. Again, lower interest rates have the opposite effect, ie they tend to increase asset prices.

Exchange rates
A particular influence on prices comes through the exchange rate. A rise in interest rates relative to those in other countries will tend to result in an increase in the amount of funds flowing into the UK, as investors are attracted to the higher sterling rates of interest. This will tend to result in an appreciation of the exchange rate against other currencies. In practice, the exchange rate will be influenced both by expectations about future interest rates and any unexpected changes in interest rates. That is because if investors expect interest rates to rise, they may increase the amount they invest in a currency before interest rates actually rise. So there is never a simple relationship between changes in interest rates and exchange rates.

Other things being equal, an increase in the value of the pound will reduce the price of imports and, because many imported goods are included in the CPI, this will have a direct influence on inflation. In addition, a higher pound will tend to reduce the demand abroad for UK goods and services. Any fall in export demand will, in turn, reduce output, as will any shift of domestic spending to imported goods. A reduction in interest rates will tend to have the opposite effect.
how long do these effects take to work?

Changes in the official Bank Rate take time to have their full impact on the economy and inflation. All the factors we have described have an impact on demand and, in turn, prices. Some influences, such as those on the exchange rate, work very quickly.
a change in the official Bank Rate takes around two years to have its full impact on inflation

But it often takes time for changes in the official Bank Rate to affect the interest payments made by consumers or firms - such as mortgage payments - or the income from savings accounts. It is likely to take a further period of time before changes in mortgage payments or income from savings lead to changes in spending in the shops, and longer still for this spending to work its way up through the supply chain to producers. Changes in production, in turn, can lead to changes in employment and wages and eventually to changes in prices.

We cannot know with any certainty the precise size or timing of these influences. And the effects might vary depending on factors such as the stage of the economic cycle - for example, the impact of higher consumer demand on inflation just after a recession will be different than that after several years of growth.
interest rates have to be set based on what inflation might be over the coming two years or so

This is because after a recession, when output has been falling, there will be plenty of spare capacity in the economy - output will be able to rise quite strongly without generating inflationary pressure.

A change in the official Bank Rate may have some instant effects - for example on consumers' confidence - which may influence spending straight away. But, more generally, a change in the official Bank Rate will take time to influence consumers' and firms' behaviour and decisions. Overall, a change in interest rates today will tend to have its full effect on output over a period of about one year, and on inflation over a period of about two years. This is, of course, a very approximate guide.

In this sense, monetary policy has to look ahead. Interest rates have to be set based on what inflation might be over the coming two years, not what it is today - though that is a relevant consideration. Policy-makers have to judge what the likely economic developments will be over that period, in particular what the rate of growth in demand will be relative to the growth in supply (output). This is why the Monetary Policy Committee uses forecasts of growth and inflation to help it decide on the right level for interest rates. We don't expect you to produce forecasts but we will explain more about their role in 'Policy Framework' under the heading 'An independent Bank of England' and in the Participants' Pack.

ROBERT LUCAS AND RATIONAL EXPECTATIONS

http://www.huppi.com/kangaroo/L-chilucas.htm
An even bigger attack on Keynesianism came from Robert Lucas, the founder of a theory called rational expectations. (1) This highly mathematical theory dominated all economic thought in the 70s and early 80s, so much so that Lucas attracted a broad following of disciples who raised to him to cult-leader status. By 1982, Lucas' views were so entrenched that Edward Prescott of Carnegie-Mellon University would boast that his students had never heard Keynes' name.

Lucas won the Nobel Prize in 1995 for the core aspect of his theory, that rational businessmen adjust their behavior to the government's announced economic policies. However, history has not been kind to the rest of his theory. Lucas himself has abandoned work on rational expectations, devoting himself nowadays to other problems, like economic growth. His once broad following has dissipated. And Lucas himself would admit upon receiving his Nobel prize: "The Keynesian orthodoxy hasn't been replaced by anything yet." (2)

There are two main parts to rational expectations. First, Lucas began with the old assumption that recessions are self-correcting. Once people start hoarding money, it may take several quarters before everyone notices that a recession is occurring. That's because people recognize their own hardships first, but it may take awhile to realize that the same thing is happening to everyone else. Once they do recognize a general recession, however, their confusion clears, and the market quickly takes steps to recover. Producers will cut their prices to attract business, and workers will cut their wage demands to attract work. As prices deflate, the purchasing power of the dollar is strengthened, which has the same effect as increasing the money supply. Therefore, government should do nothing but wait the correction out.

Second, government intervention can only range from ineffectualness to harm. Suppose the Fed, looking at the leading economic indicators, learns that a recession has hit. But this information is also available to any businessman who reads a newspaper. Therefore, any government attempt to expand the money supply cannot happen before a businessman's decision to cut prices anyway. Keynesians are therefore robbed of the argument that perhaps the Fed might be useful in hastening a recovery, since Lucas showed that the Fed is not much faster than the market in discovering the problem.

Lucas then gave a fuller and more supported version of Milton Friedman's argument. Suppose the Fed established a predictable anti-recession policy: every time the unemployment rate climbs one percent, the Fed increases the money supply one percent. Rational businessmen would only come to expect these increases -- hence the term, rational expectations -- and would simply build automatic responses to monetary policy in their pricing systems. So in order to be effective, then, monetary policy would have to surprise businesses with random increases. But true randomness would make the economy less stable, not more so. The only logical conclusion is that the government's efforts to control the economy can be actually harmful.

Rational expectations borrowed heavily from earlier conservative theories, but Lucas supported these arguments mathematically, and in far greater detail and nuance. In fact, rational expectations spawned many new mathematical and statistical techniques, and allowed a generation of economists to specialize in these techniques. In a typical rational expectations model, the public adjusts its behavior to announced monetary policy. This is supposed to result in a more realistic description of the economy.

But despite its technical brilliance, today we know there are several major flaws in the theory.

First, it is not reasonable to believe that business owners generally determine their prices by following macroeconomic trends. Can you cite the Federal Reserve's rates and policies at the moment? The inflation and unemployment rates? The nation's GDP growth? Even more improbably, do you set your budget, prices and wage demands by these indicators? Only an economist (who knows all these statistics anyway) would think this is natural behavior.

Second, it is not reasonable to believe that humans are perfectly rational or perfectly informed. Much of Lucas' theory "worked" only after making such idealistic assumptions. Interestingly, Lucas and his followers have usually defended these assumptions by attacking their opposite. Early Keynesians had "overlooked" the fact that people would adjust their behavior to national economic policy. Here are some typical criticisms of this oversight by Lucas and others:

"The implicit presumption in these Keynesian models was that people could be fooled over and over again." -- Robert Lucas (3)

"The problem with the old models was that they assumed people were as dumb as dirt and could be fooled by the government into changing their behavior." -- Paul Romer (4)

"The essence of rational expectations could be summarized as 'people aren't as dense as policy makers used to think they were.'" -- Ron Ross (5)

The black and white universe of the Lucas school is rather amusing: if human beings are not walking calculators or walking statistics manuals, then, by God, Keynesians must think they are complete idiots. The truth is a bit more prosaic. Keynesians have primarily based their theories on historical evidence, not assumptions of citizen ignorance. Money has never deflated easily, for whatever reason, and Keynesian policies seem to work best in smoothing out the business cycle. The failure to deflate may spring from many sources: not just citizen ignorance of monetary policy, but certainly price rigidities as well. For example, during the severe recession of 1982, the Fed's proposal to expand the money supply was widely debated in the press. When the Fed did move, it was well announced. But rational and expectant businessmen did not raise their prices and create inflation. On the contrary, 1983 actually saw lower inflation, as well as a job-creation boom that would last seven years.

And this leads to the third flaw: Lucas's theory just doesn't explain reality very well. In an article entitled "Great Theory… As Far as it Goes," economist Michael Mandel writes: "Unfortunately, models built on rational expectations do not reflect the real world as well as the old Keynesian models they were supposed to replace… Most economic forecasting models still have a Keynesian core." (6)

To wit, the recessions of 80-82 and 90-92 behaved very differently from what Lucas's models predicted. Keep in mind their key assertion that recessions only happen because individuals are temporarily confused about the situation. Once workers realize they are in a general recession, they will cut their wage demands, which will restore full employment. But after the unemployment rate hit 10.7 percent in the winter of 1982, it took until 1987 for it to recover to 1979 levels (about 5-6 percent). Did it really take workers eight years to figure out they were in a recession before cutting their wage demands by the necessary amount? Of course not.

The main obstacle to Lucas's theory is that that recessions last far too long to attribute them to temporary public confusion about the situation. Jimmy Carter was voted out of office for a "misery index" (inflation plus unemployment) that crested 20 percent. Yet it wasn't until the second year of Reagan's term that a recovery started. The same with George Bush -- a recession struck in 1990, and his 90 percent approval rating took a free fall in the election campaign that followed. That campaign was defined by James Carville's slogan, "It's the economy, stupid." The economy did not truly start recovering until 1992, and employment took even longer to recover. If the public's awareness of recessions is great enough to drive presidents out of office after extended campaigns, it's clear that people understand their plight. But then why do recessions last so long?

Lucas and his followers searched everywhere for a model that would keep businessmen aware of leading economic indicators and yet ignorant of the fact that they were in a recession. Needless to say, they did not find one.

Life after Lucas

Around the mid-80s, economists became aware of the theory's shortcomings. One of these was probably Lucas himself, who never really bothered to defend it when journals began seriously questioning it. As Lucas moved on to other projects, conservatives economists found themselves back at the drawing board, asking themselves such basic questions as: what is a recession?

The existence of recessions has always been an embarrassment to economists on the right. Recessions suggest that markets are not magical, that they often result in hardship and suffering. One far-right tack, as exemplified by the Austrian School of Economics, is to blame them on government. But depressions were exclusively a feature of laissez-faire economies; since the rise of modern welfare states, nations have seen greatly reduced recessions and unprecedented economic growth. So much for the government scapegoat.

The opposite tack, as exemplified by "real business cycle theory," has been to claim that recessions are actually beneficial self-cleansing rituals of the market. Thanks to recessions, the market adapts to change. This idea has been satirized in such Keynesian articles as Willem Buiter's "The Economics of Doctor Pangloss," after Voltaire's fictional philosopher who believes everything is for the best. As Paul Krugman remarked: "If recessions are a rational response to temporary setbacks in productivity, was the Great Depression really just an extended, voluntary holiday?" (7)

Real business cycle theory was presented as a replacement to rational expectations, but it ended up imploding under self-criticism and ideological infighting. Unlike monetarism or rational expectations, it never became a serious movement.

Instead, economics has seen the revival of Keynes, with the emergence of New Keynesianism. Many people thought that Lucas had refuted Keynesianism as a matter of principle. Any businessman with a newspaper would learn of a recession as quickly as the Fed, and would nullify the Fed's actions with the appropriate counteractions. However, economist George Akerlof would undermine this "refutation" with his own seminal article, "The Market for Lemons." Akerlof made two crucial observations, one of them obvious, one of them not-so-obvious.

The obvious one was that human beings are nearly rational, not perfectly rational. The not-so-obvious one is that nearly rational people may make decisions that approximate those of perfectly rational people, yet still obtain completely different economic results. Two examples best illustrate this point:

Suppose a farmer is selling wheat on the market, and notices that demand drops. Every other farmer is selling wheat for five cents a bushel less than he is. Now, wheat is a homogenous product, meaning that one farmer's wheat is virtually identical to another farmer's wheat. There is no advantage for a buyer to buy wheat at a higher price, so it would be foolish for the farmer to stay a nickel above the competition. The farmer may not want to lower his prices, but the market's supply and demand will force him to. So although the farmer is only nearly rational, he can come to perfectly rational decisions when the product is a homogenous one.

But what if the product is not homegenous? What if you're selling artwork? Artwork can range from a first-grader's finger-painting to "Ambroise Vollard" by Picasso. You might have a general idea of what's it worth, but to figure it to the penny, like wheat, is impossible. Too many variables affect the final price. One art collector might want the Picasso more than another collector, and be willing to pay more for it during an auction. A movie or book about Picasso might spur unusual interest in his paintings over those of Monet. A rich idiot might come along who has no idea what it's really worth. Therefore, an art seller is not being irrational by refusing to sell it to someone in the hopes of gaining a higher price. In other words, there is a range of acceptable prices, and most people hold out for higher prices out of self-interest.

The vast majority of goods on the market are not homogenous: examples include cars, homes, even workers on the labor market. People may be fully aware of a recession when they are in one, but they do not know how much they should reduce their prices. To know the exact percentage would require an astronomical amount of information and calculating ability. The cost of arriving at such a calculation would surely outweigh its benefits. Therefore, people should -- as a matter of principle -- try to make best guesses. Unfortunately, this often results in the sort of price stickiness that prevents recessions from curing themselves. Keynesian policies therefore remain a useful tool in cutting recessions short. We have long known that this is so in practice; it's heartening to know that this is so in theory now as well.

The study of economics is driven by theories of economic behavior and economic performance, which have developed along the lines of the classical ideas, the Marxist idea, or a combination of both. In the process, various models were developed, each trying to explain such economic phenomena as wealth creation, value, prices, and growth from a separate intellectual and cultural setting, each considering certain variables and relationships more important than others. Within the aforementioned historical framework, economics has followed a trajectory that is characterized by a multiplicity of doctrines and schools of thought, usually identifiable with a thinker or thinkers whose ideas and theories form the foundation of the doctrine.
Classical economics.

Classical economic doctrine descended from Adam Smith and developed in the nineteenth century. It asserts that the power of the market system, if left alone, will ensure full employment of economic resources. Classical economists believed that although occasional deviations from full employment result from economic and political events, automatic adjustments in market prices, wages, and interest rates will restore the economy to full employment. The philosophical foundation of classical economics was provided by John Locke's (1632–1704) conception of the natural order, while the economic foundation was based on Adam Smith's theory of self-interest and Jean-Baptiste Say's (1767–1832) law of the equality of market demand and supply.

Classical economic theory is founded on two maxims. First, it presupposes that each individual maximizes his or her preference function under some constraints, where preferences and constraints are considered as given. Second, it presupposes the existence of interdependencies—expressed in the markets—between the actions of all individuals. Under the assumption of perfect and pure competition, these two features will determine resource allocation and income distribution. That is, they will regulate demand and supply, allocation of production, and the optimization of social organization.

Led by Adam Smith and David Ricardo with the support of Jean-Baptiste Say and Thomas Robert Malthus (1766–1834), the classical economists believed in Smith's invisible hand, self-interest, and a self-regulating economic system, as well as in the development of monetary institutions, capital accumulation based on surplus production, and free trade. They also believed in division of labor, the law of diminishing returns, and the ability of the economy to self-adjust in a laissez-faire system devoid of government intervention. The circular flow of the classical model indicates that wages may deviate, but will eventually return to their natural rate of subsistence.
Marxist economics.

Because of the social cost of capitalism as proposed by classical economics and the industrial revolution, socialist thought emerged within the classical liberal thought. To address the problems of classical capitalist economics, especially what he perceived as the neglect of history, Karl Marx (1818–1883), a German economic, social, and political philosopher, in his famous book titled Das Kapital or Capital (1867–1894) advanced his doctrine of dialectical materialism. Marx's dialectics was a dynamic system in which societies would evolve from primitive society to feudalism to capitalism to socialism and to communism. The basis of Marx's dialectical materialism was the application of history derived from Georg Wilhelm Friedrich Hegel (1770–1831), which maintained that history proceeds linearly by the triad of forces or dialectics called thesis, antithesis, and synthesis. This transition, in Marx's view, will result from changes in the ruling and the oppressed classes and their relationship with each other. He then envisaged conflict between forces of production, organization of production, relations of production, and societal thinking and ideology.

Marx predicts capitalist cycles that will ultimately lead to the collapse of capitalism. According to him, these cycles will be characterized by a reserve army of the unemployed, falling rate of profits, business crises, increasing concentration of industry into a few hands, and mounting misery and alienation of the proletariat. Whereas Adam Smith and David Ricardo had argued that the rational and calculating capitalists in following their self-interest promote social good, Marx argued that in rationally and purposefully pursuing their economic advantage, the capitalists will sow the seeds of their own destruction.

The economic thinking or school of economic thought that originated from Marx became known as Marxism. As the chief theorist of modern socialism and communism, Marx advocated fundamental revolution in society because of what he saw as the inherent exploitation of labor and economic injustice in the capitalist system. Marxist ideas were adopted as the political and economic systems in the former Soviet Union, China, Cuba, North Korea, and other parts of the world.

The neo-Marxist doctrines apply both the Marxist historical dimension and dialectics in their explanation of economic relationships, behavior, and outcome. For instance, the dependency theory articulates the need for the developing regions in Africa, Latin America, and Asia to rid themselves of their endemic dependence on more advanced countries. The dependency school believes that international links between developing (periphery) and industrialized (center) countries constitute a barrier to development through trade and investment.
Neoclassical economics.

The period that followed Ricardo, especially from 1870 to 1900, was full of criticism of classical economic theory and the capitalist system by humanists and socialists. The period was also characterized by the questioning of the classical assumption that laissez-faire was an ideal government policy and the eventual demise of classical economic theory and the transition to neoclassical economics. This transition was neither spontaneous nor automatic, but it was critical for the professionalization of economics.
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Neoclassical economics is attributed with integrating the original classical cost of production theory with utility in a bid to explain commodity and factor prices and the allocation of resources using marginal analysis. Although David Ricardo provided the methodological rudiments of neoclassical economics through his move away from contextual analysis to more abstract deductive analysis, Alfred Marshall (1842–1924) was regarded as the father of neoclassicism and was credited with introducing such concepts as supply and demand, price-elasticity of demand, marginal utility, and costs of production.

Neoclassical or marginalist economic theories emphasized use value and demand and supply as determinants of exchange value. Likewise neoclassicals, William Stanley Jevons (1835–1882) in England; Karl Menger (1840–1925) in Austria; and Léon Walras (1834–1910) in Switzerland, independently developed and highlighted the role of marginal utility (and individual utility maximization), as opposed to cost of production, as the key to the problem of exchange valuation. Neoclassical models assume that everyone has free access to information they require for decision making. This assumption made it possible to reduce decision making to a mechanical application of mathematical rules for optimization. Hence, in the neoclassical view, people's initial ability to maximize the value of output will, in turn, affect productivity and determine allocation of resources and income distribution. Neoclassical economics is grounded in the rejection of Marxist economics and on the belief that the market system will ensure a fair and just allocation of resources and income distribution.

Since its emergence, neoclassical economics has become the dominant economic doctrine in the study and teaching of economics in the West, especially in the United States. A host of economic theories have emerged from neoclassical economics: neoclassical growth theory, neoclassical trade theory, neoclassical theory of production, and so on. In the neoclassical growth theory, the determinants of output growth are technology, labor, and capital. The neoclassical growth theory stresses the importance of savings and capital accumulation together with exogenously determined technical progress as the sources of economic growth. If savings are larger, then capital per worker will grow, leading to rising income per capita and vice versa. The neoclassical thinking can be expressed as the Solow-Swan model of the production function type Y F (N, K) which is expanded to ΔY/Y = ΔA/A + ΔN/N + ΔK/K where Y represents total output, N and K represent the inputs of labor and capital, and A represents the productivity of capital and labor, and ΔY/Y, ΔA/A, ΔN/N, and K / K represent changes in these variables, respectively.

The Solow-Swan model asserts that because of the diminishing marginal product of inputs, sustained growth is possible only through technological change. The notion of diminishing marginal product is rooted in the belief that as more inputs are used to produce additional output under a fixed technology and fixed resource base, additional output per unit of input will decline (diminishing marginal product). This belief in the stationary state and diminishing marginal product led neoclassical economics to believe in the possibility of worldwide convergence of growth.

Known also as the neoliberal theory, neoclassical economics asserts that free movement of goods (free trade), services, and capital unimpeded by government regulation will lead to rapid economic growth. This, in the neoclassical view, will increase global output and international efficiency because the gains from division of labor according to comparative advantage and specialization will improve overall welfare. Even modern trade models (such as the Hecksche-Ohlin) are based on the neoclassical trade theory, which assumes perfect competition and concludes that trade generally improves welfare by improving the allocation of factors of production across sectors of the economy.
Rational expectation.

Rational expectation is the economic doctrine that emerged in the 1970s that asserts that people collect relevant information about the economy and behave rationally—that is, they weigh costs and benefits of actions and decisions. Rational expectation economics believes that because people act in response to their expectations, public policy will be offset by their action. Also known as the "new classical economics," the rational expectation doctrine believes that markets are highly competitive and prices adjust to changes in aggregate demand. The extent to which people are actually well informed is questionable and prices tend to be sticky or inflexible in a downward direction because once they go up, prices rarely come down. In the rational expectation doctrine, expansionary policies will increase inflation without increasing employment because economic actors—households and businesses—acting in a rational manner will anticipate inflation and act in a manner that will cause prices and wages to rise.
Monetarism.

Like rational expectations theory, monetarism represents a modern form of classical theory that believes in laissez-faire and in the flexibility of wages and prices. Like the classical theorists before them, they believe that government should stay out of economic stabilization since, in their view, markets are competitive with a high degree of macroeconomic stability. Such policies as expansionary monetary policy will, in their view, only lead to price instability. The U.S. economist Milton Friedman, who received the Nobel Prize in 1976, is widely regarded as the leader of the Chicago school of monetary economics.
Institutionalism.

Institutional economics focuses mainly on how institutions evolve and change and how these changes affect economic systems, economic performance, or outcomes. Both Frederick Hayek and Ronald Coase, major contributors to the Institutionalist School in the tradition of Karl Marx and Joseph Schumpeter, look at how institutions emerge. Hayek examines the temporal evolution and transformation of economic institutions and concludes that institutions result from human action. Hence, he suggests the existence of a spontaneous order in which workable institutions survive while nonworkable ones disappear. Coase believes that institutions are created according to rational economic logic when transaction costs are too high. Other notable contributors to institutionalism include Thorstein Veblen, Clarence Ayers, Gunnar Myrdal, John R. Commons, Wesley Cair Mitchell, and John Kenneth Galbraith.

The New Institutionalism, represented mostly by Douglas North, Gordon Tullock, and Mancur Olson, uses the classical notions of rationality and self-interest to explain the evolution and economic impact of institutions. It considers such issues as property rights, rent-seeking, and distributional coalitions and argues that institutional transformation can be explained in terms of changes in property rights, transaction costs, and information asymmetries.

PU Peak Oil Conference, Washington, DC
DA May 9, 2006

HD The Steady-State Economy and Peak Oil

AU By Herman E. Daly*

*School of Public Policy University of Maryland

In classical economics (Smith, Malthus, Ricardo, Mill) the steady-
state, or as they called it the "stationary state" economy was a real
condition toward which the economy was tending as increasing
population, diminishing returns, and increasing land rents squeezed
profits to zero. Population would be held constant by subsistence
wages and a high death rate. Capital stock would be held constant by a
lack of inducement to invest resulting from zero profits thanks to
rent absorbing the entire surplus which was itself limited by
diminishing returns. Not a happy future -- something to be postponed
for as long as possible in the opinion of most classical economists.
Mill, however, saw it differently. Population must indeed stabilize,
but that could be attained by Malthus' preventive checks (lowering the
birth rate) rather than the positive checks (high death rate). A
constant capital stock is not static, but continuously renewed by
depreciation and replacement, opening the way for continual technical
and qualitative improvement in the physically non growing capital
stock. By limiting the birth rate, and by technical improvement in the
constant capital stock, a surplus above subsistence could be
maintained and equitably distributed. The stationary state economy
would not have to continually expand into the biosphere and therefore
could leave most of the world in its natural state. The stationary
state is both necessary and desirable, but neither static nor eternal
-- it is a system in dynamic equilibrium with its containing,
sustaining, and entropic biosphere. The path of progress would shift
from bigger and more, towards better and longer-lived.

In the late 1800's classical economics was replaced by neoclassical
economics, and although the term "stationary or steady-state economy"
was retained, its meaning was radically changed. It no longer referred
to constant population and stock of capital, but to a situation of
constant tastes and technology. In Mill's conception physical
magnitudes (population and capital) were constant, and culture (tastes
and technology) adapted. In the new version culture (tastes and
technology) are constant and the physical magnitudes (population and
capital stock) adapt. Given that our cultural tastes were assumed to
reflect infinite wants, and that technical progress was considered
unlimited, the way to adapt was by growth, so-called "steady-state
growth" which means proportional growth of population and capital
stock. The absolute magnitudes continue to grow while the ratio
between them is supposed to remain constant. Furthermore the concept
of a steady-state is no longer thought of as a real state of the
world, whether desirable or undesirable, but as an analytical fiction,
like an ideal gas or frictionless machine. It is a useful reference
point for analyzing growth, and has neither normative nor ontological
significance, whereas for Mill it had both. Mill's steady state was
both necessary in the long run and desirable much sooner. It is not
too much of an oversimplification to say that in a sense the classical
economists were concerned with adapting the economy to the dictates of
physical reality, while the neoclassicals want to adapt physical
reality to the dictates of the economy. In an empty world the dictates
of physical reality are not immediately binding on growth; in a full
world they are. Consequently, and paradoxically, it is the older
classical view of the steady-state, Mill's version, that is more
relevant today, even though the neoclassical view dominates the
thinking of empty-world economists.

Another basis for the stationary state comes from the demographers'
model of a stationary population, one in which birth rates and death
rates are equal and both the total population size and its age
structure are constant. This model is both an analytical fiction and
also for some a normative goal. Indeed, a constant population is part
of the classical view of the stationary state. A constant population
requires only that the birth rate equals the death rate, and that
could be the case at either high or low levels. Most of us prefer
lower levels, within limits, because we value longevity. Likewise, the
constancy of the capital stock requires production rates equal to
depreciation rates. Basically the preference here is also for equality
at low rather than high levels. Greater life expectancy of capital
(the total stock of durable goods) requires less depletion and
pollution (lower rates of throughput). In this view new production is
a maintenance cost of a capital stock that unfortunately depreciates
as it is used to serve our needs. Like other costs it should be
minimized, even though the idea of minimizing the flow of new
production is strange to most economists.

Something similar to the classical stationary state was revived by
Keynes in his concept of the "quasi stationary community". This was
also a real state of the world rather than an analytical fiction, and
was considered desirable by Keynes. It assumed population stability,
no wars, and a couple of generations of full employment and capital
accumulation. Keynes believed that in the resulting world of abundant
capital the "marginal efficiency of capital" would fall to zero,
leading to a situation in which new investment would merely replace
capital depreciation and the capital stock would cease growing.
Capital would in effect no longer be scarce leading to a near zero
interest rate and the happy consequence that it would no longer be
possible to live off of accumulated wealth -- the "euthanasia of the
rentier." As Keynes put it, "The owner of capital can obtain an
interest rate because capital is scarce, just as the owner of land can
obtain rent because land is scarce. But whilst there may be intrinsic
reasons for the scarcity of land, there are no intrinsic reasons for
the scarcity of capital" (General Theory..., p. 376, 1936). That
Keynes' vision did not come true is due to many things, including
destruction of capital by wars, dilution of capital by population
growth, and an enormous increase in consumption in wealthy countries
such as the US, fed by novel products, advertising, and financed not
only by reduced savings and investment, but also by capital
decumulation. In the US this decumulation takes the form of enormous
consumer debt as well as huge continuing deficits in both the domestic
budget and the foreign balance of trade. In addition, regardless of
the marginal efficiency of capital, the interest rate has been kept up
by the Fed in order to attract foreign investment from our surplus
trading partners, and to avoid inflation -- as well as by the Fed's
feelings for the rentier class that are more tender than were Keynes'.
Nevertheless Keynes, like Mill, saw a real possibility that was simply
rejected by the growth mentality, to which of course conventional
"Keynesian economics" has itself contributed to substantially.

The classical view of the steady-state economy was replaced by the
neoclassical view for two historical reasons. First, the neoclassical
subjective utility theory of value replaced the classical real cost
theory of value that emphasized labor and land. There are no obvious
limits to growth in utility (a psychic magnitude), as there are to
growth in labor and in the physical product that labor extracts from
nature. Second, with the advent of the industrial revolution there
came the enormous subsidy of fossil fuels. The annual flow of solar
energy captured by land and harvested by labor was now supplemented by
the concentrated sunlight of millions of Paleolithic summers
accumulated underground. Growth now seemed limitless, and neoclassical
economists attributed this bonanza not to nature's nonrenewable
subsidy, first of coal then of petroleum, but to human technological
invention that was taken to be renewable and not limited to the
particular resources being exploited. Indeed, a general presupposition
of neoclassical economics is that nature does not create value. Peak
oil signals the end of the bonanza with no alternative subsidy in
sight, either from nature or human invention. And even before the
source limit of global peak oil hits, we have begun to experience the
sink limit of greenhouse-induced climate change. Not only are the
sources emptying, but the sinks are filling up as well. A modernized
classical view of the steady-state economy as a subsystem of a finite,
non growing, and entropic biosphere, as foreseen by Mill, must now
replace the misnamed, misconceived, oxymoronic, and temporary "steady-
state growth" still celebrated by the neoclassical economists, even as
the oil bonanza is burning out.

Many will say that I am selling technology short, and that it will
find a substitute for cheap oil. Even assuming this were true, should
we not limit our depletion of petroleum now to drive up prices and
provide an incentive for developing these new hoped for technologies
as soon as possible? Should not the technological optimists have the
courage of their convictions and provide the incentives to develop the
very technologies of which they are so confident? A policy of
frugality first will induce efficiency as a secondary response: our
currently favored policy of efficiency first does not induce frugality
second, and in fact makes it less necessary, as often documented in
the so-called "rebound " or "Jevons effect." The most obvious policy
response to peak oil, and to furthering the classical steady-state
economy is to shift the tax burden from "value added" (income produced
by labor and capital) and on to "that to which value is added", namely
the resource throughput, especially fossil fuels. We need to raise
public revenue somehow, so why not tax what is truly most scarce, and
is not the product of anyone's labor, rather than tax labor and
entrepreneurship? Why not tax resource rents, "unearned income" as the
tax accountants so honestly call it, instead of earned income or value
added in the form of wages and profits? This is not only fairer but
also more efficient because it raises the relative price of the truly
scarce and long run limiting factor, the throughput of low-entropy
matter-energy, natural resources. In addition to being the long run
limiting factor the resource throughput, principally fossil energy, is
also the factor most responsible for external environmental costs --
another reason to raise its price by taxation. The tax shift could be
revenue neutral, taking the same amount from the public but in a
different way. It would offer an opportunity to get rid of some of our
worst taxes (e.g. the payroll tax) at the same time we add taxes with
better incentives. To the extent that a throughput tax reduces its
base, that is all to the good since throughput is depletion and
pollution, both costs. However, such reduction is likely to be limited
because resources are absolutely necessary for production and both
demand and supply for them are inelastic. But taxing a factor with
inelastic demand and supply is minimally distortionary, whereas the
supply of labor and enterprise is more elastic, and taxing them is
likely to reduce the incentive to add value. It is true that a
resource tax, like any consumption tax, is regressive compared to an
income tax. However, even the Mafia, drug dealers, crooked
politicians, illegal aliens, and Enron executives would have to pay
taxes on their condos, Mercedes, and yachts, whereas they currently
manage to escape income taxes by off-shoring, trusts, special lobbied
tax exemptions, or submersion in the cash economy. In any case, as
even neoclassical economists have long correctly argued it is better
to help the poor by direct income supplements than by indirectly
lowering prices through tax subsidies. A subsidized price gives the
most money to the biggest consumer, who is usually not poor.

Why is such a simple and obvious policy not advocated by neoclassical
economists? Because for them natural resources are unimportant and
ultimately non scarce. If this sounds extreme remember that the usual
neoclassical production function in micro economics omits resources
altogether -- production is seen as a function of labor and capital
only. And if sometimes neoclassicals do include R into the equation it
makes little difference because the multiplicative form of the usual
production functions implies that manmade capital is a good substitute
for resources -- you can bake a ten-pound cake with only five pounds
of flour, eggs, and sugar, if only you use a big enough oven and stir
vigorously! And, with admirable consistency, macroeconomists calculate
our national income without attributing value to resources in situ.
Resources are valued according to their labor and capital costs of
extraction (value added), and any royalty paid for resources in situ
is simply a premium paid for access to a mine or well whose extraction
costs are lower than the margin that it is currently profitable to
exploit. All resources are free gifts of nature, but some gifts are
easier to unwrap than others and therefore trade at a premium.

Paralleling the shift from a real cost (labor and capital) to a
subjective (utility) theory of value was a shift from classical
commodity money (gold) to fiat money (paper). Just as value measured
by subjective utility loses its connection to the objective factors of
labor and land, so value symbolized by fiat money loses its connection
to the real costs of mining gold, especially when amplified by
fractional reserve banking. Both utility and fiat money are
unconstrained by the biophysical world of finitude and entropy that
characterize resources, land, labor, and physical wealth. The token or
counter of wealth, money, is now governed by laws different from those
that govern real wealth. Fiat money can be created and destroyed;
physical wealth cannot. Money does not spoil or entropically
disintegrate over time; real wealth does. Money does not take up space
when accumulated; real wealth does. Money spontaneously grows at
compound interest in a bank account; manmade capital does not -- its
spontaneous default tendency is to diminish. The world of money, debt,
and finance becomes increasingly disjoined from the world of real
wealth and physical resources. The financial world is built around
debt and expectations of future growth in wealth to redeem the debt
pyramid built by expansion of fiat money. Peak oil will disrupt those
growth expectations and lead to a financial crash resulting in levels
of real production that are even below physical possibility, as
happened in the Great Depression.

The steady-state economy needs a money more congruent with real
wealth. Hubbert in his early writings suggested an energy-based
currency. The history I have sketched may suggest a return to gold or
some other commodity money. I would favor a continuation of fiat
money, but subject to the discipline of one hundred percent reserve
requirements, as suggested by Frederick Soddy, Irving Fischer, and
Frank Knight -- but that is another story.

There is a bright side to peak oil if we can adapt to it. Obviously
lower inputs of petroleum will, other things equal, reduce outputs of
CO2 and greenhouse effects, albeit with a lag. Also, higher prices for
petroleum will act not only as an incentive to more efficient
technology, but also as a tariff on all international and long-
distance trade providing protection to national and local producers,
thereby increasing local self-sufficiency and slowing down the lemming
rush to globalization. Without the subsidy of cheap oil the rates of
exploitation and takeover of the natural world by mining, drilling,
cutting, draining, filling in, digging, blasting, paving, dredging,
leaching, overharvesting, monoculturing, etc., will all be slowed.

The big obstacle to the steady state economy is our religious
commitment to growth as the central organizing principle of society.
Even as growth becomes uneconomic we think we must continue with it
because it is the central myth, the social glue that holds our society
together. Consider the Washington Post's recent editorial, "The Case
for Economic Growth" (4/2/06). They admit that the case for growth has
been greatly weakened in the US by the fact that most of the growth
for over a decade has gone to the rich and little if any to the poor.
Also, even that growth to the rich has produced little welfare in view
of studies by psychologists and economists showing that beyond a
$10,000 per capita GNP threshold self-evaluated happiness ceases to
rise with rising income. Despite these two blows, however, the
Washington Post believes the case for growth remains strong, for two
additional reasons. First, as Americans become richer they become more
optimistic and tolerant, and therefore act more generously toward
racial minorities, immigrants, and the poor. Second, only a richer
America can continue making the world safe for free trade and
democracy. If the mouthpiece of official Washington can't make a
stronger case than that, then I think the growth ideology may finally
be in trouble. But notice that even to make that weak case they had to
assume that growth in GNP is in fact making us richer, when that is
the very point most at issue in the growth debate! The evidence is
that at the current margin growth increases environmental and social
costs faster than it increases production benefits, making us poorer,
not richer. Furthermore, by their own admission nearly all GNP growth
has all gone to the rich. It has not, therefore, led us to act more
generously to the poor. Is that because GNP growth has in fact not
made us richer, or perhaps because generosity has little to do with
wealth in the first place? Nevertheless, this is the level of
reasoning that passes for serious economic discourse in Washington DC.
Does it reflect honest confusion, or cynical pandering to the ruling
class ideology? In either case it falls far short of John Stuart
Mill's 150 year-old analysis.

In the absence of a good substitute for petroleum, something currently
not identifiable on the required scale, peak oil will signal an era of
rising prices and dwindling supplies of the major energy source of the
industrial economy, requiring a thorough adaptation of the economy to
more severe geological and biological constraints. The classical
steady-state economy is a way of thinking accustomed to adapting the
economy to reality. The idea of a steady-state economy predates and is
independent of peak oil -- this is true even for M. King Hubbert who
wrote about the steady state long before his famous prediction of US
peak oil. But the growing evidence that we are close to peak oil for
the world should dramatically increase interest in the classical
steady-state economy as a better fit for the real world than the
current neoclassical perpetual growth machine. Does someone have a
better idea?

THE CLASSICAL THEORY OF EMPLOYMENT

The basic contention of classical economists was that if wages and prices were flexible, a competitive market economy would always operate at full employment. That is, economic forces would always be generated so as to ensure that the demand for labour was always equal to its supply.

In the classical model the equilibrium levels of income and employment were supposed to be determined largely in the labour market. At lower wage rate more workers will be employed. That is why the demand curve for labour is downward sloping. The supply curve of labour is upward sloping because the higher the wage rate, the greater the supply of labour.

In the following figure the equilibrium wage rate (wo) is determined by the demand for and the supply of labour. The level of employment is OLo.

classical theory of employment



The lower panel of the diagram shows the relation between total output and the quantity of the variable factor (labour). It shows the short-run production function which is expressed as Q = f ( K, L ), where Q is output, K is the fixed quantity of capital and L is the variable factor labour. Total output Qo is produced with the employment of Lo units of labour. According to classical economists this equilibrium level of employment is the ‘full employment’ level. So the existence of unemployed workers was a logical impossibility. Any unemployment which existed at the equilibrium wage rate (Wo) was due to frictions or restrictive practices in the economy in nature.

The classical economists believed that aggregate demand would always be sufficient to absorb the full capacity output Qo. In other words, they denied the possibility of underspending or overproduction. This belief has its root in Say’s Law.

(a) Say’s Law: According to Say’s Law supply creates its own demand, i.e., the very act of producing goods and services generates an amount of income equal to the value of the goods produced. Say’s Law can be easily understood under barter system where people produced (supply) goods to demand other equivalent goods. So, demand must be the same as supply. Say’s Law is equally applicable in a modern economy. The circular flow of income model suggests this sort of relationship. For instance, the income created from producing goods would be just sufficient to demand the goods produced.

(b) Saving-Investment Equality: There is a serious omission in Say’s Law. If the recipients of income in this simple model save a portion of their income, consumption expenditure will fall short of total output and supply would no longer create its own demand. Consequently there would be unsold goods, falling prices, reduction of production, unemployment and falling incomes.

However, the classical economists ruled out this possibility because they believed that whatever is saved by households will be invested by firms. That is, investment would occur to fill any consumption gap caused by savings leakage. Thus, Say’s Law will hold and the level of national income and employment will remain unaffected.

(c) Saving-Investment Equality in the Money Market: The classical economists also argued that capitalism contained a very special market – the money market – which would ensure saving investment equality and thus would guarantee full employment. According to them the rate of interest was determined by the demand for and supply of capital. The demand for capital is investment and its supply is saving. The equilibrium rate of interest is determined by the saving-investment equality. Any imbalance between saving and investment would be corrected by the rate of interest. If saving exceeds investment, the rate of interest will fall. This will stimulate investment and the process will continue until the equality is restored. The converse is also true.

(d) Price Flexibility: The classical economists further believed that even if the rate of interest fails to equate saving and investment, any resulting decline in total spending would be neutralized by proportionate decline in the price level. That is, Rs 100 will buy two shirts at Rs 50, but Rs 50 will also buy two shirts if the price falls to Rs 25. Therefore, if households saves more than firms would invest, the resulting fall in spending would not lead to decline in real output, real income and the level of employment provided product prices also fall in the same proportion.

(e) Wage Flexibility: The classical economists also believed that a decline in product demand would lead to a fall in the demand for labour resulting in unemployment. However, the wage rate would also fall and competition among unemployed workers would force them to accept lower wages rather than remain unemployed. The process will continue until the wage rate falls enough to clear the labour market. So a new lower equilibrium wage rate will be established. Thus, involuntary unemployment was logical impossibility in the classical model.
Keyne’s Criticism of Classical Theory:

J.M. Keynes criticized the classical theory on the following grounds:

1. According to Keynes saving is a function of national income and is not affected by changes in the rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled out. So Say’s Law will no longer hold.

2. The labour market is far from perfect because of the existence of trade unions and government intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages are more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a fall in production as well as a fall in employment.

3. Keynes also argued that even if wages and prices were flexible a free enterprise economy would not always be able to achieve automatic full employment.

The concept of equilibrium: a key theoretical element in Keynes' revolution

Introduction

In part, Keynes' belief that the General Theory (1) would create a revolution in economics was based on his theoretical goal of attacking what he termed the classical model [Keynes, 1982, p. 42]. By classical he meant primarily the neoclassical economists who preceded him or were his contemporaries [Keynes, 1936, p. 3]. The classical model, hereafter the neoclassical orthodoxy, was characterized by perfectly competitive markets with flexible prices leading to self-adjusting, market-clearing, aggregate markets. Combined with the neoclassical extension of Say's Law, this model assured the existence of an equilibrium at full employment. (2)

Keynes' attack on the neoclassical orthodoxy proceeded along two distinct lines [Johnson, Ley, and Care, 2001; Johnson and Cate, 2002]. In his first line of attack, Keynes took the institutional variables of the neoclassical orthodoxy as given and examined the functional relationships embodied in their concept of equilibrium, the loanable funds theory and the quantity theory. Having determined that these functional relationships were not useful given his framework of analysis, Keynes substituted his own short-run functional relationships regarding consumption, saving, investment, the demand for money, and his own concept of equilibrium [Keynes, 1936, Books II, III, and IV].

In the second line of attack, Keynes took the functional relationships as given and examined the institutional variables. He focused on the assumptions of perfectly competitive markets and continuous market-clearing prices, namely the institutional features of the labor and real goods markets. The basis of this line of attack was his perception of price and/or wage rigidity resulting from imperfect competition and market power. (3) Having found the neoclassical assumptions unacceptable given his analytical framework, Keynes substituted his own notions of equilibrium, product prices, and money wages [Keynes, 1936, Book I, Chapter 2, and Book V].

What emerged in the General Theory from Keynes' two lines of attack on the neoclassical orthodoxy was a core comprised of five key theoretical elements. (4) which were generalized into a coherent message regarding involuntary unemployment [Cate and Johnson, 1997]. The message was that a less than full employment equilibrium was not only possible but could well represent the norm in a market-capitalist economy [Keynes, 1936, pp. 250-52].

This paper presents one of the key theoretical elements that constituted the core of the General Theory--Keynes' concept of equilibrium. Keynes' concept of equilibrium differed in its structure, content, and purpose from that of the neoclassical orthodoxy of his day. Keynes' concept of equilibrium, which played a crucial role in both of his lines of attack on the neoclassical orthodoxy, contained four unique features. Each of these features reflected his overriding focus on involuntary unemployment.

Keynes' Concept of Equilibrium and his Purposive Function

The first unique feature of Keynes' concept of equilibrium was that it reflected a purposive function (PF), the ultimate purpose or goal pursued by practitioners of normal science, that differed in its maximand and normative content from both classical and neoclassical economics. The classical PF was concerned with whether a perfectly competitive market-capitalist economy was capable of maximizing total social welfare, measured in material terms (vendable commodities), overtime. As used by classical economists, (5) equilibrium implied that total social welfare was maximized if an ethically acceptable distribution of income existed. Hence, classical equilibrium reflected their primary concern with the issues of economic growth and distribution [Johnson, 1980, 1983].

The neoclassical PF was concerned with how, in a perfectly competitive market-capitalist economy, individual welfare, defined subjectively in terms of utility, would be maximized at any point in time. For neoclassical economists, equilibrium implied individual welfare would be maximized given any distribution of income. As such, neoclassical equilibrium reflected their primary concern with the issue of allocative efficiency [Johnson, 1980, 1983; Johnson and Ley, 1990].

Keynes' PF was concerned with whether an imperfectly competitive market-capitalist economy was capable of maximizing total social welfare, measured in terms of goods and services, in the short-run. However, Keynes' equilibrium was ethically neutral in that it did not imply that total social welfare would be maximized given any distribution of income. The key issue for Keynes in evaluating this question was economic stability, (6) as measured by involuntary unemployment and affected by the distribution of income. As such, Keynes' concept of equilibrium reflected his overriding concern with involuntary unemployment. This aspect of Keynes' equilibrium reflected his challenge to certain institutional variables subsumed under perfect competition in the neoclassical model, and hence, was important in his second line of attack on the neoclassical orthodoxy. In short, Keynes argued that the neoclassical orthodoxy and its concept of equilibrium dealt with the issue of allocative efficiency and was not intended to deal, nor capable of dealing adequately, with the problem of economic stability as measured by involuntary unemployment [Cate and Johnson, 1997; Johnson and Cate, 2002].
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Keynes' PF led to the emergence of a new paradigm, which ultimately resulted in macroeconomics being treated as a separate branch of economics. This paradigmatic shift altered the fundamental transmission mechanism for achieving equilibrium from a paradigm in which the market-capitalist economy was viewed in terms of price adjustments to a paradigm in which price adjustments alone were nearly powerless to bring about or alter the existing equilibrium [Johnson and Cate, 2002; Stanfield, 1974].

The paradigmatic shift caused by the General Theory was so dramatic it was quickly labeled the Keynesian Revolution [Klein, 1949]. (7) For the majority of economists, Keynes' economics became the macroeconomic orthodoxy for much of the next four decades. (8) In fact, at least two writers have compared Keynes' General Theory to Einstein's Theory of Relativity in terms of its revolutionary impact. For example, Skidelsky [1992, p. 487] notes:

"Keynes' identification with Einstein is also too clear to miss.
Keynes was writing a ' General Theory' of employment, in which he
called classical economics a 'special case' and classical economists
'Euclidean geometers' in a non-Euclidean world."

More recently Togati [2001, p. 121] has argued:

"Just like Einstein, Keynes searches for a new image of the world to
oppose that of orthodox economic theory and suggests that a
revolutionary theory is not one that rejects old concepts but one
that redefines them."

Keynes' Concept of Equilibrium and His Theory of Aggregate Demand

The second unique feature of Keynes' equilibrium was that it reflected his belief that the composition of national income determined the level of aggregate demand, which in turn, was the primary determinant of the equilibrium level of national income and employment in the short-run. (9) Thus, Keynes' equilibrium reflected a different direction of causation than that of the neoclassical orthodoxy, creating the possibility of involuntary unemployment in equilibrium. (10)

In the neoclassical model, unemployment was either voluntary, frictional (seasonal), or a short-run disequilibrium phenomenon, which would be eliminated when the economy adjusted to equilibrium [Lindert, 1976, Ch. 2]. This conclusion resulted from the direction of causation in the neoclassical model. The neoclassical direction of causation was from the labor market, which determined the equilibrium level of employment to the real goods market, where, in conjunction with aggregate supply, the equilibrium level of national income was determined. This direction of causation was a result of the classical dichotomy, which Keynes sought to undermine in his first line of attack on the neoclassical orthodoxy [Johnson, Ley, and Cate, 2001; Johnson and Care, 2002]. With the classical dichotomy, the economy was divided into two air tight components--the real and the monetary sectors of the economy. The levels of employment and output were determined by real factors alone, while the general price level was determined strictly by monetary factors. Money was merely a medium of exchange, demanded only for transactions purposes, as such, it was a veil and had no impact in determining output and employment [Ackley, 1978, pp. 114, 118, 124, 146-48].
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The neoclassical direction of causation resulted in the failure of the orthodox definition of equilibrium in the labor market to distinguish between the willingness to work and the ability to work. Therefore, as Keynes noted [Keynes, 1936, p. 5], the problem of involuntary unemployment in equilibrium was simply defined away. Moreover, this line of reasoning led to the conclusion that unemployment was ultimately the fault of the workers themselves. In the case of voluntary unemployment, the problem was the workers lack of an appropriate work ethic. In the case of involuntary unemployment, workers are also responsible, since involuntary unemployment only occurs in disequilibrium as a result of wages failing to fall to their equilibrium, level.

With Keynes' concept of equilibrium, the direction of causation runs in the opposite direction to that of the neoclassical model. The composition of national income determines the level of aggregate demand and the equilibrium level of national income in the real goods market. The equilibrium level of national income, then, determines the equilibrium level of employment, via derived demand in the labor market. With the new direction of causation introduced in the General Theory, Keynes distinguishes between the willingness to work and the ability to work at equilibrium in the labor market. Thus, involuntary unemployment in equilibrium is possible, with or without price and/or wage rigidities. As such, the reversal of the neoclassical direction of causation by Keynes became critical to his argument that the economic system may not operate at full employment in equilibrium. (11)

The reversal in the direction of causation can be visualized in its simplest form in the flow diagram presented in Figure 1. (12) In the upper-loop, the level of aggregate demand determines the equilibrium level of national income via the level of ex ante spending on consumption and investment in the real goods market. The equilibrium level of national income, then, determines by way of the derived demand for labor, the equilibrium level of employment in the labor market. In the lower-loop, the equilibrium level of employment determines earnings, hence, the level of disposable income, which in turn, determines the composition of national income. The composition of national income then determines the level of aggregate demand in the next period. (13)

[FIGURE 1 OMITTED]

Keynes' fundamental message regarding the fact that involuntary unemployment can exist in equilibrium was embodied in the simple yet elegant short-run static model of a closed economic system contained in the General Theory. Consumers decide how to divide their stream of income into two parts--spending on consumption goods and saving. Simultaneously and yet independently of consumers, producers decide how to divide the stream of output into two parts--consumption and investment goods. Three outcomes are possible; ex ante savings can be greater than, equal to, or less than the ex ante investment. If ex ante saving and ex ante investment are equal, then the economic system is in equilibrium. This consistency of decisions, however, does not imply that the economic system is operating at full employment. Full employment is one of an infinite number of possible equilibria. In fact, not only was less than full employment possible, but it could well represent the norm in a market-capitalist economy, particularly if the worldwide depression of the inter-war period persisted. This feature of Keynes' equilibrium was an important component in his first line of attack on the neoclassical orthodoxy.
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Keynes' Concept of Equilibrium and His Ex Post-Ex Ante Analysis

The third unique aspect of Keynes' concept of equilibrium was the ex post-ex ante analysis he employed. While this approach may have been novel to mainstream British economists, it was not the case for Hayek, Wicksell, and Myrdal. Laidler's [1999] masterful survey has emphasized the extensive debate that took place during the inter-war years between the Wicksellians, the Austrians, and the Stockholm School. However, these writers accepted and extended the two key linchpins of the neoclassical orthodoxy--the quantity theory and the loanable funds theory. In addition, these writers focused on allocative efficiency, though their discussions were often couched in terms of intertemporal as opposed to static allocation. (14) Finally, downturns in the trade cycle resulted from disequilibrium in aggregate markets [Laidler, 1999, pp. 29, 32, 34-5, 57-8, and 61-2]. As such, the Wicksellian, the Austrian, and the Stockholm School writers, like all orthodox economists, viewed the collapse of output and employment during the inter-war period as a disequilibrium process, resulting from the divergence between the natural and market rate of interest in their version of the loanable funds theory [Myrdal, tr. 1939], (15) or from price and/or wage stickiness due to market frictions [Laidler, 1999, pp. 40-1, 57-8, 61-4]. (16) In sum, neoclassical economists prior to the General Theory, applied the ex post-ex ante analysis to disequilibrium adjustments, motivated by their concern with intertemporal allocative efficiency. Ironically, Keynes' use of the ex post-ex ante analysis emerged from his rejection of the same loanable funds theory which was pivotal to the neoclassical orthodoxy [Johnson and Cate, 2000, 2002].

According to orthodox doctrine, consumption, saving, and investment were all functions of the rate of interest. In such a model, household decisions regarding consumption and saving, and business decisions regarding investment, depend on the same decision variable. In such a theory, household and business decision makers became one and the same, and the distinction between ex post and ex ante saving and investment becomes trivial in the determination of equilibrium. The rate of interest is determined in the loanable funds market. As long as the interest rate is sufficiently flexible, ex ante saving is automatically converted into ex ante investment. Perfect competition and Say's Law then ensure that the supply of (saving) and demand for (investment) loanable funds are in equilibrium at full employment. Thus, deficiencies in aggregate demand due to excessive ex ante saving or deficient ex ante investment never create involuntary unemployment in equilibrium. Keynes' attack on the loanable funds theory had its origins in A Treatise on Money [Keynes, 1930]. Though he did not employ the ex post-ex ante analysis in the Treatise, Keynes [Keynes, 1930, Vol. I, p. 250] made it clear that:

"... the decisions which determine saving and investment
respectively are taken by two different sets of people influenced by
different sets of motives, each not paying very much attention to
the other."
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Thus, the foundation is laid for the General Theory where the distinction between ex post-ex ante saving and investment is critical in defining the possibility of macroeconomic equilibrium at less than full employment.

The model Keynes developed in the Treatise was designed to explain changes in the general price level. However, two key features are relevant here. First, consumption is a function of income [Keynes, 1930, Vol. I, p. 121]; a result which followed from his basic definitions. However, because of the purpose of the Treatise, Keynes did not develop the concept of a consumption function any further. Second, Keynes treated saving as a function of both income [Keynes, 1930, Vol, I, p. 155] and of the rate of interest in the Treatise [Keynes, 1930, Vol. I, p. 180]. Again, given the purpose of the model in the Treatise, the saving-interest rate connection is emphasized over the saving-income connection [Keynes, 1930, Vol. I, pp. 179-87].

However, in the General Theory, both consumption and saving are stable functions of current disposable income. Thus, Keynes viewed the factors that determined household decisions to consume and save as very different from the factors that determined business investment decisions. As such, macroeconomic equilibrium is defined in terms of relationship between ex ante saving and ex ante investment, and macroeconomic equilibrium is achieved when the sum of ex ante leakages equal to the sum of ex ante injections into the income stream. Thus, Keynes created the possibility that ex ante savings, a leakage from the income stream, might not be converted into an equivalent amount of ex ante investment, an injection into the income stream. Hence, increases in ex ante savings (decreases in ex ante consumption) became a source of deficient aggregate demand, resulting in involuntary employment in equilibrium. Therefore, Keynes removed the interest rate from its central role as the dependent variable that served to coordinate spending and saving decisions in the economy, which assured, via Says Law, full employment in equilibrium [Keynes, 1936, Chapters 6, 7, and 18]. This aspect of Keynes' equilibrium concept, therefore, also played a critical role in his first line of attack on the self-adjusting neoclassical model.

Keynes' Concept of Equilibrium and Market Clearing

The final unique feature of Keynes' concept of equilibrium involved the definition of market-clearing. Market-clearing in the orthodox model occurred with flexible product and resource prices. In such a model, wage and/or price inflexibility resulted in disequilibrium. Such was not the case, however, with Keynes' equilibrium. Not only was macroeconomic equilibrium achieved when the sum of ex ante leakages equal to the sum of ex ante injections into the income stream, but all markets would be cleared even in the face of wage and price rigidities. So again, with Keynes' equilibrium came the concept of involuntary unemployment in equilibrium.

The standard assumptions of the orthodox model lead to three implications regarding the nature of their concept of equilibrium. First, it implied that market equilibrium is uniquely a function of the price toward which the market will gravitate. Second, it implied that in equilibrium all desired trades can be completed at that price. Finally, it presumed that since each individual optimizes at equilibrium, equilibrium is a normative ideal providing the highest attainable level of consumer welfare. While Keynes retained the concept of equilibrium as a situation in which the value of dependant variables would be stable, none of the implications of neoclassical equilibrium were required in his concept of equilibrium.
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The first implication of the neoclassical orthodoxy's concept of equilibrium is that market equilibrium is uniquely a function of the price towards which the market will gravitate. Price and/or wage stickiness creates non-clearing disequilibrium in the orthodox model. However: Keynes' concept of equilibrium allows for market-clearing in the face of price and/or wage rigidity. This is the difference between Keynes' discussion of wage and/or price rigidity and that of Hawtrey, Pigou, and the other neoclassical writers of the inter-war period [Laidler, 1999, p. 16]. For these writers, wage and/or price stickiness resulted from market frictions, such as workers unwillingness to accept wage cuts in the case of wage rigidities. Hence, involuntary unemployment was seen as a problem of disequilibrium [Laidler, 1999, p. 17].

In A Tract on Monetary Reform [Keynes, 1924, pp. 25-30], Keynes mentions labors' success in keeping wages from falling as rapidly as prices during the inter-war deflation. By the time of the General Theory, Keynes introduced the money wage illusion as the motivation for wage rigidity. However, the money wage illusion cannot create wage rigidity unless labor exercises a sufficient degree of market power.

With respect to product prices, Keynes was certainly aware of the work being done on the theory of imperfect competition in the 1930s. He had to be aware of the work of Chamberlin [1933] and Robinson [1933] on monopolistic competition and the resulting perception that imperfect competition may lead to a degree of price rigidity capable of preventing the price mechanism from coordinating behavior in a timely fashion. Moreover, Keynes may have been aware of discussions and working papers on the theory of oligopoly, (17) which provided an even stronger theoretical rationale for the price rigidity in the Keynes' analysis [Reid, 1981[. Keynes appeared to be arguing that market power exercised by big business was employed to maintain a break on falling prices during the deflationary environment of the rapidly spreading depression of the inter-war years. This, of course, is a very different view of the use of market power on the part of big business today, where some see market power employed as a source of profits-push inflation.

The second implication of the neoclassical orthodoxy's concept of equilibrium is that all desired exchanges can be completed at the equilibrium price, a position that resulted from the neoclassical orthodoxy's direction of causation, and (in the labor market) the resulting failure to distinguish between the willingness to work and the ability to work. However, as noted above, given the reversal in the direction of causation in the General Theory and Keynes' concept of equilibrium, even if equilibrium prices are obtained, Keynes did not presume that all desired trades could be completed at these prices. Again, with reference to the labor market, the wage could attain its equilibrium level, but this does not necessarily equate the willingness to work and the ability to work. Hence, while markets cleared in Keynes' equilibrium, they could do so without either full employment or optimization occurring. (18)
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The third implication of the neoclassical orthodoxy's concept of equilibrium is that consumer welfare will be maximized since each consumer optimizes his or her welfare in equilibrium. Therefore, this concept of equilibrium implied a normative ideal whereby individual welfare, measured in terms of utility, would be maximized given any distribution of income. However, as noted above, Keynes' concept of equilibrium was ethically neutral in that it did not imply that total social welfare would be maximized given any distribution of income. Again, this is a result of the fact that market-clearing in Keynes' concept of equilibrium does not imply optimization. For Keynes, macroeconomic equilibrium is merely where the system comes to rest, which is achieved when the opposing theoretical forces in the model are in balance. In the basic model contained in the General Theory, the opposing forces are the decision makers in households that determine the division of their disposable income between planned consumption and saving, and business decision makers who must determine planned investment. When the plans of these opposing forces are in balance, the sum of ex ante leakages will equal the sum of ex ante injections into the income stream. All markets will clear, with or without flexible wages and/or prices, and macroeconomic equilibrium is reached, with or without, full employment.

Because his notion of equilibrium and market-clearing attacks the very idea of the efficiency of market processes, Keynes' concept of equilibrium and its definition of market-clearing represents a significant aspect of his attack on the neoclassical orthodoxy of his day. The General Theory, with his concept of equilibrium and market-clearing, clearly articulated his perceived limitations of efficiency economics. As such, this feature of Keynes' equilibrium is another important component in his second line of attack on the neoclassical model.

Conclusion

The theoretical goal of the General Theory and a major reason Keynes thought the book would create a revolution in economics, was his attack on the so-called classical model. A number of key theoretical elements emerged from Keynes' two lines of attack on the neoclassical orthodoxy of his day, and these elements constituted the theoretical core of the General Theory. This core was generalized into a coherent message that less than full employment in equilibrium was not only possible, but could well represent the norm in a market-capitalist economy. This paper presents Keynes' concept of equilibrium, which was one key theoretical element that constituted the core of the General Theory and was critical in his two lines of attack on the neoclassical model. Keynes' concept of equilibrium differed in structure, content, and purpose from that of the neoclassical orthodoxy. Moreover, there were four unique features of Keynes' notion of equilibrium, and these features all reflect his overriding focus on involuntary unemployment.

Footnotes

(1) This paper is concerned exclusively with the economics of Keynes and not the various divergent views of Keynesian economics or Post-Keynesian economics. The authors are concerned only with what Keynes said or meant and not with what he could have said or should have said [Johnson, 1980, 1983; Blaugh, 1985, 2001, 2003].
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(2) Keynes' classical model was admittedly a straw man. However, with the exception of Malthus and Marx, the prototype classical and neoclassical macroeconomic models, though based on somewhat different analyses, came to the conclusion that full employment would prevail in equilibrium [Johnson and Cate, 2002; Johnson and Ley, 1990; Lindert, 1976].

(3) Keynes also discussed the impact of price rigidity in the money market in the form of the liquidity trap and a rigid rate of interest. How serious the possibility of the liquidity trap really was in Keynes' mind has long been subject to debate. However, it is clear that the trap emerged from Keynes' theory of probability and his theory of expectations rather than imperfect competition and market power [Cate, 1997; Cate and Johnson, 1997, 1998].

(4) The five key theoretical elements of the General Theory include: (1) Keynes' concept of equilibrium; (2) his theory of probability, expectations, and uncertainty; (3) his critique of the loanable funds theory of interest rate determination; (4) his liquidity preference theory of money and interest rate determination; and (5) Keynes' theory of labor supply and market clearing at less than a full employment equilibrium [Cate and Johnson, 1997].

(5) To be sure, some qualifications have to be admitted in the case of Malthus and Marx in light of their measure of value [Johnson, Gramm, and Hoaas, 1989, 1991; Johnson and Ley, 1990].

(6) Today, of course, the term economic stability most commonly refers to both employment stability and the stability of the general price level as reflected in the business cycle.

(7) To be sure, there were those who initially rejected the model contained in the General Theory, such as the Chicago school, the Austrians, and the institutional economists. Moreover, others like Pigou [1936] and Hicks [1937], attempted to treat Keynes' analysis as simply a special case of the neoclassical model.

(8) The analytical framework contained in the General Theory to deal with involuntary unemployment was rapidly extended to deal with cyclical inflation and the issue of economic growth. Harrod [1939, 1948, 1960] and Domar [1946, 1947, 1948, 1952] initiated an entire body of literature on Keynesian growth models and should be credited with founding modern growth theory [Besomi, 1997, p. 231]. Moreover, Hansen, initially skeptical of the Keynesian analysis, turned into a supporter [Haber, 1997], developing the theory of secular stagnation [Hansen, 1938, 1939], a straight forward extension of Keynes' short-run static analysis of the deficiency of aggregate demand. According to Samuelson [1976], Hansen also provided the original insight to the whole class of Keynesian type multiplier accelerator growth models, which are generally associated with the work of Samuelson and Solow [Samuelson, 1939a, 1939b; Solow, 1956[. This, despite the fact that the accelerator principle had been articulated first by Kahn [1931] and later by Harrod [1936], though the latter was concerned with the trade cycle and not the long-run problems of economic growth at the time. Finally, many economists such as Lerner [1936], began to explore the possibilities that seemed to be implied in the General Theory for achieving economic stability through the use of monetary and counter-cyclical fiscal policy.
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(9) Keynes' concept of equilibrium does not deal adequately with the problem of time since he seems to vacillate between the concepts of analytical and calendar time, hence, the attacks on the instantaneous nature of the multiplier analysis. However, his concept of equilibrium established the theoretical existence of an equilibrium at less than full employment. Moreover, his less than full employment equilibrium would continue unless the government intervenes in the operation of the economic system by undertaking certain public works, thereby, increasing aggregate demand. Finally, despite his somewhat unclear treatment of time, it is clear that Keynes was never concerned with the long-run in the analytical sense of that term.

(10) Though not relating Keynes' direction of causation to his concept of equilibrium, others such as Thirlwall have certainly recognized the importance of Keynes' direction of causation as opposed to the neoclassical view. In fact, Thirlwall refers to the fact that output and employment are ultimately determined in the real goods market as opposed to the labor market as one of the "... central messages of Keynes' vision" [Thirlwall, 1993, pp. 335-337].

(11) Employing the Pigouvian Real Balance or Wealth Effect, Patinkin and others have shown that Keynes' direction of causation does not necessarily lead to a less than full employment equilibrium. However, it must be pointed out that the Pigou Effect was not articulated until 1946. Moreover, with Keynes' view that the general price level tended to be rigid downward, the Pigou Effect would not have been relevant to Keynes. Finally, the empirical evidence suggests that while the Pigou Effect is an interesting theoretical substitute for the self-correcting mechanism of Say's Laws, its actual effect would be too small to move the economic system to a full employment equilibrium by itself. [Mayer, 1959; Tanner, 1970].

(12) For a more analytically rigorous framework of the impact of the change in the direction of causation introduced in the General Theory, see Johnson, Ley, Hoaas, and Thour, 1986.

(13) This simple flow diagram can easily be expanded to incorporate the role of market power and aggregate supply in the real goods market and the supply of labor in the labor market. Additionally, Keynes' theory of expectations, money demand, interest rate determination, and the level of ex ante investment can be easily included in the diagram.

(14) For example, Hayek's complaint was net with the focus on allocative efficiency, nor with the assumed norms of the competitive market model, but rather with the Marshallian comparatively static, partial equilibrium version of the neoclassical orthodoxy. After all, Hayek was an exponent of the Walrasian general equilibrium analysis [Laidler, pp. 3132, 36], and the Austrians, in general, focused on maximizing individual behavior and the incentives conveyed by market prices [Laidler, pp. 14, 32].

(15) For example, Wicksell's aim was to extend the quantity theory of money and connect it to the loanable funds theory by way of the relationship between the natural and the market rate of interest in defining monetary equilibrium [Laidler, p. 28].
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(16) While some of these writers advocated public expenditures, they did so while still adhering to the neoclassical paradigm, which provided no rationale for this type of government intervention in the economy [Johnson and Cate, 2002].

(17) The discussions and working papers on oligopoly eventually lead to the publications by Kahn [1937], Hall and Hitch [1939], and Sweezy [1939].

(18) While Keynes was aware of the effects of interdependence between markets, his discussion was presented in terms of the interdependencies between markets that had cleared in the face of price and wage rigidity. Thus, if there is an excess supply of labor relative to full employment in some markets, not only did involuntary unemployment exist in those markets in equilibrium, but the demand for a range of products will be less than they might have otherwise been, further discouraging employment opportunities elsewhere. This interdependence appears to be one of the insights upon which the multiplier analysis was developed.

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L. E. JOHNSON, * ROBERT D. LEY, * AND THOMAS CATE **

* Bemidji State University--U.S.A., **Northern Kentucky University--U.S.A. The authors would like to thank Cynthia Benzing, John Cochran, Francesco Saraceno, and Rabindra Chakraborty for their helpful suggestions.
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