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«ERRATUM Page 131, first line of the second paragraph should read: As inflation progresses, even the least inflation- conscious Pp,ge 172, last line ...»

-- [ Page 1 ] --


The propensity to work,

and not the propensity to spend,

is the foundation

of national income and wealth






Page 131, first line of the second paragraph should


As inflation progresses, even the least inflation- conscious

Pp,ge 172, last line of the second paragraph should read:

tious have to be liquidated. Over-speculation ends in df~flation.

Page 198, fifth line should read:

smaller part of total earnings was then distributed, expressing © Copyright 1956 by L. Albert Ha~n Library of Congress Catalog Number: 56-5919





As the English version! of this book goes to press the economy of the United States, as well as that of many European countries, has reached a state which can be described only as that· of a highly inflationary boom. All pertinent data-total investment, demand deposits, consumer credits and production

-show clearly a steep upward trend. And many characteristic signs of an overstressed economy, such as bottlenecks in employment and raw materials, backlogs for deliveries, exaggerated stockmarket booms, have made their appearance.

The inflationary ch;lracter of the American boom is now recognized by an increasing number of economists but is still denied by some. The main argument in support of the latter's opinion, and therefore of a laissez-faire, laissez-aller attitude, is based on the relative stability of the general price level in the United States.

The consumer price averages have indeed remained entirely, and the wholesale price averages almost, unchanged since

1953. However, the picture is very different when one examines the prices of the single groups of commodities upon which the price averages are based.. One sees immediately that the prices of industrial finished goods have risen substantially since 1953, and those of industrial goods, especially building materials, since 1954. These increases are offset in the price averages by the decline in agricultural prices. But this decline is.merely the result.of the liquidation of over-production during the World and Korean wars. Viewed from a quantity theoretical standpoint these lower prices appear to be due to a temporary over-supply from the side of goods; this, however, does not change but only conceals the over-demand from the money side. The price movements in the industrial sector alone show all the features of inflation. And this is decisive. For crises are nowadays-this should not be forgotten-industrial and not agricultural crises.

But apart. from this it seems very doubtful that much im- portanc

–  –  –

times of marked increases in productivity. Higher productivity without inflation leads to lower prices. If prices remain stable in spite of rapidly increasing productivity, this can be only the result of an inflationary credit expansion. Such a monetary inflation without, or with only little, price inflation is in principle not less dangerous than an inflation with strong price inflation. Whether inflation profits are the result of prices going up while costs lag, or of prices remaining stable while costs decline through an increase in productivity, a dynamic process is stimulated which is bound to end in crisis and depression-if for no other reason than because every stimulus must finally exhaust itself. 2 Was the present inflation unavoidable, or avoidable only at the cost of permanent unemployment? I do not believe so.

When, in 1953, the Republicans took over the administration they endeavored-successfuUy-to interrupt the inflationary post-war boom3 by the classical means of tightening money and credit. As a result unemployment had risen substantially by the end of the year. The Republican administration found itself faced with the dilemma of correcting this unemployment

-which was essentially a stabilization and not a deflation phenomenon4-through renewed inflation or through enforced adjustments of costs to the no longer permanently inflating price level. The administration chose-to the regret of conservative and to the satisfaction of Keynesian economists-the first method. As was easily predictable,5 unemployment disappeared, but at the price of continued inflation.

Recognizing the danger of inflation the authorities have, since the beginning of 1955, allowed the interest rates to go up somewhat. But the boom has not decreased and has even increased in vigor-see, for instance, the movement of prices for steel scrap and certain metals in 1955.

This is not surprising. For the measures adopted are adequate only for dampening but not for stopping inflation.

What the authorities are doing, in order to keep the economy See also pp. 127-128 and Appendix I, p. 223.

2 For a description of the period before 1953, see Appendix I, p. 220.

S For details see Appendix II, p. 233.

4 5 See my prognosis in June 1954, Appendix II, pp. 236-237.

vii FOREWORD running at a high level of production and employment, is to tighten the reins when inflation seems to be getting out of hand, and to loosen them-thus resorting again to inflationas soon as the boom appears to be weakening. One must concede that this policy of "leaning against the wind" is carried out with ability and-considering the strong political pressure in favor of inflation-with remarkable courage. But will this policy which is nevertheless one of inflation, even though that inflation is a slow and regulated one, succeed in the long run?

I doubt it. It is the tragedy of every boom created and carried forward by inflationary credit expansion that it never leads to stabilization but always to reaction.

Thus there is only the choice: either one tolerates further inflation, then the. boom continues until a saturation point of demand is reached-at that point a depression will inevitably set in, the more severe the longer the boom has lasted; or one stops inflation, then the reaction sets in immediately-a very unwelcome occurrence especially in an election year.

This whole paradoxical situation of the economies of the United States and of most Western countries is, I think, in the last analysis the logical consequence of an economic policy which in theQry overstresses the importance of effective demand for the attainment of (ull employment, and in practice recommends the correction of any sign of unemployment by more and more credit expansion, using for its justification the old purchasing power theory and all the other semi-scientific arguments advocated for centuries by inflationists.

The present" book is, from the first to the last word, nothing but an endeavor-perhaps inadequate-to demonstrate the theoretical shortcomings and the practical danger of this philosophy by stressing the importance of the supply of production factors for the maintenance of a high and stable level of economic activity.

My grateful acknowledgments are due to Mrs. Elizabeth Henderson of London and Rome, whose editing improved the English manuscript and purged it of a number of inconsistencies.


Paris, June 1956.


My book, The Economics of Illusion, published in 19491, was essentially a critique of the late Lord Keynes' General Theory of Employment, Interest and Money. My conclusion was, briefly, that what is new in Keynes' work is not good, and what is good is not new.

Since then I have often been asked to add to my negative critique of Keynes' theory the positive exposition of an economic theory which offered a more correct explanation and description of economic reality. The present book is my answer to this request. I have called it Common Sense Economics in contrast to Keynes' theory, which I regard as illusion economics since its underlying factual assumptions seem to me to rest on illusion.

I approached this work with mixed feelings. On the one hand, I was fully aware of the fact that professional economists have more experience and a better technique in the exposition of economic relationships than a person whose main activity has consisted in making business decisions. On the other hand, I had long been tempted to try, at some time, to describe the economic model which I myself, after more than thirty years of activity in economic theory and practice, regard as adequate because close to reality. Also, I have often asked myself how I would rewrite today my Economic Theory of Bank Credit, which first appeared thirty-five years ago.

The arrangement of the present volume is in deliberate contradiction to that usual nowadays, particularly in English and American literature, foUowingKeynes' General Theory.

In my view, the. Keynesian theory is original, but also fatal in its peculiar, almost paradoxical, decisions as to what is to be regarded as constant and what as variable in the economy.

The workers' nominal wage demands, for instance, are 1 Squier Publishing Co., New York, distributed through New York Institute of Finance.

viii ix


assumed to be relatively constant, while aggregate purchasing power is assumed to be continuously fluctuating and the economy therefore continuously exposed to inflation and deflation. The ensuing picture of the economy appears to the nonKeynesian as a sort of trick film. Everything happens in a manner that is exactly the opposite of what he is used to~ It is no longer the supply of labor, but the propensity to consume which determines the volume of production; the old and oftrefuted under-consumption theories-of which Keynes' theory is no more than a replica-once more become respectable. I am firmly convinced that this allegedly revolutionary progress in economic science is really retrogression compared to classical economics. The long-run economic forces, such as the propensity to work, are.completely eclipsed by less important factors, such as the propensity to consume; and, notwithstanding occasional assurances to the contrary, Keynes' theory, as a general theory~ also purports to be a theory of secular developments. Nor does Keynes provide a satisfactory theory of short-run developments, and in particular no business cycle theory. There is no explanation of the dynamics of the cycle, and such indications as are given-note· for instance the under-employment equilibrium which allegedly comes about when savings become excessive and which disappears when savings contract-are unrealistic and untrue.

The present work tries to avoid the dangers of overestimating the importance of "effective demand." To this purpose it starts, in an old-fashioned manner, with the description of a stationary economy, i.e. one which ever repeats itself without any changes in data. Next comes the description of a changing economy, in which, however-and this, too, is decisively old-fashioned-the monetary system is assumed to be entirely inelastic. Here new credits are granted only to the extent of new savings. Such a monetary system is presupposed in order to demonstrate the changes occurring in the economy when changes from the money side are eliminated. The next section, on the contrary, is concerned with an economy with an elastic monetary system, that is an economy where inflationary credit expansion and deflationary credit contraction


are possible. The business cycle is then treated as a special case of the economy in inflation and deflation. Finally, Part V is a substantially unaltered reproduction of a lecture given in 1952, in which I examined the laws of price formation on the stock markets, on the basis of developments on the New York Exchange during the last twenty-five years.

Part I begins with a description of the Robinson Crusoe economy. This ·may appear superfluous or elementary to the professional economist. I included it, first because the principles which I consider essential are most clearly seen in the case of the isolated producer; second because in publishing this book I had also a secondary purpose in mind: it is meant as a sort of minimum economics for the business man, banker and investor who is interested in theory. For this reason I have also included, at the end of each section, some practical conclusions with regard to stock prices.

I know, of course, that theoretical knowledge is despised by many practical business men. I can only say, in justification of my secondary purpose, that on the few occasions I have been successful in my own business life I have been so not because of any superior practical ability, but simply because my studies of monetary and business cycle theory had disclosed to me earlier than to many others the consequences of the initially inflationary and later deflationary monetary and credit policies of European governments.

I would like, however, to add a word of warning. Although I consider a knowledge of the fundamentals of economics essential for any business and investment management, I do not consider it sufficient for success. Our economy is.subject to constant changes. These changes, whether ·they are technical, legal, institutional, political, or simply in consumer taste, are uncertain and as unforeseeable as is the whole future.

Business men and investors have to judge the relative strength of the forces that· will bring about future changes and adjust their dispositions accordingly. In· order to do so they will have to draw upon everything they have ever read, thought, or experienced. Even so they will often be wrong. In no case, however, can future change be predicted scientifically.



Therefore, business and especially investment management is an art and not a science, and the concept of scientific method of investment is nonsensical.

As regards my method of presentation, I would like to make the following remarks.

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