Re Correcting Excess Investment, Inadequate Demand, and Inflated Pricing


The sanguinity of entrepreneurs and bankers, based upon a) a misinterpretation of systematic, scarcity-induced, price increases, and an underappreciation of technological finitudes, results in excess lending by the banking system, excess investment by the producer group, and excessive production and pricing of point-to-line capital goods. A normative rate of surplus expansion is converted into a boom to be followed by a systematically necessary corrective slump. (See Steven Gjerstad and Vernon L. Smith: From Bubble to Depression)

Previously I have suggested a lack of adaptation in the free economies to the requirements of the pure cycle.  What that lack is can now be stated.  It is an inability to distinguish between the significance of a relative and an absolute rise or fall of monetary prices.  A relative (i.e. “real”) rise or fall is, indeed, a signal for a relatively increased or reduced production (of one product relative to another) … Inversely, the rising prices of the surplus expansion are not real and relative but only monetary and absolute rising prices; to allow them to stimulate production is to convert the surplus expansion (of the ideal pure cycle) into a (trade cycle of) boom (which must be followed out of systematic necessity by a correlative and devastating slump).  This I believe is the fundamental lack of adaptation to the productive cycle that our economies have to overcome. [CWL15, 139-140]

In a surplus expansion, some of the increasing money in the point-to-line surplus circuit “leaks” from that investment circuit into the point-to-point basic circuit; thus, that demand for more and better consumer goods accelerates before their supply by more and better capital goods can be realized.

Thus, in the later parts of an overall expansion, the failure of basic income flows to keep pace with greater potential basic product flows constitutes inadequate demand.  This failure typically occurs after a substantial capital expansion.  The diagram below – Rate of Change of v, w, and f During a Pure Cycle, Ideal Maximum f – shows the course of the Pure Surplus Income Ratio

f = vw = vI”/(I’+I”) (CWL 15, 150)

Pure surplus income turns down and is systematically declining, but entrepreneurs seek to preserve the recent high rate of increase of pure surplus incomes when, in fact, the system is not producing pure surplus incomes at that higher rate; entrepreneurs fail to increase purchasing power among the groups who would purchase more and better consumer goods; demand is inadequate vis a vis the potential supply of consumer goods; the new capital and much old capital are idled or classified as scrap and written off; and when, subsequent to a surplus expansion, basic incomes should be increasing, contractions and layoffs by entrepreneurs decrease the systematically necessary basic income.

(In a capital expansion,) unless the quantity of money in circulation expands as rapidly as prices rise and, as well, as rapidly as the productive expansion of quantities requires, there will result a contraction of the process: then, instead of adjusting the rate of saving to the requirements of the productive cycle, the productive cycle is arrested to find adjustment to the rate of saving. [CWL 15, 135-37]

Two periods are to be distinguished subsequent to the maximum of f: a first period in which average pure surplus is decreasing though aggregate pure surplus continues to increase; and a second period, in which both average and aggregate pur surplus income are decreasing. … in any case, f, v, and ΣFiare reverting to zero, which they reach as dQ’, following dQ”, reaches zero. [CWL 15, 152]

Major responsibility for corrections of imbalances between productive capacity and monetary demand in the system mistakenly get placed in the hands of the ignorant and inadequately-tooled Fed.

The Fed attempts to stimulate the economy by the only weapons it has at its disposal, i.e. by reducing short-term interest rates, and by flooding money into the redistributive function through open-market purchases in the bond market.  The first action fixes the short-term interest-rate, i.e. the price of short-term money; the second action reduces intermediate and long-term interest rates, and it boosts the monetary demand for secondary bonds; but if the infusion does not reach productive workers who would consume more in the operative basic circuit, it tends only to inflate prices in the secondary markets.

In order to increase basic demand, there are actions which are more fundamental and more effective than manipulating interest rates or flooding the stock and bond markets with money.  Indeed the Fed gets saddled with responsibilities that belong to others and for which the Fed does not have effective tools.  The Fed should not force an even greater overexpansion, and the Fed itself does not pay wages and salaries directly to the nation’s productive consumers throughout the economic process

We may distinguish between a normative interest rate and a market rate.  The normative current interest rate is a determinate internal relation among current functional flows in the current, purely dynamic process.  It is not external to the operative economic process; it is an intrinsic relation among productive elements in the process.  It should not be misunderstood as a magic lever.  Being loose with metaphors: Manipulation of the interest rate is the infusion of a snake oil missing the wound and without regard for its curative properties or side-effects.  Indeed the snake oil may cause counterproductive and otherwise unfavorable direct or indirect side effects.  The out-of-sorts patient’s self-healing may be misunderstood and delayed, if not actually blocked by resulting contractions and layoffs.

Our concept of the normative macroeconomic interest rate is the monetary correlate of a productivity growth rate to be shared by risk-assuming investors according to the perceived and anticipated degrees of risk.  It is intrinsic to a system of interrelated, implicitly-defined functional flows of products and money.  And this system of flows exhibits an immanent intelligibility of which the normative interest rate is (merely) an internal relation, not a golden lever.

There follows a clarification of the problem of internal and external relations.  Relations are said to be internal when the concept of the relation is intrinsic to the concept of its base; they are external when the base remains essentially the same whether or not the relation accrues to it.  Thus if ‘mass’ is conceived as a quantity of matter and matter is conceived as whatever satisfies the Kantian scheme of providing a filling for the empty form of time, then the law of inverse squares is external to the notion of mass.  On the other hand, if masses are conceived as implicitly defined by their relations to one another and the law of inverse squares is the most fundamental of those relations, then the law is an internal relation, for the denial of the (law) would involve a change in the concept of mass. [CWL 3, 493/517]


If the current normative interest rate is conceived as a current relation in the immanent intelligibility of normative functional flows, including operative interest payments, implicitly-defined by their functional relations to one another, then the interest rate is an internal relation; for the denial of the interest rate’s defining formulation would involve a change in the explanatory concepts of both the current, purely dynamic process of interrelated flows implicitly defined by their functional relations to one another and that internally relational interest rate.  On the other hand, if the interest rate is considered to be an externally situated lever, and a lever is conceived as something filling the form of the mechanical advantage of fulcrum and lever, then the concept of the interest rate as a lever would be external to the notion of internal interrelated functional flows.

The Fed and its proponents and critics are stuck in the conceptual mud of the interest rate as a single-effect, magic lever to be operated from outside the system.  In reality any manipulation of the normative functional flows induced by open market operations will be double-edged, producing an imbalanced double effect.

The traditional doctrine of thrift and enterprise looked to the supply of and demand for money to adjust interest rates and the adjusted rates to adjust the rate of saving to the requirements of the productive process.  But it can be argued that a) this view was not sufficiently nuanced in its estimate of the requirements of the productive process, b) that it missed the magnitude of the problem, and c) that it tended to lump together quite different requirements. … [CWL 15, 140, ftnt. 197]

Though the adequate human adaptation to the demands of the process is conceived or explained as a shift of incomes, instead the inadequate strategy of variations of interest rates is “felt” to be the answer.  The Fed is charged to produce a correction with a double-edged, essentially counterproductive tool.

 (Functional Macroeconomic Dynamics’) account (of the monetary distributions scientifically distinguished as basic and surplus incomes) springs from a (scientific) characterization of possible types of productive rhythms which lead (in turn) to the (scientific) specification of the adequate human adaptation to the (intrinsically cyclical) demands of the process, and also to (an identification and) determination of inadequate strategies of adaptation such as variations of interest rates, varieties of taxation and monetary policy.  [McShane, 1980, 125]

Re a) the nuance:  The economic process is nuanced by phases with different requirements for income distribution. The process, as a process, advances, and its requirements for nuanced changes in income distribution change.

The requirements of an expanding productive process are that pure surplus income has to keep increasing in the surplus phase of an expansion, that it has to keep decreasing in the basic phase of the expansion, and that it vanishes when the cost of replacements and maintenance absorbs the whole of surplus. [CWL 15, 140, ftnt. 197]

Re b) the magnitude:

(in a surplus expansion,) it would take enormous interest rates backed by all propaganda techniques at our disposal to effect the negative values of dw(which symbolizes the propensity to consume of an income stratum i) that are required interval after interval as the surplus expansion proceeds; what is needed is something in the order of ‘incentives to save’ that is as rapid and as effective as the reduction of purchasing power by rising prices. … [CWL 15,  141-144]

Re c) the lumping together and treating a double edge as a single edge:

Higher interest rates increase short-term savings to a minor extent, but they damp large, long-term investment to a major extent.

The ineptitude of the procedure arises not only from its inadequacy to effect a redistribution of income of the magnitude required  … the effect of raising interest rates to encourage savings (for investment) is not to keep the rate of saving and the productive process in harmony as the expansion continues but simply (and counterproductively) to end the expansion by eliminating (by discouragingly higher charged interest costs) its long-term elements. [CWL 15,  141-144]

Savings vs. consumption require continuous adjustment depending on the particular current requirement of the current phase of the process.  A sound explanatory theory will reveal that it is not even the Fed’s responsibility to adjust savings vs. consumption.  Rather it is the responsibility of an enlightened government and free people of good will to voluntarily accept the adjustments of incomes required by the mechanism and to effect the adjustments.

Anyway, the Fed and its proponents and critics do not understand how the economic process really works and what is the most effective way to adjust savings.  And without a sound theory and accurate measurement of current Gross Domestic Functional Productive Flows, the Fed cannot know what are the current monetary requirements in the current phase of the process of production and exchange.

real analysis (is) identifying money with what money buys. … And that is the source of the problem in real analysis.  If you want to treat money that doesn’t make a difference, you can have a beautiful liberal monetary theory.  But it doesn’t say the way the thing works. [CWL 21, Editors’ Introduction, xxviii  quoting Lonergan]

The correction by adjustment of incomes is the responsibility of the fiscal authorities and private enterprise.  (See on this website Plain Precepts for Free People).

To increase the rate of saving (in a capital-goods-expansion phase), increase the income of the rich (who have a lower average propensity-to-consume percent). … to decrease the rate of saving (in a consumer-goods-expansion phase), increase the income of the poor (who have a higher average propensity-to-consume percent). … The foregoing is the fundamental mode of adjusting the rate of saving to the phases of the productive cycle.  It reveals that the surplus expansion is anti-egalitarian, … but it also reveals the basic expansion to be egalitarian, for that expansion postulates that increments go to low incomes … [CWL 15, 135-37]

Thus, there is nothing as practical as good theory.  A good theory is enlightening and useful. It explains the process and is a guide to its management.