The key lack of understanding (by economists, politicians, journalists, and businesspersons) in macroeconomics leading to misinterpretations and reactive blunders is the lack of understanding of the meaning of  general price changes.  The meaning is implicitly defined by the basic price-spread ratio.  The magnitude of the ratio is determined by rates of acceleration and rates of production and sale.  It is an operative functional meaning.  A comparison of Case 1 and Case 2 reveals how basic prices can increase in a surplus expansion.

In the perspective of microeconomics – repeat MICRO – the price of product A may rise more than the price of product B signaling a preference for A relative to B.  But in the distinctly different perspective of Functional Macroeconomic Dynamics, prices generally may rise as monetary demand outstrips physical supply for any good or bad reason.  The most frequent reason, but not the only reason, is the lag.  Outlays are being made to workers and devoted by workers to basic monetary demand before an increase of associated products becomes available.  More money is chasing the same quantity of goods. Increasing outlays are becoming increasing incomes directed to an unchanging quantity of products.

In the case of a small unit of enterprise producing a small amount of a new product on spec, the impact on prices generally is negligible.  But in a major long-term expansion of the whole economy – e.g. historical expansions associated with the development of railroads, automobiles, applied science, computers and software – in which the surplus level is, first,  making major outlays to increase its own capacity and then the basic level makes major expenditures to purchase the new and better technology to expand its own offerings, the magnitudes and the time lags are considerable.  Prices are bound to rise as major outlays are made in a major lag.

But these price increases must not be taken as a signal to invest beyond the technical constraints of the finitudes.  Such a misinterpretation is at the root of a future depression.

Now in any expansion it is inevitable that quantities under production run ahead of quantities sold.  Current production is with reference to future sales, and if there is an expansion, then future sales are going to be greater than current sales. But in the free economies the acceleration factors are not held down to the minimum that results from this consideration.  During the surplus expansion the basic price-spread ratio J will increase from an increase of R, of a”, and also of a’.  The advance of the price-spread ratio will work out through a rise of the basic price level, and selling prices generally will mount.  Now, when prices are rising and due to rise further, the thing to be done is to buy now when prices are low and sell later when they are high.  There results a large amount of liquid investment. Each producer orders more materials, more semifinished goods, more finished goods, than he would otherwise. Moreover, he makes this speculative addition to a future demand estimated upon current orders received, so that the further back in the production series any producer is, the greater [will be] the speculative element contained in the objective evidence of current orders received, the more rosy the estimate of future demand, and the greater the speculative element he adds to this estimate when he places orders with a producer still further back in the series. Thus an initial rise in prices sets going a speculative expansion that makes the acceleration factors quite notable, expands the price spread still more, and stimulates a pace of further acceleration that it will be quite impossible to maintain.  Etc. [CWL 15, 160]

Now it is true that our culture cannot be accused of mistaken ideas on pure surplus incomeas it has been defined in this essay; for on that precise topic it has no ideas whatever. [CWL 15, 153]

In addition, we note that there is pressure put on the banking system to provide excessive amounts of credit, which they tend to do so as not to contract the process. Credit expands rapidly.

(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

This monetary and absolute rise of prices in general must not be misinterpreted by a) entrepreneurs as a signal to expand beyond the technical norms and constraints into a boom requiring a subsequent corrective slump, and b) workers as a signal to demand higher fees, wages, and salaries.  Such would be “the fundamental lack of adaptation to the productive cycle that our economies have to overcome.

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)………(much) …….. 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 into a boom (which must be followed out of systematic necessity by a corrective and devastating slump).  This I believe is the fundamental lack of adaptation to the productive cycle that our economies have to overcome.  The problem, however, has many ramifications of which the most important is the relativity of the significance of profits (“pure surplus income”).  To this we now turn.  [CWL15, 139-140]

The rising prices of the surplus expansion – as a substantial part of investment outlays is used as income for the standard of living – must be understood as higher basic monetary demand for an as yet unchanged basic supply. “the basic price spread is to a greater or less extent a part of the social dividend [rate of saving] in an expanding economy.”

Surplus income as a macroeconomic concept … results from the functioning of an expanding economy. … The fact that people earning their living in the surplus circuit spend a notable part of it on consumer goods gives rise to the basic price spread. This price spread is the excess of basic receipts over basic costs.  In microeconomics it is interpreted as profit, … but in macroeconomics, which is aware of the need of a crossover balance for equilibrium, the basic price spread is to a greater or less extent a part of the social dividend [rate of saving] in an expanding economy. [CWL 15, 145]

By macroeconomic law, corrective depression follows excess prosperity: the Roaring 20’s was followed by the Great Depression; the irrationally exuberant boom of the late 1990’s (mistakenly called by some the Goldilocks Economy) was followed by the dot.com bust; the irrationally exuberant, excess credit-fuelled rise in housing prices of the early 2000s was followed by the Great Recession of 2009.[1]  Depression is not a mystery; it can be explained as a systematically necessary correction.

At the root of the depression lies a misinterpretation of the significance of pure surplus income. … [CWL 15, 152]

Some participants are less vulnerable to downturns in a depression than others.  This prolongs the depression.

Such relative invulnerability brings the circuits to a distorted quasi-equilibrium in which an artificial rate of pure surplus income is sustained by a rate of losses. … there is no compensating rate of new fixed investment to offset this drain [of artificial pure surplus income].  There results a negative value of (D”-s”I”) [as the less vulnerable direct money into the Redistributive Function] but the squeeze gives positive values to of (S” – s”O”) and particularly (S’-s’O’) as embarrassed entrepreneurs undergo [and must borrow to support] a continuous and equal stream of losses. … however the matter is expressed, the rate of losses has to equal the emergence of more surplus income than the process in the given interval is generating; and if at any time the rate of losses proves insufficient, the familiar mechanism of falling prices, decreases total income, and increased purchasing power comes into play either to decrease the rate of savings [of the less vulnerable] or to increase the rate of losses [of the more vulnerable]. … Any number of [the more vulnerable] firms may go bankrupt and be liquidated.  But until the position of the strong is undermined by the general and prolonged contracting, the requirement for the rate of losses continues, and with it the depression. [CWL 15, 154-55]

The distorted quasi-equilibrium of a depression, characterized by pure surplus incomes of some equaling offsetting losses by others, must be avoided by all incomes being properly spent in the appropriate circuits.  In particular, subsequent to capital expansion there should be an egalitarian shift in the distribution of income.

Even when a surplus expansion has not been excessive, failure to implement an egalitarian shift in income so as to implement the basic expansion will be the root of contractions and liquidations.

Lonergan’s point is that there is no automatic mechanism creating monetary boundary conditions for a shift into this final distribution and price system.  Attempts to persist in accumulation (of capital) stage (pure surplus) incomes would rather eventually be frustrated by the labour supply boundary condition…producers could only lay off workers to avoid a growing hoard of the new tool…Lonergan suggests we consider more cooperative solutions based on a collective understanding of his more sophisticated national income accounting which illustrates the full employment need to (increase basic incomes rather than) accumulation incomes which have lost their dynamic profit motivation. (i.e. now they are only sloshing back and forth for exchanges between stocks and bonds in the secondary markets doing nothing useful.) [Burley 1992-2, 278]

 [1]Gjerstad, Steven and Vernon J. Smith, From Bubble to Depression, Wall Street Journal, 4/6/2009 [Gjerstad and Smith 2009]  “In the last 40 years there were two other hosing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997., probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.  The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn.  When the Fed increased liquidity, money naturally flowed to the fastest expanding sector.  Both the Clinton and Bush administrations aggressively pursued the goal of expanding home ownership, so credit standards eroded.  Lenders and the investment banks that securitized mortgages used the rising home prices to justify loans to buyers with limited assets and income. … The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system.  It appears that we’re witnessing the second great consumer debt crash, the end of a massive consumption binge.”