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Policies for Globally Sustainable Common Wealth

Po l i c i e s for Globally S u st a i n a b l e
Common We a l t h

Is there tech n o l ogical unemployment? 4

The Big Picture: How the labor market is cleared 7
A Puzzle involving Stock Prices 8
L ow Pro d u c t ivity Equilibria 16
L abor and its Rewa rd 19
There is no Free Lunch - or is there? 29
The Island of Yam 32
H ow to Pay for the War 35
An Introduction to Money 43
The Creation of Money, and its relation to Government Debt 46
The money multiplier 49
The Monetarist Policy Experiment and Conclusions 52
A Synopsis of the Economy as a Whole 58
International Aspects 62
A Very Short Economic History 67
A Distant Mirror - Aristotle 76
Outlook 80
Pragmatic-Capitalist Solution of the Pro blem of Underproduction 83
Economics for the Good Life 85
B i bl i og raphy 89
Appendix on Miscellanious Economic Trivia 91
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I n tro

At the beginning of the 21st century economic themes again (or shall we say: still?) domi-
nate the broader socio-political issues. Not too far off the world’s population will presum-
ably peak at around 9-10 billion, implying more of the severe ecological problems we
already face. It’s not that we lack the technology, it’s just that it would be somewhat more
expensive in the short term to implement it (the long term bill being footed by our chil-
dren anyway, so what the heck).
But our old, still affluent societies are mined by a creeping economic decline: Good, well
2 paid, secure jobs have become much harder to come by than 30 years ago. The average
American household weighs in 1000+ hours of work per year more than in 1960s (Juliet
Schor, The Overworked American) to make ends meet. Juggling two low-paid, under-pro-
ductive jobs may be followed by extended spells of unemployment. Countries with
halfway reliable unemployment statistics (the US isn’t one of them) show a steadily rising
base level of long term unemployment, which I will henceforth call structural unemploy-
ment - as being deeply ingrained in economic structure. Is this an inevitable by-product of
globalization, i.e. outsourcing production from high to low wage countries? With global
competition enforcing a merciless race to the bottom of wages?
Will we soon be either unemployed or find ourselves working in a sweatshop?
Is this process enhanced by replacing human labor with machinery?
Some have argued that the transformation to a plutonomy 1 - an economy domineered by
the rich, while the others are inexorably sucked into a pervasive underclass - is already well
under way. Is all of this inevitable, or can we do something about it? And if so, what?
Even the partial booms which enliven the OECD-countries seem to be built on the shifting
grounds of credit and finance; could they evaporate overnight? And we are left with the
bills, but no job? Recall that during the Asia-crisis (1998) nearly half the financial wealth
of whole continents got wiped out within days; whence did it come, where did it go?
The very sluggish take-off after this crisis, and of the post-socialist economies in general
is not compatible with the rose-colored visions of most economists, our modern Can-
dides: Many predicted a future of bounty after overcoming socialism; after all, the people
T In a round letter on equity strategy from Citibank (not known for ideological pro p a ganda) in 2005.
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in these countries had to equip themselves with all the new consumer goodies. Well, it
didn’t happen. It’s in the nature of poverty that it’s not the wants and desires which are
lacking, - it is something else.
The discourse of neo-liberal economics which dominates the world - in a nutshell that all
will be great, at least as good as it gets, certainly much, much better than the past, and
that everyone will win - is not borne out by the facts.
And I’ll add a last question to the list; an issue which people working in science, or well-
read humanists, may conjecture as well: Is economics a science through and through - or
do we not encounter, behind the neat equations, a residue with the poignant smell of ide-
These are the kinds of guiding questions, defining a problematic situation for which we
seek a solution. To get there we will need to cover some economic theory at the beginning.
But take heart; just as Wittgenstein used to say that there is nothing hidden in philosophy,
there is also nothing in economics that would not be ultimately amenable to common
sense, and be accessible to the layman’s judgment.
Questions of economic order ultimately affect everyone, and it is in our interest to look
closely when old arguments are resurrected from the grave of history that were used in the
19th century against soup kitchens and social security (which, by the way, was suggested
already in the 17th century by Leibniz).
And one last word; A solution must be recognizable as such to be one - it must fit the facts 3
much better than any competing accounts, and there must be no space at all for nagging
doubt after the explanation. The explanation must satisfy.
So, expect a lot. But we better get onto the case lest it becomes cold; enjoy!
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Is there technological unemployment?

The proposition that the increased usage of machines would crowd out the work-force goes
back at least to David Ricardo (On Machinery, chapter 31 of his Principles). It spells out
the intuitive apprehension of the working man, about to be replaced by the machine.
These occurrences are more dramatic, and more visible, than a potential opening of new
positions in other regions of the economy.
If, in a factory, due to some technical innovation, the same output can be maintained with
half the workforce; what hinders the now laid off 50 % to found the same factory in the
4 vicinity, such that, in the economy twice the output is produced?
Only a missing effective demand for the additional product.
Theories of “The End of Work” are in effect theories of underconsumption - missing
effective (i.e. effectively backed up by purchasing power) demand. Unemployment due to
technical innovations is strictly equivalent to unemployment due to other causes, say an
economic recession, and can be cured in the same way. Following Gertrude, we may say
Unemployment is Unemployment is Unemployment.

However there are good reasons why technical progress leads not to less, but rather to
more employment. Entirely new products and pursuits are created, and along with them
new needs and industries arise - think of the automobile, which requires a whole infra-
structure of roads, petrol-stations, petroleum to fill them up etc.
Technical progress deepens the economic structure: On the more basal strata like agricul-
ture, new layers of economic activities are sedimented, which, through their need for
mutual input, support each other. The analogy to an ecosystem is to the point: The exu-
berant vegetation of the evergreen rain-forests towers above a thin crust of relatively infer-
tile topsoil; it is the biomass itself which is the nutritional basis for its own continuous
transformation. Fell the trees and no such vegetation will be possible for a long time.
Employment does not come from a, say geographically or otherwise given stratum, like
natural resources2, but from all those human pursuits which are possible.
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And how does it look empirically - did leisure and idleness keep increasing since the Stone
Age, when life was just endless toil and trouble? And then how we have brought things on
at last to such a splendid height?3
The anthropologist Marvin Harris compares the working schedules by sex of three soci-
eties: The Kung San, hunters and gatherers, work the least - 20 hours per week, the same
for both sexes; but they are well-fed and attain old age. Among the Machiguenga, slash-
and-burn-farmers in the Andes of Eastern Peru, men work 6, women 7.4 hours per day. In
Kali Loro, a community in Java practicing irrigated rice-farming - hence technologically
the most advanced - men work 8.37, and women 10.37 hours per day.
Now we are slowly getting near the timetables of employees in our own, industrialized
societies: To the 8 hour day add 1 hour commuting, half an hour shopping, half an hour
cooking, half an hour household chores, and half an hour childcare, on average. Harris
conjectures that this is actually an underestimation for typical Americans, and so would I.
As mentioned in the introduction, the operating expense in terms of working-hours of
the average 4-person-household has actually increased by more than 1000 hours per year
even since the 1960s.

4. 5
Hence it is not so that since the days of the flint-stones, along with developing technology,
a grinding boredom would have set in for humanity - so that by now we have no choice but
to lie there in chagrin and stare at the ceiling. That would be a strange thing to surmise,
on reflection. At the dawn of the 19th century, when steam-power was about to revolution-
ize industry, the world still looked much the same as in the many centuries preceding it.
More than 80 % of the people worked in agriculture, the others were mostly busy with
the production of basic necessities like accommodation, clothes, etc. Back then people
could simply not imagine what these masses should just do when for example textile pro-
duction became more efficient due to mechanization. In hindsight these worries seem
innocuously naive. Christ, even the cinema was not invented back then!
With the recent arrival of the new media, which provide for more active content creation,
and the obviously labor intensive input they need to keep going, the fear of boredom has
abated somewhat in the 21st century. Do you think that in a 1000 years from now, people
will do... nothing? Apart from there being other pleasurable pursuits beside work, and we
would think only in terms of a market-based mode of mutual service provision, we recog-
nize that the production of basic necessities may become a smaller and smaller part of
economic activities. Already right now, the larger part of the added value of about any
product which encapsulates some basic necessity, say transportation, or food, is constitut-
ed by a component having to do much more with design and lifestyle rather than their
underlying. By extrapolating the current trend a bit more, it is not improbable to antici-
Think of Japan – scarcely much in the way of natural resources, lots of t e ch n o l ogy and automated pro d uction,
but also lots of employment.

Quote from J.W. Goethe, Faust I.
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pate that just as agricultural products occupy less than 3 % of the work-force, in the more
distant future 95 % of the people will work in lifestyle-oriented services which may com-
prise a mixture of wellness, enter- and infotainment, recreation, research, organize games,
parties or dinners, sport, bionic design, nano-mechanics, art and what have you.

At any rate it should be clear by now that it’s not that the problem endless toil on one
side, and un- and underemployment4 on the other is fate, or there being nothing to do per
se, but rather that the economic system distributes tasks in an inefficient manner not con-
ducive to using the full human potential. This is what will be investigated subsequently.

Unemployment is for states wh i ch have social security; the phenomenon manifests itself as underemployment
in states without or with low social security. Underemployment is the non-efficient usage of human wo rk .
Think of low wa ge service jobs – the wo rking poor - in industrialized countries, or 3rd wo rld countries with
people walking miles just to fe t ch wa t e r, or selling single cigarettes on the streets etc. Surely the time could be
better employed by using at least a mule, or going to school.
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The Big Picture: How the labor market is cleare d

In the face of unemployment, the typically proposed remedy by neo-liberal economists is

for wages to fall. This argument is plausible on a micro-scale: If labor gets cheaper, firms
may want to hire some more staff, provided they can sell at least the same as before. But
can they? The counterargument from the unions’ side would be: Less in the workers pock-
ets means less demand for the firms’ output. Who then is right?
Sargent (1979, p. 44) nicely sums up the mechanisms involved in what he calls the classical
model: “In the classical model the level of employment is determined in the labor market.
The assumption of perfectly flexible money wages and prices implies that the labor mar-
ket ‘clears’, a real wage being determined at which the quantity of labor demanded by
firms exactly equals that which workers are willing to supply. There can be no involuntary
unemployment since the volume of employment is always equal to the labor supply forth-
coming at the prevailing real wage. Everyone who wants to work at the existing real wage is
employed. If for some reason unemployment were to emerge because of deficient aggre-
gate demand, the unemployed workers would bid down the money wage. Since firms are
competitive, this would lead in the first instance to proportionate reductions in the price
level, which would in itself leave the real wage unchanged and do nothing to alleviate
unemployment. But the reduction in the price level would increase the supply of real bal-
ances, causing the interest rate to fall. That would increase the level of aggregate demand
for goods and services and cause the level of employment to rise. [...] The interest rate
plays the role of totally alleviating any ‘Keynesian’ problems of deficient aggregate
So, in short we could say: The labor market is cleared by the capital market. This is the
crucial adjustment mechanism, also for things that have on the face of it little to do with
it, like employment.
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A Puzzle involving Stock Prices

In the preceding section the interest rate emerged as a central parameter in the economy.
Even though most people encounter interest rates in practice, especially when they enter
into a mortgage, the overall, macroeconomic picture of interest rates may remain some-
what fuzzy and arcane for the layman. Fortunately there is actually a very simple and very
intuitive way to look at them (first explored by James Tobin in his q-Theory). Let’s start
by considering an eternal bond. This is a security which pays off say 10 $ per year, for
ever. That it pays forever is less unusual than it may seem. A stock is a quite similar invest-
8 ment, which pays a dividend, also forever (if the company doesn’t go bust). The dividend
is in the real world somewhat uncertain; on the other hand there are analysts which pub-
lish estimates for years ahead, for free, at the discount broker of your choice. Also if you
diversify investments, you can eliminate much of the risk - one company may go bust, but
another one may be spectacularly successful. Forthwith we shall abstract from issues of
uncertainty, which means we also largely abstract from business cycles; yes, they exist, at
least during certain periods, but they won’t be our focus. We will focus exclusively on long
term equilibrium positions.
If the bond mentioned above would have a market value of 100, that wold be equivalent to
saying: the interest rate is 10 %. If the interest rate goes to 5 %, the bond would be worth
200: It still pays 10 $ per year, and at the lower interest rate, people are ready to pay 200 $
for this cash flow. Now imagine the bond is a stock with a certain dividend of 10 $ (we roll
together all types of investment vehicles into a single composite one).
The stock was issued when the company was founded just a short while ago. When it was
floated at the stock exchange we suppose the issue price - what investors were willing to
pay (being cautious) - was exactly what the investment goods within the firm were worth.
The market value of the company is just the market value of all its net assets (net of
debt): the real estate, the vehicle fleet etc., minus the debt. If the company would go out
of business tomorrow, the investors would still get all their money back, when the compa-
ny’s assets are sold - certainly an assuaging thought. This net asset value can also be called
book value.
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Now interest rates go from 10 % to 5 %, and thereby the price of the stock from 100 to
200 $. Something interesting has now happened: The market value is now double the book
or net asset value. It would cost say 100 million to set up such a company; so its reproduc -
tion cost is 100m (m=million) $, but its market value 200m $. Would this be a long term
equilibrium value? One would think that this would induce lots of entrepreneurial types
to enter the market and set up such a firm, just to sell it on the stock exchange. On the
other hand it’s not that easy to build up a firm from scratch, and it will take time. If some
years down the line the premium over market value has vanished, one may be in big trou-
ble. So this is not really realistic. But surely the managers of the existing firms - who are
certainly in the position right now to do so - would expand them; at least somewhat; and if
the favorable conditions persist, somewhat more. Conveniently, they are also in a position
to lock in the now lower borrowing terms of 5 % right now, with their bank, for the next
decades ahead if they want. If we assume that their firm has a permanently secure profit
rate of 10 %, this looks like a good idea indeed, and the scene is set for an economic
expansion driven by a boom of investment spending.

What we just sketched was in fact already the essence of Tobin’s so-called q-theory. The
letter q stands just for market value in relation to reproduction or replacement cost, or 9
book value. In the above example 2 $ market value per each 1 $ book value (q is 2). We
can formulate Tobin’s intuition in terms of market values: When the market value, the
financial value of a firm is above its reproduction cost, investment will happen.
Just as well we can formulate the same in terms of interest rates. We said above the divi-
dend per stock is 10 $. One stock costs 100 $ in terms of real outlays to set up, so the
internal rate of return of the firm is 10 %. The market rate of return or interest is, as
above, now 5 %. So if the firm can borrow money readily from the market at 5 %, but
investing it get a return of 10 %, it will certainly start to invest, and build up capacity.
Here are two quotes from Tobin himself, in which he expresses what we just said, also
once in terms of market values, and once in terms of interest rates.
Tobin and Brainard (1990) state: “If [capital] stock adjustment, no matter how large, costs
neither time nor resources, actual and desired [capital] stocks will always be equal. Arbi-
trage via real investment would keep q continuously at 1.”
Tobin expressed the same idea in his Nobel-lecture 1981: “The aggregate stock of capital
at any time consists of all surviving durable or storable goods, previously produced or
imported but not consumed. These stocks are valued continuously in markets for the
goods themselves (realistic examples are used vehicles and machinery, and existing resi-
dences and other buildings) and in markets for corporate securities or for entire business-
es. These market valuations of old capital goods typically differ, up or down, from their
replacement costs, i.e., from the costs of producing, and installing at a normal pace, new
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capital goods of the same type. These deviations are, in turn, the incentives for rates of
investment faster or slower than normal. When equity markets place high values on capital
goods, the margin above replacement cost induces investors to speed up capital accumula-
tion. This inducement is essentially what the great Swedish economist Knut Wicksell
ascribed to a natural rate of interest higher than the market interest rate.” The natural
rate of interest in our case would be the profit rate of the firms, the return on real, entre-
preneurial investments. And a bit further: “q is the ratio of market valuation of capital
goods to normal replacement cost at time period t. Its normal value is 1.”
In an earlier publication (1969), he goes as far as making real investment dependent on q
only: “The rate of investment - the speed at which investors wish to increase the capital
stock - should be related, if to anything, to q, the value of capital relative to its replace-
ment cost”.
Let us state again where we are here: We want to get an understanding of how interest
rates or q work, because this is really important. Once we have understood that, we can
move on to non-technical themes. The above casts rates in a very appealing and intuitively
understandable form: So long as something is financially worth more than it really costs,
there will be real investment, until this difference disappears.
Until now I shouldn’t have lost anyone, and it doesn’t get much harder than that, but you
will have to be alert and tread carefully for the next few pages.
10 We will zoom in on the economy and look at 3 cases: The case of a private investor; the
case of additional real investment of the firm financed by private investors (IPO=Initial
Public Offering); and that of an owner-entrepreneur, who can finance it out of her pock-

The Private Investo r

Say you, as a private, hard-working individual decide to save this year the amount of 5000
$. A car company you are interested in has an operating return of 10 %; but their compa-
ny stock price is so dear, namely 200 $, such that your return is only 5 %. Unfortunately
there is no alternative for you to buying the company stock. You cannot, for instance, act
as a car manufacturer this year in the volume of 5,000 $. This is obviously absurd. The
‘work’ of the financial investor is something completely distinct from the work of an
entrepreneur. You would like a return of 10 % much better, but you do not have access to

Initial Public Of ferings

An Initial Public Offering is when a firm wants to undertake some investment and sells
directly shares to the public in order to get the money for the investment from them. This
is where the sphere of the private investor sort of mingles with the real sphere of the
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firm. And one may conjecture that there is somehow a contradiction between the two co-
existing returns of 5 % and 10 % respectively. So lets look at how this works.
We suppose the firm consists financially of 1m shares; the book value is 100m $. Each
share has a dividend of 10 $, hence at reigning interest rates of 5 % each share costs 200
$. Say the firm doubles in size and undertakes another investment of 100m $, which it
now needs from the public.
How many shares will now be sold, and at which price?
The answer is: 333,333 new shares at price 300 $. That brings in the 100m $ needed; the
new investors own only 25 % of the firm and therefore get a quarter of its profits, which
is 5m $; they had to pay 100m $ to get the annual cash flow of 5m $, so their return is 5%.
Conclusion so far: There is no erosion, or any convergence effect of the spread between
operating return and financial return. The transactions in the financial sphere are settled
at current market conditions in the financial sphere only, and the operational, real invest-
ments rake in the operational return, here 10 %. It’s not that they are somehow more
risky in any way, they are just a different kind of business. When stocks are sold initially
the dependent, equilibrating parameter is the premium over book value which the finan-
cial investors have to pay. It is interesting to note that in older times, the book value was
written on the share, so it would have said in the above example: This share represents 150
$ worth of our
company, and in the IPO-prospectus - but we sell it to you for 300 $. Hmmm; since quite 11
some time already this practice was discontinued, because it is obviously hard to communicate.
The little vagaries of finance.

O w n e r- E n t r e pr e n e u r s

The previous, more pedagogical examples have confirmed something we really know,
namely that private financial investors are not entrepreneurs and must content themselves
with the financial return no matter what.
We now look at it from the lofty height of the CEO of the company.
First let us realistically take into account that effective demand for the firm’s output is
limited; the firm cannot sell just any amount of product it may want at the current price.
If demand for the product is limited, then it becomes immediately clear that Tobin’s con-
dition from above is no longer sufficient. The current value of my firm is now 200m $,
and it cost me 100m $ to set it up, nice. But since I cannot sell any more than currently,
the added value of any additional $ invested is nil.
It may or may not be worthwhile to substitute some labour with machines, and keep out-
put constant, because I can lease the machines now cheaply at 5 % (so called substitution
effect), but that doesn’t change anything fundamental, apart from there being a few more
jobless, and the profit-rate is still towering above the financial rate5.

If there is some substitution of labour by capital, the profit rate would, at least according to typical assumptions of
economics, have to be slightly lower than 10 %; those interested can refer to the appendix.
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Demand is one side of the equation, price the other. We distinguish 2 possible cases:
1. Products of the firms are strictly identical (homogeneous products in economic speak);
and 2. (you guessed it): they are not identical, they are different - aka differentiated
Case 1: If products are strictly the same (well we know in reality they aren’t, but it is use-
ful to analyse this as an extreme case), then that means that if I lower my price by just 1
cent, from 10 $ to 9.99 $, everyone in the whole economy would want to buy only from
me, so that all my competitors would go bust. This comes in handy, plus I sell for not
much less than before, and will still be able to turn every 1 $ invested into almost 2 $
financial market value. Whilst I draft the prospectus for my IPO, one of my competitors
reduces her price to 9.98 $; and then the next one to 9.97, and so on...
The end-result would be that the price would fall so quickly, and obliterate all potential
profits before anyone could break ground with a spade. The end-result will indeed be that
financial value equals construction value of any firm, yet not due to any new investments,
but the constriction of profit margins by a fall in goods’ prices.
That products are homogeneous is also what Sargent presupposes in the classical model
Case 2: Whilst there are some products which are pretty much alike, the vast majority of
products is differentiated. There are brands, copyrights, different designs, technologies.
12 The manufacturer of a branded product will typically sell somewhat more of it if he low-
ers the price, but he won’t capture the whole market. If Bentley will lower their prices by
5 %, they will likely sell more units, but not everyone will then drive a Bentley.
They sell some more, but the price is now lower for all units sold. Is it worth their while to
do so? The answer is: It depends.
It depends on two things. If it were the case that, if I lower my price by say 1 %, I sell
1000 % more, then this looks promising. So for one it will depend on what is called price
elasticity of demand: All this means is that if I lower the price by 1 %, how much more
% output can I sell? So in this case this elasticity would be 1000, good. But wait; what if
my profit margin per unit sold was just 1 %? One piece cost me 99, and I used to sell it
for 100. A price of 99 would obliterate all my profits! No matter how many I would sell,
lowering my price is clearly not a good idea.
Consequently what happens depends on two parameters: The price elasticity of demand
and the sales-margin. In the economy there may be different kinds of businesses, some
with a high sales-margin and a low output (luxury brands), and mass products with low
margins, but high turn-over (discounters), and of course anything in between. The follow-
ing little table provides sales-margins in a realistic range, and for each sales-margin the
break-even elasticity, meaning if you lower the price by 1 % how much more in % terms
would you have to sell so that you come out at least even:
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Salesmargin Minimum Elasticity to break even

2% 100
5% 25
9% 11.1
15% 7.2
35% 2.9

If for instance we take the 2nd line: The sales-margin is 5 %; if I lower the price by 1 %
I would have to sell a full 25 % more than before, just to break even.
So far we have presented the theoretical side. We still have to look at the empirical side.
One long term study6 finds - for the British industry - a price elasticity of demand of 1.58.
That is not much, it didn’t even make it into our table.
Let’s be more generous and take as a benchmark something that - as a product - is as
homogeneous as possible; this will give us a maximal elasticity. How about petrol? As sold
in filling stations to automobilists. They are by definition mobile, and can take advantage
of a good opportunity should it come by; and petrol has always the same quality, so they
needn’t think twice; a very thorough study (Barron etal. 2002) finds an elasticity of 3.
Now to the other item in the equation: the return on sales. What is the average return on
sales in the economy? Here is an overview of the return on sales of the bigger, internation-
al corporations from 1999 by country:

in Percentage

Schiantarelli and Georgoutsos (1990).
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Even the for firms most profitable country, Finland, with a sales-margin of almost 9 % is
in a range where the elasticity would have to be over 11 to just start making price-reduc-
tions profitable! However, anything above 3 would be totally unrealistic.

The conclusion is that in all OECD economies sales-margins and elasticities are firmly
within a range which rule out price reductions. There is no reduction in price, hence firms
also won’t sell more, hence there is no investment happening in order to produce more, no
matter how high the stock price.

This implies that there is no tendency of q to 1. Or, in other words, the interest rate trans -
mission mechanism is inoperative . Rates can go low, and the multiple q - which says how
much 1 $ of real investment in the firm (book value) is worth in the financial market - can
climb higher and higher without much happening. The only thing which will happen is
that installing capital becomes cheaper for firms if interest rates go lower; so they will lay
off some staff and replace them with machinery wherever possible, but they will not try to
sell more overall because that would presuppose price-reductions which they are not will-
ing to make.
If you compare it to the Sargent-quote above you will realise that this result is now totally
different, and it has massive implications.
We will get to them in a minute; in order to make it more palpable here is a little overview
of the key parameters in question. We start out with a profit rate or return on capital of
16.5 % of the firms.

Capital Workforce Return of Capital Interest Rate Share Price Q Market value Profit
of firm

unchanged unchanged 16.50% 10% 1.65 290,273,000 29,027,300

unchanged unchanged 16.50% 5% 3.30 580,546,000 29,027,300

unchanged unchanged 16.50% 2% 8.25 1,451,365,000 29,027,300

Since it is not worth lowering prices and selling more, the price, the produced quantity
and the profit stay exactly were they are. This profit becomes more and more valuable the
lower interest rates get.

You can visualize this in the table in the appendix where a few other features are dis-
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cussed. The main thing to keep in mind is that output doesn’t move because products are
differentiated and sales-margin and price-elasticity are in a certain range, and that by a
long shot. Henceforth I will refer to this mostly by the shorthand products are differentiat-
ed, but I mean the whole sentence, so add it in yourself.

We know that for the Neo-Keynesian Tobin the long term equilibrium value of q is 1, or
that the market price of invested capital is equal to its replacement cost.
It is fair to say that all macroeconomic models of the classical type would be fully in
agreement with this, so we do not need to review monetarism, neo- and new-classical eco-
nomics etc.

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Low Productivity E q u i l i b r i a

The classical model has a starkly simple, but useful inbuilt monetary theory which we will
adopt as well, the simple quantity theory of money. If we have 100 gold coins per period
circulating in an economy, and they mediate the transfers of 100 loafs of bread, then 1
coin buys 1 loaf. The transfers are thought of as happening independently, or let’s say
anyway. If people bake only 80 loafs they will exchange for 1.25 coins each in the next
Since the classical model does not know any permanent departure of the market value of
16 capital from its cost, and since capital goods are also just goods, in it the quantity of
money is proportionate to the quantity of goods at their respective prices. If the quantity
of goods is our given, as just said, the quantity of money is proportionate to the goods
price level.
If goods are differentiated, we may very well have a permanent premium of market value
over book value. The invested capital has hence a permanently higher paper-value as com-
pared to Tobin’s case. The capital is securitised in shares. These shares are transferred
from one person to another: Typically, the younger generation would save by accumulating
shares; and when older they finance their retirement by drawing down on the shares. Share
transfers are, if we stick to the really long term, intergenerational transfers. Share-trans-
fers are as real and necessary transfers as goods transfers are; nobody denies that, nor
would the classical quantity theory of money. We assume per period the same quantity in
terms of numbers of shares changes hands.
So if we plug differentiated products in the classical theory above we get the following.
Assume for some reason people become more pessimistic toward the future; they will con-
sume less and save more now. Saving more means there is more demand for the shares,
and less demand for the goods. The shares will rise in price (=interest rates go down). Less
goods circulate in the goods sector, so less money is needed for their mediation. The num-
ber of shares total in the economy has remained the same, and so has the number of them
exchanged per period, from old to young. Since their prices have risen, more money is
needed for their mediation. Interest rates have gone down, and market valuations of firms
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may be way above construction cost, but that alone doesn’t mean there is any net invest-
On the contrary, the firms will cut down investment to adjust to the lower demand of
goods. This may be offset more or less (that depends on the exact parameters and prices in
the economy) by the substitution effect (substitute labour with capital at constant output).
Contrariwise to the case of homogeneous products, in the case of differentiated products
prices do not fall, even though firms of course are in full competition with each other.
Both the scaling down of investment and the substitution effect work in the same direc-
tion vis-a-vis employment: it is scaled down, and substituted by machines.
Since the workers are in competition with each other to get jobs, and jobs have become
less, this presumably means that they’ll underbid themselves to get those jobs, hence
wages will fall. Now there are two possibilities. Let us for now follow Sargent’s model here:
Since firms are competitive, this would lead in the first instance to proportionate reduc-
tions in the price level, which would in itself leave the real wage unchanged and do
nothing to alleviate unemployment. But the reduction in the price level would increase
the supply of real balances, causing the interest rate to fall. That would increase the
level of aggregate demand for goods and services and cause the level of employment to
rise.” Stop. Rewind the last step. The last step will not occur in our context. The interest
rate will fall, but that will do nothing or little to raise demand for goods; goods prices
remain where they are. 17
Goods prices fall in Sargent’s case of the classical model only because goods are homoge-
neous (remember the successive price cuts from 10 $ to 9.99 $ to 9.98... from above?).
With product differentiation we get this: Wages fall; that which the entrepreneurs will have
saved on paychecks will remain with them, as profits. The total of aggregate demand may
be unaffected; it shifts from workers’ type of consumption to luxury goods. In a world of
differentiated products, prices will not fall.
All adjustments have taken place. There is no return to the previous level of demand. The
quantity of money in the economy - which has not changed - is in a long run equilibrium.
That which is not needed in the goods’ sphere is absorbed by the financial sphere; by the
higher share-prices there. An interesting side point: Initially people wanted to save more
as a safeguard against the expected recession - which by this very action they have success-
fully brought about. And, paradoxically perhaps, they have also succeeded in saving. Even
though the real wealth in terms of goods has declined in the economy, the financial wealth
- same number of shares, but now at a higher price - has increased. This creates an addi-
tional demand due to a wealth effect; however nothing guarantees that this additional
demand from supplementary purchasing-power due to asset-appreciation brings back the
economy to full employment.
Last question: What happens to the unemployed? They may continue to bid down the
wage. This will induce a reverse substitution effect: Because labor gets now cheap, firms
will hire more workers for low-productivity jobs. At these reduced wages less labor will
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presumably come to the market. Some will drop out of the official labor market and spe-
cialize in household production. We will again have “full employment”; but a kind of sec-
ond best full employment: Less people are employed in total, and at lower wages, working
in lower productivity jobs.

Bottom line
The main point is this: The classical model with differentiated products does not bounce
back to the full-potential employment-level. It contains long term, structurally stable low-
productivity equilibria; in these well-being is much reduced.
The low-productivity equilibria become possible because the existence of product differ-
entiation annihilates most of any supposed expansive, real effects of low interest rates.
That with differentiated products the q>1-case is possible long term, contrariwise to
Tobin’s intuitions, creates an additional, outside value component of financial assets
which binds money for its mediation. The wealth effect may or may not make the economy
bounce back to full-potential employment. That depends on the parameters of the real
economy, but casual evidence suggests it will not. Casual evidence rather suggests - as
noted in the introduction - that under-productivity equilibria exist.
The perhaps perfidiously unusual and subtle point is that it is the classical model itself
which yields them; if we factor in - and that is hard to argue with - product differentiation.
18 Everything else - quantity theory of money, full competition etc. remains in place.
To say it explicitly, no non-classical, e.g. “Keynesian” hypothesis is made. We do not say
e.g. that the wage rate is somewhat inflexible and sticky downward, because managed part-
ly by unions, that the wealthy have a lower propensity to consume out of income than the
non-wealthy, that interest rates are generally slow to adjust, or that we have a totally differ-
ent theory of the interest rate anyway.
Yes - the interest rate as sketched above works very much the way it does in Keynesian liq-
uidity-preference; it may even be formally equivalent.
But that it is derived from within the classical framework (that is not to say of course one
shouldn’t make non-classical assumptions), is the strong point of the argument. Namely
that already a fully flexible, competitive market-economy devoid of any extra-economic -
political, organisational, sociological, psychological, behavioural etc. - rigidities yields
structural unemployment (if social security exists), respectively under-employment.
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Labor and i ts R e wa rd

In this chapter we will zoom in on the labor market. The preceding analysis has estab-
lished that even the orthodox, free-market classical model (with product differentiation)
yields potentially indefinite unemployment.
That does not mean of course that there is unemployment all of the time; but it means
that the level of economic output is sluggish, and that it tends to stay where it is, because
firms adjust their investments to the effective sales they can make, and that will be it. Low
or even zero interest rates are powerless to turn the situation around.
So, if we are in a society with social security7, a part of the population will be on welfare. 19
But what about countries without social security? What will happen in the pure, free mar-
ket model?
The answer can in fact immediately be given: If increased competition of the now unem-
ployed for jobs maintains a downward pressure on wages, aggregate demand and income
might fall even further. Depending on the dynamics and actual magnitudes of the core
parameters (such as the interest rate and its obverse, the level of financial wealth, con-
sumption out of wealth etc.) it may result in an increase in labor demanded, or even in a
decrease, and the economy may spiral further into a recession.
The economy may settle down permanently (recession is not really the right word here
either, because it implies it is cyclical) in an under-productivity equilibrium: Economic
output and well-being are much lower than they could be, given current technology and
available man-power. We coined the term under-employment to designate what happens to
the factor labor in this case: lower output overall, and more labor competing for scarcer
jobs. This will make labor become cheaper and more disposable for firms; shoddy, second-
rate, low-wage, precarious jobs will spread. Welcome to the working world of Willy Low-
man and company - like the eternal interns of our day, struggling from one arduous,
thankless, temp-job to the next.
This is what happened to Argentina around AD 2000, and it happened in the decade fol-
lowing 1930 in the USA; only World War II pulled the US economy fully out of economic
misery, which began with even official unemployment rising quickly to a staggering 20 %
Unemployment insurance is the wrong word because it would not work if unemployment is potentially permanent; this
systemic risk is not insurable any more, any insurance company would go bust.
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and more, and we don’t even count the working poor.

We could leave it at this in order to refute the argument of the neo-liberal economist that
you will bring about full employment by abolishing the dole. We now know that on a theo-
retical level this is not true; on a politcy level it would be to court desaster; broad empiri-
cal evidence also disproves it, or did say Argentina or the US bounce back quickly to full
potential? Not so.
But it is interesting to have a closer look at the labor market for its own sake.

Economists typically assume (a.) that wages are rigid downward only due to extra-econom-
ic, institutional rigidities, state-, or trade-union imposed; and (b.) that the removal of
these rigidities - like the abolition of a minimum wage, and, why not? Social security -
would automatically bring about full employment by a falling wage rate. Hence their
removal is a good thing, and the typical rap goes thus: Subsidizing unemployment (social
security) is objectionable per se, like any subsidy. A minimum wage unjustly excludes the
least productive units from participation in the labor market. Extremely low wages are not
a problem because they are adequate compensation for the productivity of the economic
unit, which is correspondingly low as well. Hence they are commensurate and in this sense
deserved. The economic agent may thus be motivated to extricate himself from poverty by
20 “investing in his or her human capital”, which as a matter of course he is perfectly free to
do. If this doesn’t happen then the reason would be that the agent’s utility function is
structured in such a way that he simply has a high priority for present consumption as
opposed to future. In short that he fritters all the time and money right away instead of
providing for the future. In summa: his poverty is his personal choice; a choice as valid
and legitimate as that of choosing to be a wealthy executive.
So, no matter where or when, for the neo-liberal economist “all is for the best in the best
of all possible worlds”.

Let us begin with an illustra t ive example: Imagine you want to sue some company for an
amount of 20m $. Lawyer A, an eminent and widely respected member of her tra d e, having
previously won similar cases, well connected and briefed, might have an estimated probabili-
ty of 75 % of winning this case. Then there is lawyer B, also active in the same field, reput-
edly clever and persuasively eloquent, but with a less proven tra ck record; you figure she
may have a chance of, say, 50 % in pulling down the 20m for you.
Then there are various third tier newcomers, with solid academic backg rounds and zealous,
but with uncertain odds (say 30 %).
Ms A, conscious of her reputation and the quality of her craft, demands a remuneration
package of 30 % of the stake; Mrs. B asks for a more modest 15 % of the jackpot, and the
Cs, anxious to get into the business, are happy to offer their services at a mere 5 % or less.
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If you want to maximise the expected net outcome for you, you would go with the star of
the trade in spite of her whopping compensation package.
Ms A maximises her profit by not demanding a completely over the top fee - which would
price her out of the market - such that she still gets the big contract. Her less eminent col-
league B has to content herself with smaller cases; as time goes by she can build up the
experience and reputation to get bigger ones in the future. With respect to the Cs she is in
the same position as A is to her.
If the competence pattern and therefore the supply of law consulting services is the same
on each level - being good means to be somewhat better than the rest -, the cut made by
the people effectively chosen may well be pretty much the same; what varies is the size of
the case (as measured in $) they will get.
The example of the lawyer, who may make a certain sum of money for a person or a set of
persons is strictly analogous to the CEO of some company, who also secures an amount of
profit for the set of persons who own the company, the shareholders, and is chosen by the
In terms of compensation, the directors of large joint stock companies play in the same
financial league as the successful lawyer in the above example, and beyond.
The CEO is an admittedly extreme case, but it illustrates well the issues involved. A good
CEO may make - say - 1 billion of profit for his firm, a bad one may generate an equiva-
lent loss, and middle of the roaders are somewhere in between. If the owners of a firm 21
perceive somebody as even slightly more suitable than a competitor, they may be ready to
offer him (very rarely ‘her’) substantially more in absolute terms, up to a certain percent-
age of the profits (since the qualified effort put in is not independent from the mode of

In order to structure the discussion, we make the following assumptions, the consequences
of which will be explained subsequently.
a.) The labor-market is differentiated (and stratified hierarchically).
b.) The key job skills or qualifications which qualify for a job - hence critically determine
remuneration - can only be gotten and maintained on the job or on the level immediately
below it, within the firm or at a competitor. Out of job these skills are subject to rapid
c.) Abilities are broader than job slots
That’s the gist of it; The market is supposed to hold absolute sway. These parsimonious
assumptions are able to generate the most salient features of the labor market. I hold
these assumptions to be immediately obvious for anyone taking only a brief look at the
labor market. (a) is a no-brainer, and you can check (b) by browsing through the job-ad
section of any newspaper. So let us focus on c:
Endowments in themselves are hardly directly operational for the working sphere - like
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say the ability to appear as a dwarf in a circus. They develop through socialisation and
training. Let us define an endowment or talent by the ability to learn relatively quicker
than others certain professions or trades. Without doubt a talent - and be it a minor one -
is broader than the operational tasks or trades the mastery of which it facilitates. One may
have a talent for music; instruments and musical styles there are many, from classic to
rock. One may be gifted for formal or analytical reasoning; many professions could be
suitable: teaching math, working in an insurance company or bank, in the computer
industry, or as engineer in various different branches of industry. That is even more true
for the abstract talent ‘intelligence’.
Until now we have looked at the demand for jobs. Those who offer the jobs have a material
interest in defining their jobs in a way so that they do not depend on potentially scarce -
and therefore costly - special talent.
If we assume that there are enough relatively talented people around seeking a suitable
employment, the competition for jobs of a certain kind is as intense as for jobs that
require no special talent; hence special endowments or abilities cannot attract a premium
in the labour market.8
Mind that I take for granted that people work in suitable jobs. Someone who can’t swim or
fears the water would not want to work as a diver. I assume that reasonably well qualified
people only work in a certain job. After that, if you advance or not, may be more deter-
22 mined by “luck”. If you are too good at what you’re doing, you may not get the promotion
because your boss doesn’t want to lose a competent specialist. In all branches of business,
from shoe-making over managerial to show-biz, you have to have a certain background
skill, interest, or ability to make connections (which is also a skill). But even on the base
of these skills, in any biz, there are still the good, the bad, and the ugly to be found on any
level. For every business in a market economy, being good means making money, by luck,
or whatever. As a pre-condition for managerial jobs, you have to have a certain empathy
and communication skills. Otherwise it’s like the diver who can’t swim, it won’t work. But
I also assume that there are PLENTY of equally well qualified people around who do have
empathy, communication skills, and intelligence; much more than there are managerial
positions available. So those who can’t get into a managerial career have to work say as a
holiday club-rep (which may mean more reproductive success, but much less money). So
talents don’t explain remuneration.

In order to become general, one has to be colonel first. Individuals below this rank cannot
institutionally compete. This is so because they have to get personally acquainted with the
relevant people around them, the infrastructure of their organization and its institutional
environment. In order to be able to effectively compete for the job of CEO you have to be
a director first, and in the relevant industry; other than that your bid will not be taken
This is not true for the top performers of any field, by definition. The fastest runner/cyclist/car driver, the weirdest
artist, etc. has the limelight and gets the jackpot, and you see that those which are a few dozen ranks behind him can
hardly make a living out of it - while in absolute time, if we are taking sports-people, they are only split seconds away.
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It may not be more difficult to take on successfully the role of colonel than it is to success-
fully fill in the role of lieutenant or simple soldier. It may not be more difficult to acquire
the essential skills of a CEO than it is to learn, say perfectly 2 languages; many millions of
people have the ability to do that. But whilst you can learn French anywhere in France,
you cannot acquire the qualification or human capital for becoming the CEO in the same
fashion, or by paying for the tuition visiting a business school - you cannot acquire the
qualification publicly.
Because of that, the term human capital is fundamentally misleading. Anyone (with suffi-
cient funds, that is) can purchase any stock in the capital market; but you cannot shop in
the human capital market in the same fashion. Not because anyone would hide or mystify
a supposedly superior knowledge, but because the number of roles in which you can
upgrade your skills for the next level decreases exponentially when you go up the hierar-
chy. You can qualify yourself for the next job-upgrade only on the jobs below, not from
the outside.
The number of persons which can institutionally compete for a given position may then
become very limited.
You can only get to a more advanced position by following a career - i.e. path - through the
stratified positions of the working world. Imagine a tree structure: You only make it to the
top when you take at each turn, or at any rate most of them, the upper branch. Tarry too
long in the lower echelons, and the top ones are no longer within reach. 23
Consider two managers: Both are equally intelligent, competent and good at what they do,
have an MBA, speak several languages, work 12-hour days in which they convene meetings,
inform themselves, and make reasonable decisions. One, being the head of a group or
small department may get 100,000 $ per year, whereas the other - being the CEO - may get
10,000,000 $.
Most people would probably agree that their amount of work, their input, is pretty much
the same. Is the discrepancy in remuneration due to a higher responsibility of the latter -
responsibility here figured as the literally onerous burden of power?

Responsibility may be big because it concerns many people; however for the powerful in a
rather abstract, impersonal fashion. Decisions are taken according to schematic principles:
profitability, shareholder value etc. In teaching and social work, there is another kind of
responsibility; it concerns few people, but it takes on a more direct, personal form, and
cannot be slighted by quoting an authoritative principle. Think of nurses, teachers etc. - a
kind of work no less critical for the gestation of society than the managerial kind.
Who will step forth and contend that responsibility as such is much greater in the latter
case than in the other? Indeed, concrete studies such as the well-known Milgram-experi-
ment suggest the exact opposite. Responsibility by and of itself is no grounds for compen-
sation - you can check it out by comparing the salaries of managers and kindergarten-
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Responsibility in the sense of unconditional liability however, is one of the oldest and
most efficient managerial instruments which exist. The principle “By success gold, by fail-
ure heads are gonna roll” neatly resolves all of the grief designated - perhaps somewhat
pompously - as principal-agent-relationships in economics, even though nowadays the
heads don’t roll physically. It is important that liability be unconditional, meaning that
whether failure is due to one’s culpability or just bad luck plays fundamentally no rôle. If
it were possible to shift the blame, or invent exonerating excuses, anyone would be moti-
vated to do just that when things start to turn ugly. If liability is unconditional, one is
instigated to use time and effort only to carry out the task successfully. The principals on
the other hand are not necessarily qualified to judge their agents work directly. Take as
principals the stockholders of a big company; could they figure out if a certain decision
of the manager employed by them was good? Maybe it was, but another one would have
been better? They do not have the resources, time, information nor indeed the inclination
to judge the input of their agents. They are likely to focus on the one thing they’re really
only interested in - the result, the bottom line figure.
Even if you are just unlucky, and still would have done a very good job in averting worse,
your career opportunities would look as dire as the profit and loss statement you dare to
24 Conclusion: Realistically the eligibility for the next position up the ladder is determined
(according to axiom c relevant qualification on the job being presupposed anyway) by no
small degree of luck or randomness.

When statistics on personal earnings and wealth became more widely available 100 or so
years ago, the economist Vilfredo Pareto found it obeyed a power law for the higher
While the normal distribution has a relatively large middle field and the more extreme
manifestations are few and get progressively less - like most adults are between 1.55m and
1.85 m in height, not many are over 2 meter, and there are definitely no 3-meter-men - this
is not so for power laws. They have more outliers, which furthermore continue steadily up
the extreme ranges. The normal distribution describes many phenomena where lots of
small, independent factors overlap to produce a result: in people e.g. height, intelligence
etc. So why are personal incomes not normally distributed, whilst the personal capacities
demonstrably are?
Herbert Simon suggested an explanation in the 1950s: there is an extra-economic, socio-
logically derived pecking order type principle at work, such that superiors should earn at
least x % more than their subordinates. Going up the hierarchy there are exponentially
less superiors getting exponentially more money (= power law). This remuneration
according to rank was contrasted with remuneration according to productivity as dealt out
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by the market, which was supposed to erode it. Thus it is only a partial explanation,
specifically applicable to large bureaucratic organizations or corporations.
However we have established above a genuinely economic explanation of income distribu-
tion. Let us illustrate it with a fictitious numerical example of a company making 1 billion
$ gross profit, from which salaries will be deducted. The higher up you are, the more prof-
it you are responsible for, hence the more critical is your position, hence the higher your
leverage; we assume a modest cut of just 1 % out of the profits accruing at the respective
level. This leverage-component is added on top of an assumed base-level salary of 30,000
$ per annum. We assume that each manager can manage 5 people - the ones immediately
below him:

Level of... Number of profit / person Leverage Cut Salary Multiple Multiple Total
people on component per previous to base wages
level year level level on level
CEO 1 540,988,802 5,409,888 1% 5,439,888 4.84 177.54 5,439,888

director 5 109,320,970 1,093,210 1% 1,123,210 4.47 36.66 5,616,049

depart. director 25 22,115,348 221,153 1% 251,153 3.35 8.20 6,278,837 25

group-leader 125 4,498,050 44,981 1% 74,981 1.90 2.24 9,372,563

team-leader 625 939,000 9,390 1% 39,390 1.22 1.29 24,618,750

specialist 3,125 220,000 2,200 1% 32,200 1.05 1.05 100,625,000

employee 15,625 64,000 640 1% 30,640 478,750,000

Totals 19,531 630,701,086

This reproduces remarkably well Pareto’s empirically found distribution. The vast majori-
ty of people earn “normal” salaries of up to 2.45 above base level, which accounts for 97
% of the total wage bill. Then there is a small number of people earning substantially
more, but the percentage of this component of the total wage bill is small.
The market does indeed erode the seniority principle, but the market is even more polariz-
ing: Executive compensations are a much higher multiple in real terms of the average
salary now than they were in 1950. These numbers suggest that the cut in profits made
was reigned in in former times, bounded by sociological considerations; the market
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unleashed will magnify this cut up to just short of the pain threshold - see the lawyer-
example above.
The leverage theory of the labor market is very parsimonious, but has a high explanatory
power; it can be applied to whole economic sectors: The banking-business has by defini-
tion a high leverage, the business here being capital allocation itself. Within firms we see a
similar pattern: Positions which involve power over budgets are systematically remunerat-
ed better than positions of technical specialists, even though education and training costs
for the latter are at least as high.
Until now we focused mainly on top positions, which are not everybody’s lot. Therefore
one might think that the leverage theory of income is only applicable to few people, in
particular to managers, or to specialists with key knowledge whom the managers consult.
But that would be an error. The leverage effects work their way down the hierarchy to the
very bottom. Consider for example the cleaning personnel, which still earns more in clean-
ing in a bank than in cleaning public toilets. The banking business has by definition a
high leverage, and if the time of the managers there is precious, they are willed to pay
their employees somewhat more in order to encourage them to a more cooperative behav-
iour or else, they will loose their relatively good job. This incentive is also needed for
encouraging them to leave valuable items on the desks. In the no-leverage environment of
public toilets, it would be cheaper to pay the cleaners less, and supervise them more strict-
26 ly.
The only sociological parameter left in the above table seems then to be the base-level
salary of here 2,500 $ per month. Or can we find for that an intra-economic explanation as

In effect assumption (b) from above has a corollary. Communication, learning on the job, a
certain pro-active behavior etc. require an at least medium term perspective, which is why
the salary must at least cover personal outlays like reasonable accommodation (which does-
n’t involve prohibitively long commutes), health-care and so on (remark: we are not even
talking here about the reproduction of the working force involving raising and educating
children). If you want someone to travel for you, you’d also have to pay him a hotel. If
you want a company car to last a few years, you also have to maintain it, use the right
petrol and so on. The entry-level salary hence hovers above individual cost of living for
those economic units which are to be used longer term, but not substantially. This is the
world of the basic employee or salaryman, as they say in Japan.
There is another kind of work which does not even require this medium term perspective.
This is the kind of work for which output can be easily measured like: Picking fruit,
painting walls, cutting down trees, cleaning public toilets and suchlike (serving food in
restaurants is already a notch above this - was she nice to the customer? Will they come
back?) This is the world of the day-laborer.
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For this kind of work even short- or medium-term considerations play no role, and its
remuneration will be hit hard by market forces if the labour force is about to be down-
scaled. The remuneration of this type of work will dip immediately; it is bounded down-
ward only by: (a.) transfer payments of the state (social security); (b.) legally imposed
minimum wages; (c.) because the person has access to resources via kinship (other mem-
bers of the family with better paying jobs) and can withdraw from the official labor mar-
ket. Beyond (a), (b) and (c), starvation wages are literally a distinct possibility. Conversely
in a booming economy the remuneration for this type of work will be bid up rather quick-
ly to approach employee-salaries.
Even if they would like to, modern firms typically cannot cover all or even most of their
productive activities by rolling over day-laborers; this would be too disruptive. The stream
of productive activities and the information flow which makes up the network of the firm
needs some more stability in its nodes, to which the employee-type status is more suited.
The consequences from the above are these: firms produce with a mix of day-laborers and
employees; in modern times activities requiring the latter have become progressively more
important and are now dominant. I am talking overall, for the whole economy.
Otherwise, if all work could be done by day-labourers, there would be no employees at all,
because it doesn’t matter to the firms if the guy appears the next day to work or not. But
this is not the case; there are many employees; and for many types of work it does matter
whether it is the same guy having some background knowledge, or whether another one 27
hired straight from the street would do just as well (for most types of work he won’t).9 In
our paradigmatic case of unemployment, not all day-laborers can become employees, even
if they would like to, because the number of employee positions is limited. In an econom-
ic downturn, employees get outsourced and dumped into the day-laborer pool. As for the
upper echelons, the principle of unconditional accountability demands that those in areas
with low profitability will be degraded in the leverage hierarchy, or be eliminated entirely
from it. But even with unemployment, the employee-base-wage cannot fall below the aver-
age cost of living for an urban 1-person-household. In recessions the wage-bill may fall,
mostly due to the day-laborer-component, but the employee-sector wage will just stagnate.
Its being bounded downward is not due to rigidities imposed on the business sector from
outside, like legislation or unions. The labor-market will be in equilibrium, and if you
like, in “full” employment, but the kind of employment many people will be in may be
rather precarious.

Take the case of Germany: In 2005, from those 41 million of the population who were working officially, 19 million did
as employees, 10.7 million as labourers (and that doesn’t mean day-labourers; the rest as entrepreneurs, civil servants,
other). Source: Statistisches Bundesamt Deutschland, available online It does not make much sense in my view to look at figures
from severely underemployed economies like developing countries, because they are not reliable; and people may have
litle choice but to come back the next day anyway, even if they formally work as day labourers. When they mature these
economies will likely converge to the picture just discussed.
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If we contrast our analysis with the theory of the neo-liberal economist above, we can say
that he represents remuneration as an entirely individual merit. Comparing the salary of
the CEO with that of the rank- and file kind, we would have to infer from neoclassical the-
ory that his internal personal productivity accounts for that, so that his productive powers
would stand in the same relation to that of his employees like Superman’s superpowers to
those of the common mortal. This is not only patently absurd intuitively, but note that it
is add odds with the known fact that abilities are normally distributed, whereas income
and wealth isn’t.
Our leverage-theory of income distribution explains the observed facts effortlessly. We
have a component from personal effort, but due to assumption (c.) the market outcome
will be pretty much egalitarian. Then we have a component due to the position of the per-
son in the institutional structure of the economy; the absolute size of this component is
determined by the leverage of the position, i.e. how much money depends from it.
Think back of our two competent managers from above, one getting 100k and the other
10m; the difference in remuneration comes from the huge difference in the size of the
budgets they are responsible for.
28 Bottom line: Apart from explaining the observed distribution of incomes, the main con-
clusion from this chapter is that unemployment is possible; you may not even find work as
a day-laborer. This is a real possibility, which, strangely, neo-classical economics does not
allow for.
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There is no Free Lunch - or is there?

There is no free lunch. This well-known slogan from Milton Friedman can be understood
in 2 ways. One banal: Each meal must be cooked, behind each meal there is necessarily
some expense of effort preparing it. You can also understand it in a strong sense: Overall
there are no underutilized or idle resources. If some eat somewhere some more, others eat
correspondingly less somewhere else. The credo then is: The economic system tends of
and by itself to the maximum utilization of comparative advantages - via specialization
and exchange - so that in total there are no idle resources. In other words full employment.
The popularity of the slogan presumably comes from it not distinguishing between the 29
self-evident and the strong meaning, such that a cliché seems to teach economic wisdom.
On a conceptual level this means that certain macroeconomic mechanisms are assumed
behind the scenes which always bring about full employment. On an empirical level - do
we have unemployment, or don’t we? Do we or not have unnecessarily under-productive
jobs, which don’t pay the bills? Poverty is the single most important root of the evils of
the world, be they ecological, medical (no AIDS vaccine in Africa), social, political. Pover-
ty is just another name for the under-utilization of an economy’s work-force. The non-
usage of the human productive potential = POVERTY are idle resources lying waste on a
gigantic scale globally.

The central dogma of neo-liberal economics is its a priori design of the market as an
instrument which via specialization and exchange eliminates idle resources. Mark that this
is not the deductive result of an analysis, it is an a priori, methodologically motivated
Its immediate corollary is, that since the market is maximally efficient, all observed ineffi-
ciencies or economic ailments must be due to the action of the state, or some other extra-
economic force impeding the smooth functioning of the market. Some institution like the
Central Bank, unions, or a piece of legislation are routinely blamed. The other side of this
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- shall we say marketing-strategy - is that any economic boom is also routinely attributed
to the free market. So the boom of the 1980s US Reagan-era, verbally sold as the triumph
of capitalism, yet fostered rather by gigantic budget deficits. The relatively strong US
economy from the 1990s till today, kept afloat by an inflation of financial wealth and real
estate prices which generated a staggering quantum of purchasing power and its subse-
quent wealth-effect within the economy. As a matter of course, these higher valuations
were explained by academic economists by a “more productive”10 real sector as the a priori
driving force (where this “productivity” suddenly sprang up from will remain their secret;
how can an entire economy transmogrify itself from top to bottom in the space of 2
years?). The more pragmatic reasoning of financial analysts unanimously holds that it is
rather the high paper-value of the assets themselves which props up consumption, hence
the whole economy, because (especially in the US) consumption is its major constituent.
Look at any 3rd world country11; the neo-liberal economist will tell you that people there
are poor because they are not very productive.
Don’t you realize that this is a tautology of the most obvious kind? Yes, there is clearly not
much happening there in the way of production. Is that an explanation?
If we cast the ideology12-tainted goggles of the neo-liberal aside, and embrace the pragmat-
ic common-sense of an engineer, we can say: The people in those countries do not produce
very efficiently, because they do not use - at least not on a large scale - the known technical
30 devices and procedures. Producing those (it’s not rocket science, we are talking first and
foremost of basic needs like food, accommodation, textiles, infrastructure, transport) and
learning how to use them will certainly take a few years. But why then is nothing happen-
ing? A society remaining mired in poverty is clearly not a technological or organizational
problem, but a systemic economic one. And a one that should be addressed one would
think, instead of assumed away - at least if we want to claim to partake in a grand old tra-
dition called science.
For a recent entertaining example have a look at the Q and the tech bubble chapter in the appendix.
There is one argument targeting, again, the political sector, with some superficial plausibility in the case of threshold
countries, namely the corruption-argument. There may be some truth in it; but one shouldn’t overestimate it if the prob
lem falls short of civil warfare. In effect, you can also make the case of those countries being a paragon of unfettered
free-market capitalism. Countries with poor public services will consequently have a low tax burden; civil servants, police
and so on are paid relatively badly. If you own a shop, and want it protected by local police, you have to pay them extra;
police acts effectively more like a private security agency. This is akin to tipping in the US: if you want service, you pay
extra; in Europe or Japan you wouldn’t have to because it’s already included in the price. Both systems work and will, at
bottom, not be much different with respect to total outlays or level of service. In a baksheesh-culture you pay for what
you get; this economy is thus more akin to pure capitalism than our OECD-economies with their inflated, bureaucratic
and interventionist state-sectors. It is unlikely that profitable investments will not be undertaken in an environment
where some legislative issues remain formally pending, because the baksheesh-principle is predictable: grease a few palms
and the project gets under way. It is rather more likely that an actually powerful and autonomous bureaucracy not acting
in the service of private enterprise would be more successful in foiling profitable business ventures. However even a cul
ture of excessive litigation instigating still pending multi-billion-dollar-lawsuits in a sequence of figures which would
obliterate any profits of the tobacco industry for good have not succeeded in hampering the supply of cigarettes, let
alone force the tobacco industry out of business.
In order to catch up on the rightfully negatively charged term ideology: An ideology is a system of concepts and axioms
which marginalises the - necessarily always present - social-philosophical value judgements, and aims to present itself as
“natural”, positivist or value-free. No ideology, but a foundation in social and political philosophy is present, when the
fundamental value-judgements are explicitly spelled out and analysed to their consequences.
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The standard remedy with which well-meaning politicians and the less dogmatic of econo-
mists tend to come up with - be it for a 3rd world country or an industrialized one with
significant structural unemployment - is that of education. They note that it is mostly the
people without degrees who are poor and populate the favelas, so they infer - elementary,
my dear Watson - that education is the key to prosperity. Of course, in the process of pro-
ducing more, people will get more educated, more proficient, more productive. But will
this process get under way? It is important not to confuse cause and effect here. People
adapt to their environment; parachute a group of educated and successful people (say
marketing-executives and content-managers) to a favela and see how well they do, stripped
off their positions, credit cards, and associated infrastructure. The closest comparable
empirical evidence are the already mentioned post-Socialist economies with a well-educat-
ed population13, who nevertheless didn’t experience economic miracles after embracing
capitalism. Instead, most of them and many other regions of the world remain mired in
chronic under-employment and poverty.
But it is now time to make our way toward the real solution.


In the Learning for Tomorrow’s World -PISA 2003 evaluation of pupils’ overall performance in mathematics, the USA
is just barely ahead of the Russian Federation (with Portugal in between them).
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The Island of Yam

Since the end of the 2nd world war Keynesianism was for 30 years the leading economic
paradigm, epitomized by Richard Nixon’s statement “we are all Keynesians now”.
Keynesianism14 and Deficit Spending are used interchangeably; the program they stand for
is quite simple: In times of an economic downturn and potential unemployment, the state
spends more than it receives (incurring a budget-deficit), thereby stimulating the econo-
my; in better times the state reduces its debt by spending less than it receives, and uses
the surplus to retire debt.
32 Obviously this presupposes for one that on average the economy would be in full employ-
ment; in other words that there is only temporary unemployment due to business cycles.
If there were persistent, structural unemployment there would have to be a deficit each
year. The total state debt would grow exponentially and ultimately explode, which makes
this policy unsustainable. And secondly, there is no ground for the belief that the state
must needs have a budget-surplus when there is no unemployment. This obviously
depends on how the budget was financed in the past. Should it have been financed by
repeated deficits, a big mountain of debt would have piled up, the service of which mak-
ing it perfectly possible to have anything but a surplus even with little or no unemploy-
There is another obvious issue: If I buy with 100 $ newly issued treasury bonds, instead of
using the 100 $ to buy newly issued stock from a car firm, these 100 $ purchasing power
will go to the state, who may spend it on craftsmen’s services in road construction. Where-
as those same 100 $ - had they gone to the car-company - would have been used in crafts-
men’s services in car construction. So, at least according to conventional wisdom, budget
deficits have only redistributive effects, but no net effect on total output, hence are unsuit-
ed to engineer an economic boom; because the state takes away with one hand what he
spends with the other.
I reckon these simple and completely obvious arguments would undermine the appeal of
the Deficit-Spending-type economic policy in the eyes of many.

It may come as a major surprise to most people that the British economist J. M. Keynes himself in fact never recom-
mended budget deficits. This is consistent because he embraced the possibility of persistent unemployment.
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We continue our discussion of deficits. Consider the following quote from the English
economist David Ricardo (1817, chapter xvii):
“When, for the expenses of a years war, twenty millions are raised by means of a loan, it
is the twenty millions which are withdrawn from the productive capital of the nation. The
million per annum which is raised by taxes to pay the interest of this loan is merely trans-
ferred from those who pay it to those who receive it, from the contributor to the tax to the
national creditor. The real expense is the twenty millions, and not the interest which must
be paid for it. Whether the interest be or be not paid, the country will neither be richer
nor poorer.”
What he intimates here for one is that the existence of a national debt is no net burden on
society. The debt service requires to pay interest on the debt; so the state taxes some indi-
vidual A and hands the proceeds straight over to some individual B within the economy
(i.e. to the government bond holder as interest). We can add that this is also true of those
debt service payments which relate to repayment of principal; because these are just as
well a transfer of individual A within society to individual B.
Hence it is clearly the case that the outstanding Government bonds are no “real wealth”,
like shares would be: they are just a signpost for the future necessity of the state funneling
money from one citizen’s pocket to another. 33

There is so much confusion surrounding issues such as budget deficits, that it is pedagogi-
cally advisable to revert to another useful grand old tradition, that of island parables in
economics. By this device, we blank out superficial phenomena and concentrate on the
core structure.
So, imagine an island; the main product are yam roots. You can eat them, stock them,
plant them. Traditionally people provided for old age by stocking the yam roots physically
in little, dedicated huts. Lately, a more efficient system evolved: Instead of physically
stocking the yam themselves, people lend it to the farmers. They in turn plant it, and grow
additional yam with it. As affidavit the farmer gives them a little clay-ball, bearing his seal
and a time-stamp, which represents 1 yam root. At any time in the future, they can present
the clay ball to the farmer, who takes it back and hands out the yam root and, say, half of
the yam which since then has grown from it. Also, people use these clay balls as a means of
payment among themselves.
Now, imagine the chief of the tribe wants to organize an expedition to a neighboring isle.
To make this happen, he needs 3 heaps of yam to feed his people while building rafts and
during the expedition. He may say to his people: “Please give me 3 heaps of yam, I will
give them back to you in the future plus an additional heap for gratuity”, and so may
obtain them. He may also tax his people outright, thereby also extracting the 3 heaps of
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yam. Hence there is an equivalence of tax and debt in that, in both cases, the productive
capital of the island will have decreased by 3 heaps of yam.
We can envision the debt-case as follows: The chieftain emits his own clay-balls, which
carry a higher promised return than the farmers’. Then he swaps his 3 new clay-balls
against 3 farmers’ clay balls held by the public; the public is willing to do this transaction
because of the higher return of the chieftain’s balls. Then the chief goes with the farmer-
balls he just obtained to the farmers and withdraws the yam.
The now outstanding financial instruments have changed in structure: before there were
say 10 balls representing 10 physically existent yam roots. Now there are still 10 balls, but
they are covered by only 7 yam roots. 3 of them consist of a claim of the community
against itself. The moment the chieftain’s balls were added they spill over 1:1 into addi-
tional effective demand for products now; which was in effect the purpose of the exercise.
At the end of the day this is not really much different as if the chieftain had forged in
some clandestine glade 3 farmers’ balls, and then went on to spend them. In this case as
well, there is in the current period an additional effective demand for 3 units of real prod-
uct now.
So the moment this happens the people are, ultimately, cheated of 3 heaps of yam.
If we ask the question: Are Government Bonds Net Wealth? 15 We can say:

34 · Government Bonds are clearly financial wealth: They represent, nay, are latent
purchasing power, just like any other financial asset in the economy, say a painting or a
stock. Their holders can decide at any time whether they want to cash in on them.
Whether the community as a whole would be able to do that is another matter, but that
doesn’t change this bassic fact.
· Government Bonds are also quite clearly not real wealth, like a planted yam-root is;
they constitute a claim of the community on itself.

By the way, the possibility of the chieftain to always sell his Government Bonds comes
from the number of players involved. If there were only one person, the latter could
refuse to buy the Bonds if she doesn’t approve of the chief’s deficit. If there are many,
there is no reason not to buy into the higher-yielding Government Bonds, or else your
neighbor will. As any security, they guarantee the holder a series of cash flows, just like
private debt.
Anyway; what you should keep in mind is that deficit spending is additional spending per
period, and is effective in raising output if there is unemployment.

A title of a journal-article from the economist Robert Barro, an aticle which recasts the Ricardian view of public debt.
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H o w to Pa y fo r t h e War 16

The starting point of our investigation was an economic aberration: On the one side there
is a reserve army of underemployed, who would like to use their underutilized workforce
more productively. On the other, basic human needs go unrequited. The economy is
wrongly set on a macro level.

The firms know full well how to produce, and they also know how to produce more (even
double digit growth rates of whole, giant economies are not an impossibility, the case of
China). But they will only produce more if there is a credible, cash-backed demand for the 35
additional product. The paupers on the other hand - who have many needs but no cash -,
have to wait until they are given a job by the firms, then they get paid, and only then can
they effectively demand/buy the firms’ output.
A classic deadlock: Each side has to wait for the other side to make the first move. Each
side is obstructing the other side from moving forward. Like two gridlocked entrenched
armies facing each other in the muddy fields of the 1st world-war, the situation can remain
like this indefinitely. It need not - there can be self-reinforcing outbreaks of optimism
which may or may not lead to full employment - but it could.
Technically this is called an indifferent equilibrium: The level of current economic output
is a powerful attractor; movement away from it in either direction needs new, explicit
The existence of differentiated products neutralizes the interest rate transmission mecha-
nism, which plays the pivotal role in all current economic theory. Or, in other words:
Because most products are differentiated and sales margins are what they are, firms have
no incentive to invest if the market value of their equity is way above its book value.
Calling this deadlock a market failure would be inappropriate: Firms successfully maxi-
mize profits, are in unfettered competition, the products get produced in the exact quanti-
ties demanded and so on, there are no failures within the markets themselves.

This title comes from the title of two articles in The Times of the 14th and 15th November 1939, in which Keynes suggested
how to pay for Britain’s war effort against Germany. Since his proposal can be generalized to what is subsequently proposed, and
is not available on the web, the important extracts from the articles can be found in the appendix.
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As a handy visualization - a deadlock is something like this (figure from Nutt, 1997):

Surely, the picture is self-explanatory, when you glance over it - but only then. The indi-
vidual driver sees only traffic jamming up in front of her, but she doesn’t realize that the
distribution of automobiles in space is blocking itself.
The deadlock exists on a macro level only; it is only visible from above. The actors in the
economic piece, from the worker to the CEO, try to do their best within their particular
36 niche and its constraints, so they think micro, not macro, and hence won’t even see it.
The deadlock lies also in the temporal sequence: Had one of the car columns passed earli-
er, all the others quite possibly would have zoomed by unhindered. Deadlocks are path-
dependent: they may, or may not occur. Deadlocks are excluded a priori by all neo-classi-
cal economic analysis; the upside of this is that this secures the computability of the eco-
nomic models; the downside is that they are unrealistic. The heroic assumption that dead-
locks don’t exist is the Achilles heel of all of modern economics. This reveals where the
obstinate optimism of economists is coming from, but it also reveals it as baseless.
Every network administrator, or anyone understanding general systems theory like for
ecosystems etc. would shudder at the bloodcurdlingly foolish approach to hypothesize
away a potential systems’ deadlock.
Road traffic is monitored from above, and there is a task force who rapidly intervenes to
dissolve trouble. Worryingly, no such institution exists on the macroeconomic-level. Yes,
there is the Central Bank, but it is not powerful enough to dissolve a financial deadlock.
The best it can do is to lower interest rates, if need be to zero, but this in itself does not
enforce economic recovery, or dissolve an under-employment-deadlock, as we know.
Note that the deadlock is located in the financial sphere: What we are dealing with is pur-
chasing power. It is not located in the real or engineering sphere, there are no physical
bottlenecks, limitations, or real shortages of any kind. On the contrary, there is only a real
surplus - a vast potential slumbering in the underused human resources.
A financial deadlock can only be bridged by financial means.
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=> The economic actors in the system would in principle be able to extricate themselves
from the underemployment trap, if all firmly believed that future demand will pick up
massively. Then they start investing, which in turn enhances the recovery. But they will
not start believing this out of the blue, however much the politicians would like them to.
Realistic businessmen as they are, they also form realistic expectations.
Since the economic actors are mired in the system, an outside force would have to set a
stimulus to achieve a catalytic effect.
=> Hence this outside force must instigate the recovery. It must engineer what, with lots
of luck, would happen naturally: the universal, unwavering belief in an economic miracle,
the certainty of a future pick-up in demand.

If the state wants to raise its demand, with the goal to increase economic output and
thereby employment, there are currently two orthodox, known ways to finance it: By
“Deficit Spending”; or by financing the additional state demand with additionally printed
money. Both these methods have their drawbacks.
Contrariwise to the Ricardian intuition - the traditional view of public debt - we saw above
that deficit financed spending is indeed effective in generating additional demand per peri-
od (think of the chieftain and his clay-balls).
Before addressing the long term problem of debt accumulation (an outstanding public 37
debt getting bigger and bigger), consider the logical problem first: The debt-instrument is
inappropriate in a situation of idle resources.
The amount of current consumption is strictly limited like a pot of chili con carne: If you
want to have more of it now, someone else has to have that much less now. This is how
debt works: You can only have more now if someone else foregoes that part now (against a
promise on your part to give it back later = you are now in debt, indebted toward some-
In a situation of unemployment though, the aim is to make additional chili, not to parti-
tion differently what’s in the pot. Hence there is no necessity that anyone give something
up right now. Formerly idle, unemployed labour should now become productive - that is
the aim.
That you could achieve this via deficit financing is already questionable to an alert mind,
since the state would take away with one hand at some place what it spends with the other
somewhere else - in the traditional, simplistic, Ricardian view of public debt.
But it is not the state’s aim at all to withdraw resources from the private sector and spend
them in it’s stead; the aim is to provide an impulse, a catalytic stimulus, to set off the
expansion of the private sector as a whole.
Or look at the matter thus: The real burden that must be borne in relieving a situation of
unemployment consists in the additional labor input now provided by the formerly idle,
unemployed. This real burden must be borne by them, now, there is no other way. Obvi-
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ously it cannot by transferred forward into the future by some financial tricks or wizardry,
because manifestly the additional work must be done now by those present now.
Hence it is utterly unnecessary to “finance” this additional work by interest-bearing debt.
This is so because the future generations, who inherit the interest-bearing securities and
along with them the future taxes to pay them off, have evidently not been involved in any
way in remedying the present unemployment.
The bottom line: In a situation with idle resources debt financing is unnecessary.
That debt is the only thing which comes to mind as a means of spending more, be it in
the 30+ year Keynesian regime of deficit spending, or thereafter, lies in 2 rationales:
a.) No rationale at all: As a private individual, I must incur debt if I want to spend more
than I have, and this micro-view is simply projected onto the macro-level.
b.) The previous item would only be true and correct if there are no idle resources. In an
economy with idle resources it is no longer so. Mainstream Economics assumes no idle
resources exist.
Hence the omnipresence of deficit spending as the only tool of state financing lies in
intellectual sloth coupled with the assumption that there is no unemployment.
You can get a glimpse of that through the cracks of the arguments - which works well for
individuals, but not overall - when it is projected to aggregate questions. We cannot contin-
ue to live above our means, and at the expense of future generations... we have to tighten
38 our belts... So you may read it in the paper, and hear it on the streets, until it seems a self-
evident truth. But to any thinking man the absurdity of it must be immediately obvious:17
How much did you borrow from the future generations? How many Government bonds
did they buy? Have our unborn children’s children already worked their hands weary, pro-
ducing those goods which you now consume? By which magical operation are they trans-
ported from the future into the now?
The simple and obvious point if unused resources=poverty=an economic problem is pres-
ent is in effect implicitly recognized by many: ask someone on the street about the source
of the current economic problems, and most people spontaneously tend to locate them
(not enough can be sold because people don’t have money) in a deficit of effective demand
due to insufficient purchasing power. One step further that way and they would also guess
the solution to the problem.
That this additional effective demand needed need and should not by financed by
debt=Government bonds is only slightly more subtle: After the initial stimulus of
demand, all the Government-Bonds are is a mere reshuffling of some money from the
pocket of person A to the pocket of person B. For the next couple of decades ahead. Why
would you want to stipulate that? What have the people in AD 2037 got to do with our
present demand-deficiencies?

“Few men think; yet all will have opinions.” (Berkeley)
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I hope it has become sufficiently clear that spending financed by debt is not logical in
order to remedy an under-employment problem. In a market-based system, more spending
there must be if you want to operate at full capacity, but without the debt. The future
period debt burden is totally unnecessary.18
Well then, how about more spending by the state which is paid for by freshly printed
money? Especially when phrased like this, the instinctive, knee-jerk reflex will be “oh no -
inflation!”. However, that would not be necessarily true - if there is 10 % more money
zipping through the economy, but also 10 % more goods, then it would still be one on one,
and there would be no inflation.
But take a step back and consider something else for the moment.
The depreciation rate of physical capital in a modern firm is in the order of 20 % per
year. That means, if nothing is repaired and re-invested, all of the capital will have van-
ished in an economic sense in the space of five years. Now, if we have a slump in con-
sumption demand, the firms will immediately suspend re-investments; investment outlays
are much more volatile than consumption, which is more inert.
The reason is obvious: people have to eat, pay rent, commute etc.; firms do not have to
invest, but gear their capital stock such that it is just enough to produce the expected
demand. 39
The corollary is that in the longer run there are no industrial excess capacities. This point
is as crucially important as it is routinely overlooked. Say consumption demand falls by 20
%; then firms will immediately stop investing altogether, and after one year the capital
stock in the economy will have adjusted to the now 20 % lower level of consumption (also
by not investing this year, this will have exacerbated the recession). So 20 % of the people
are now unemployed. If there is no excess capacity, especially consumption cannot be
increased promptly. This is so because first the necessary capacity would have to be
rebuilt, i.e. the machinery with which the 20 % unemployed are supposed to work, plus of
course the 20 % unemployed will have to be retrained as well if they were on the dole for
an extended period of time.
But to hire, train, and build capacity is costly. If the firms think that a sudden demand
increase is only transitory, and will not last, they will definitely try to avoid this.
Therefore the supply of chili con carne available now is strictly limited/inelastic.
If the state, this year, demands 10 % more of it, it would be your best option to make
everyone in the kitchen work 10 % longer hours, preferably of course without paying
them overtime. “Come on, guys, one more effort... we do have to get that bit done now, I
know it’s hard, but it’s not always that busy...” You will not want to start investing in new
pots, a bigger oven, and hire additional cooks, if you think the demand increase is transi-

Quite incredibly, very few economists have clearly recognized this point. Among them is Nobel laureate James
Buchanan, please refer to the appendix for more.
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So, sudden increases in spending by the state lead not necessarily to corresponding
increases in employment, even though, temporarily, some more goods may be produced.
If the situation should be thus that all the cooks are already working like hamsters in a
wheel, then squeezing in yet more overtime wouldn’t work.
In that case, sudden demand increases would indeed most likely be met by a flash in the
pan of inflation=higher prices for the chili available now, not more thereof
Only if the chef thinks that the new, higher level of demand will be permanent, would he
want to invest in a bigger kitchen and more cooks.
Maybe it doesn’t seem that daunting to you to do these things. After all, there are firms
who do kitchens, there are temp-agencies who rent out cooks. But our case is different,
because we think about the economy as a whole - all are working like hamsters, including
the temp-cooks and kitchen people. In the whole economy entirely new items will have to
be constructed from scratch where there was nothing else before. Entirely new, formerly
un- or underemployed people will have to be newly added to the work-force. Initially they
would also need to be trained by those already working, which would diminish somewhat
their output.
40 So while there are idle resources if there is unemployment, there is a considerable cost-
and time-threshold for getting these idle resources to do something productive, since there
is no excess capacity, which would have to be built as well as we go along.
This is the reason why the deficit-spending-style Keynesianism of the 1970s had to fail in
the face of the then prevalent protracted recession - new consumption demand is initiated
by the state, but the effect will be inflationary, since in the short term economic output is
relatively inelastic,
The industrial capacity per head (including the infrastructure for information and physi-
cal transportation as a sound basis to work for the services sector) is - in a mechanized and
technology-intensive economy like ours - a crucial parameter. It is especially relevant for
attaining very high growth rates. The Chinese case of 10 % growth per annum (by the way
as inflation free as some stagnating European economies) can only be attained with a rela-
tively high industrial capacity per head, which is used to build yet more infrastructure and
capacity, while consumption is temporarily still restricted (output is geared toward invest-
ment, not consumption goods).

We recapitulate: Debt-financing is balderdash anyway. Money-financed spending is injec-
tion of purchasing power now, which may - if there is excess capacity and hence some
wiggle-room - be effective in raising output somewhat, but not necessarily employment.
If there is no short term excess capacity, then sudden demand expansions will be infla-
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tionary only. The goal is to deploy the long term excess capacity, namely the underem-
ployed human potential, but that would need to be developed first. Yet in the inflation-
bonfire, the purchasing power for any additional demand will be annihilated.
Remember what we said earlier: Hence this outside force must instigate the recovery. It
must engineer what, with lots of luck, would happen naturally: the universal, unwaver-
ing belief in an economic miracle, the certainty of a future pick-up in demand.
We need to replicate the natural profile of a developing economic boom, which is charac-
terized first and foremost by investment; so to speak frantic capacity building in order to
become larger hence capture that much more of the bountiful demand.
The goal is to fill the firms’ order books for years ahead, so that they start investing and
hiring people. The second leg of the strategy - as important as the first one - is to avoid
that too much of this purchasing power spills into the present, and becomes effective for
immediate consumption goods demand, which would in turn crowd out the necessary
investment, and produce inflation.
In practice it could be done like this: Each unemployed or needy person gets a newly cre-
ated savings account from the central bank or one of its ancillary institutions, on which it
prints, say 25,000 $. This sum will not be available for immediate spending, but only after
some specified future date in tranches (5,000 $ after a year, up to another 10,000 $ after
year two and so on); nor could it serve as collateral to obtain loans.
However, the firms now know that in the future so-and-so-much additional purchasing 41
power will become available, and, if they want to profit from it, should position them-
selves accordingly and start investing and hiring.
Hence the formerly unemployed worker now finds a job on a construction site, were he
and his formerly unemployed colleagues build the very apartment block in which they
have already purchased a flat they will soon occupy (with the future-money future purchas-
es are certainly possible).
A formerly underemployed designer now gets back an adequate job: Firstly she’ll have to
sit on a provisional side-table facing the wall, working on a 2nd-hand computer, but this is
entirely sufficient for doing the job and will soon change; while machines are running
longer and an additional shift is introduced to produce more investment goods.
You get the idea. If, say, 25 % of the population in working age are underemployed, then
the first priority while they enter the workforce is the manufacture of investment goods;
because only after the total amount of investment goods will be 25 % greater, all people
can enjoy the same living standard that before only 75 % of the population had.
The 2nd leg of the full employment policy is hence to make it more attractive to produce
investment goods than consumption goods, in the interim. To get there we will have to
temporarily penalize consumption, e.g. by the introduction of explicitly temporary con-
sumption taxes. Profits for firms will be lower for immediate sales, and people will get
much more for their money if they defer the purchase.
In the 10 years after WW II the emphasis during the so-called economic miracle in Ger-
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many lay - not on immediate consumption - but rebuilding the country. However - you can
be happy and found families even on a temporarily restricted budget, if you know you will
always find well-paid work, and can look with absolute confidence into a secure future
(first a motorcycle, then a car; first a narrow apartment, but in 5 years a terraced house
with garden).
Today, of course, we observe the exact opposite.
Anyway, with this policy it should be possible to maintain the economy in a permanent
state of boom.
It should have become abundantly clear that the two-legged strategy to overcome the
underemployment deadlock sketched above is not to be confused with deficit spending
style Keynesianism, nor is it the same as “printing money”. On the contrary, a fully infla-
tion-neutral full-employment policy is attainable. I do think that in order to become really
comfortable with this - it being a novel hence unfamiliar concept and policy -, you would
have to get a better understanding of this most wayward and elusive of commodities -

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An Intro d u ction to Money

The goal of this chapter is to understand topics like inflation, the quantity of money,
Government debt yet again from a different perspective, and to enable you to follow con-
troversies of monetary policy in recent decades on a high level. If you are happy with the
full-employment-strategy as expounded above, feel free to skip it.

As a first step we will return to our island economy to cover basic aspects of money.
It is the fashion on our island that the islanders pay between themselves directly with the 43
clay balls. In effect this is a rather advanced economy, somewhat more advanced than ours,
in that it really does not have any money at all!
We could also say there is no monetary constraint. Let’s make a counterexample: The
island would have money if people wouldn’t pay directly with the clay balls, but rather say
with pearls. The total quantity of pearls is strictly limited (most of which were found pre-
viously in shells around the island, and only now and then does a lucky diver find one, but
the surprise-pearls are not significant with respect to total pearls already in circulation).
In such an economy it is not enough to have the purchasing power - the clay-balls - but in
order to effectuate the purchase one must first exchange the balls against pearls; after hav-
ing gotten hold of the pearls, you can use them to directly buy the intended item. In this
case there is an additional constraint: namely to get hold of some pearls first in order to
buy something. Economists refer to this situation as money being exogenous; the quantity
of pearls is a given, from the outside. In the reverse case, in the pure clay ball economy
without pearls, economists may say money is endogenous, respectively there is no money
at all, or no monetary constraint.
You would want to get hold of pearls only if you immediately want to buy something.
Otherwise you would leave your purchasing power in clay balls, because then it earns inter-
est (the yam for which the clay-balls stand continues to grow). The pearls however do not
earn any interest. Hence it is clear that the quantity of pearls will be turned over quite
rapidly; and that the circulation of pearls will closely correspond to the circulation of
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goods exchanged in the economy. The pearls - as their counterpart, the goods the transfer
of which they mediate - change hands quickly, from one day to the next, and the quantity
of pearls in circulation must make the corresponding transactions - in their volume and
prices - possible. The number of transactions times their prices equals the quantity of
Lastly, the pearl-constraint introduces a new limitation, but this limitation may be consid-
ered a beneficial one, and acts as a kind of stabilizer in the economy. Suppose the ever
crafty chief is plotting some bigger enterprise, emits lots of state clay balls (= budget
deficit = an augmentation of the state debt), swaps them to farmers’ balls, and spends
them immediately. The effect of this would be that many clay balls would suddenly come
to market and be exchanged into pearls. This would drive up the price of pearls in terms
of clay balls. An equivalent way of saying this is the clay balls become less valuable - you
get less pearls for them. Thanks to the pearl constraint, an inflation of goods prices, which
would otherwise have happened, was avoided. So the pearl constraint acts as a safeguard
against goods prices inflation. That is an important issue to keep in mind. Goods prices
inflation is obviously something unpleasant for consumers. Also if some inflation gets
under way, it may create expectations of further inflation, and trigger social struggles of
who marks up first (prices or wages). Goods prices inflation is anti-social (the poor are hit
hardest), will impose subsequently huge costs on the economy by eroding the stability of
44 the financial system, and make planning for the future an uncertain and precarious affair.
The economist Milton Friedman emphasized these points since the 1960s, and with rising
inflation in the 1970s politicians lend him their ears finally in 1980; we’ll get back to that
In the previous example inflation was warded off by a decline in clay ball (=savings) val-
ues. This would be equivalent to a risen interest rate, because this also deflates financial
asset prices. People are not enchanted by high interest rates, or in other words a decline in
financial net worth and real estate prices, either, but something’s got to give.

Let us look at some other features of our island pearl and clay ball economy. Note that in
principle any level of economic activity is compatible with any quantity of pearls. Above
we saw that the pearls’ circulation closely corresponds to the rapid turn-over of economic
transactions. But that does not mean that a specific quantity of pearls would sort of guar-
antee that the economic output will forever remain at this volume. In fact, it is not only
volume, but also the prices of the transactions which matter. There is no contradiction in
imagining that e.g. half the population of the island has left (without taking any pearls
with them), so that now there is only half the volume of economic activity at double the
prices (in this case by the way inflation wouldn’t be even bothersome, it would be a natural
To put this into perspective, think back again to the text from Sargent. In his model, an
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excess quantity of money - excessive with respect to the volume and prices of the econom-
ic transactions which are mediated by it - resulted in a re-adjustment by volume: Economic
activity increased. However the given quantity of money could also have been equilibrated
by an upward adjustment of all prices.
Then the given quantity of money also equals volume (down) times prices (up). What ulti-
mately happens crucially depends on the sequence of events, the dynamics of adjustment,
and the additional hypothesis governing these (e.g. the old q-theory).
So if any amount of pearls is compatible in principle with any level of economic activity,
we will likely have very different goods prices on each island if we imagine an archipelago
consisting of hundreds of islands. On some islands, people have found lots of pearls; on
others there are few pearls, and a huge population producing lots of yam. On one island 1
yam root may cost 1 pearl, on another you would get 10 yam for a single pearl.
If the same kind of pearls is used on all islands, this would lead to inter-island trade, and
yam prices would start to converge (buy low sell high). This would be historically the case
of the gold standard - the same money-substance was accepted everywhere. It would also
be equivalent to a monetary regime where the exchange rates of the different currencies
are fixed in terms of each other (as roughly at least in the Bretton-Woods-system, 1944-
If different pearls are used on each island, it would not lead to inter-island trade. The
kind of pearl where you could buy 10 yam on the island of Momo would buy you 10 45
pearls of the kind used on Mumu, where 1 pearl buys 1 yam. The exchange rate of all the
different kinds of pearls would differ, according to how many yam roots each kind buys.
This is also roughly the case of the flexible exchange rate system we now have.
We don’t have a globally homologous physically based money any more, like pearls or
gold. The natural scarceness of pearls or gold has been replaced by an institutionally engi-
neered scarceness. This institutional scarceness is managed by an institution called Central
The intrinsic value that money must have in order to be money comes no longer from the
material it consists of, but from it being an enforceable contract, enforceable and backed
by the authority of the state. Look for example on what is written on each US-Dollar note:
“This note is legal tender for all debts, public and private”. Every economic subject is
forced to accept the notes as a means of payment. That, the fact that economic subjects
must also pay their taxes with this money, and their scarcity - watched over by the Central
Bank - is what makes up their value. Such a money is called a fiduciary money (fiduciary
means based on trust alone; trust that the institutions behind it function well).
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The Creation of Money, and its relation to

Government Debt

We’ll now follow through the trickling flow of money in its various forms through the
economy; this will complete our understanding of the actual economy we live in.
The Central Bank alone has the right to issue money. It is its first duty to create it so peo-
ple have something to pay with. All it needs to do is to bring the currency somehow
among the public. The people will then continue to pay each other with it.
The Central Bank does this by buying some item from the public, and paying for this item
with their newly printed money. That is how the money gets into circulation - job done.
This does have an interesting implication, though.
In practice the Central Bank buys almost exclusively Government bonds. In principle they
could buy anything, like stocks, but that would presumably arouse suspicions that the
Central Bank - i. e. civil servants - would favor certain private firms, or try to influence
them by building a controlling interest. In the past, the Central Bank has bought gold as
well, but this is of marginal importance.19
Anyway, the Central Bank now buys Government bonds. So if we look into the Central
Bank balance sheet, we see on the one side the Bonds it holds, which earn interest, and on
the other the outstanding money that it has historically paid out for the Bonds. This
money is now in circulation among the public. Since the Bonds earn interest, and the
money doesn’t, the Central Bank posts systematically a profit. As an organ of the state,
the Central Bank profit is transferred each year to the Government. Hence the Bonds held
by the Central Bank are no burden for the state: The state pays punctually interest and
principal on all Bonds, including those held by the Central Bank; and he gets it back from
the latter by return of post. We could term the stock of Government debt held by the
Central Bank virtual Government debt, because it does not constitute any burden on the
In the Bretton Woods system created in the aftermath of WW II the world’s currencies were fixed in terms of the US-
Dollar, and the latter was fixed in terms of gold, at 35 $/ounce. But the amount of Dollars kept inflating, and the rela
tion to gold became hollowed out. Well-advised investors like the French President de Gaulle demanded redemption in
gold, and fetched the gold from America with French warships. He was not the only one, and the US went off gold in
1971 or have Fort Knox emptied in no time.
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That the Central Bank brings its money into public circulation by buying assets from the
public is rooted in tradition. The Central Bank could get its money also quite easily into
circulation by printing it and just giving it away as a present. But that sounds somewhat
dodgy, doesn’t it? Also contrary to the stern classical principles your dad taught you -
there is no free lunch, you don’t get something for nothing etc. A self-respecting bank just
doesn’t do that - any money it issues must be “backed up” by some asset, one convention-
ally thinks. Otherwise it would have the hollow ring of unsound financial practices, of
money as a faux jeton. But this way of thinking is really only an atavistic remnant of the
commodity-based money we had previously.
In the preceding we have established that exactly this is the case right now, since decades:
Not the people directly, but the Government is the recipient of any newly created money.
At first the Central Bank buys some Government Bonds from the public, but when the
state repays those bonds to the Central Bank, it will immediately get those funds back. In
fact there is no “backing” whatsoever of the money which the Central Bank creates. It is
printed and basically given as a present to the state.

In order to get an idea about the magnitudes involved, let us briefly look at the Govern-
ment debt of the US.
The total public debt now is heading towards 70 % of GDP; quite substantial. To get an 47
idea: The state sector nowadays gobbles up 37 % of GDP, which roughly is also collected
in taxes, and is the state’s income. Then this debt-level would be equivalent to 189 % of
your disposable, after-tax yearly income. Not too much compared to your mortgage? Well,
the mortgage would have to be netted with the value of your house, so that you have no
net debt at all, but would post a positive balance. The public debt by contrast is net debt,
to which scarcely any saleable assets correspond!
So if your income after tax is 50,000, and you have to feed with that a hungry gang of lit-
tle rascals (recipients of public money are notoriously needy, always clamour for more,
and are also voters), the mere debt service would be - say with 5 % interest + 2 % repay-
ment of principal on 94,595 debt = 6,622 per year. While this is arguably not yet within
the red zone, you are saddled with a significant load of unpleasantness here.
The US is flanked debt-wise this year by Panama and Ivory Coast. For comparison,
Brazil’s debt is at 52 % of total GDP, Colombia at 50 %, Venezuela at 34 %, Iceland with
its generous social security system at 32 %, Iran at 29 %, Australia at 18 %, Chile at
7.5 %.20 You can rid yourself of a couple of prejudices reading through these figures.
Anyway, back to the US-debt: The last time such high levels were seen was in the later
1950s. The debt was high because of the huge debt incurred to pay for the US bit of its
World War II effort. The Government then kept paying off the debt, and in relation to
Source: CIA world fact-book, online under
Source of the figure is, data is from
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economic output, it kept declining steadily until 1981. From then on it accelerated

Although the size of the debt was the same, the real debt-burden was lower in the 1950s:
48 Because the virtual component of the debt was considerably bigger back then. The quan-
tity of money was half the size of the debt in 1959, now it is less than 15 % of the debt.22
The reason for this is the replacement of old-style payment habits and cash by electronic
money, like credit cards and so on. Until not only the pizza, but also the packet of chewing
gums is paid for by a plastic card is only a question of time. It would not be unrealistic to
speculate that in the more distant future, cash will even be banned and vanish completely.
By now serious amounts of cash are really only used for black market and drug deals; the
universal use of electronic transfers would make them much more difficult. An electronic
transfer is traceable, and a name is always attached to it; but I digress.
I think we have covered the creation of money in the sense of cash or near-cash now. But,
as we just saw, cash is not the only direct means of payment.

Numbers gleaned from the US Treasury and the Central Bank Federal Reserve: Public debt in 1959 290 billion, money
M1 140 billion. Public debt in 2006 8600 billion, money M1 1360 billion. However the money measure M1 is not really the
measure of the virtual debt; I have chosen it here because the Central Bank could enforce it if it wanted too. In practice the
virtual component of the debt was ca. 25 % in 1959 and 10 % now; still a significant difference.
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The money multiplier

Think of the banking system as a whole, or assume there is only one bank in the whole
economy. Ms A wants to buy a used car for 10,000 $, and obtains a credit from the bank.
She collects the car and pays Mr B. Mr B doesn’t need the money right now and puts it on
his account. Now the bank has the 10,000 $ back, and could give it out as another credit of
10,000 $; then will get it straight back and so on. By the way, due to the mechanics of the
money creation process, larger banks have a natural advantage: If you have a 50 % market
share, 50 % of the money flows back to you on average, if you have only 1 %, it’ll be only
1 % coming back. This is another driver for concentration in the banking business. 49

Imagine a town somewhere in Europe in the 16th century. Money is synonymous with gold.
If you go on a long and weary journey by horse and coach, it may be inconvenient to carry
the money around in the form of gold coins. Instead you may have deposited it with a
goldsmith of your trust, who in return gives you a personal receipt in the form of paper
(an enforceable contract).
At your destination, you present the receipt to the cousin of the goldsmith who lives
there, and who is also a goldsmith. He checks out the authenticity of the receipt, and gives
you a part of the sum in pure gold to meet your local payments. Conscientiously he pens
that down on the original receipt from his cousin, reducing the outstanding his cousin
now owes you.
As time went by, some of the receipts were circulating as a means of payment in their own
right. And the goldsmiths noticed that on average a part of the gold in their cellars was in
fact never reclaimed. So they proceeded to lend that out as well, making an additional
profit thereby.
This is how the system of fractional reserve banking came about. The system works, but
has one weakness. The tricky bit is: If all the clients would present their receipts sudden-
ly and at once to the goldsmith, he will not be able to pay them off. On the other hand, the
sums he lent out in the past give him a claim over resources in (hopefully) profitable busi-
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ness ventures, which would be of equal or greater value than his debts. But the problem is
that the fruits of these business ventures, in the form of actual cash income, will come
forth only in the future, hence could not be paid out now.
This reflects the situation of the whole economy, which is as a whole illiquid, but - hope-
fully, meaning if credits were allocated with care - not insolvent. Financial assets are
claims, stakes in investment projects which are currently under way. Even if we abstract
from specific banking practices, no matter which economic system you consider, the pub-
lic as a whole cannot present their claims in one go and cash in on them, because the fruits
of the investments will only materialize piecewise in the future. However, for the holders
of these claims, it will be of great value to be able to cash in on them right now should a
contingency arise. They do this by exchanging them among themselves. But as we know
the amount of current consumption is strictly limited like the pot of chili con carne: if
you want to have more of it now, someone else has to have that much less now.
Someone else has to forego her consumption, in acceptance for your claim on future con-
sumption. Evidently this doesn’t work for the community as a whole (it cannot be that all
can have more of the chili), and it doesn’t work for all stakeholders of a single goldsmith
or bank either. And that is the weakness: It can very well be that - maybe only based on
rumour -the public becomes distrustful of a certain bank. So all stakeholders rush to it to
present their claims in one go. Of course the bank cannot pay - which also confirms the
50 rumour!
These so called bank-runs typically triggered financial crisis, subsequently infecting the
real economy. This happened right up till the early 20th century.
It is in the effort to remedy this weakness that we must seek the historic origins of Central
Banking. Central Banks - such as the Bank of England, the Banque de France and others -
did not start out as public institutions. Rather, they initially arose from within the banking
system itself. The most powerful of the banks came to act as a kind of banker’s bank, and
central clearing house. The Central Bank - acting on behalf of all or most other banks in
the economy - might bail a member out in the case of a bank run. Unless there would be
an economy-wide run on all banks, the Central Bank would be able to do that. Further-
more the banks hold reserves at the central bank; these act as their visible commitment, as
a safeguard against bank-runs, so that other banks on the board of the central bank see
that everyone is doing his bit. By the way these reserves are also used by the member
banks to make payments among themselves, like if a customer of bank A wants to pay
someone who is with bank B, the amount gets subtracted from the Central Bank account
of A and credited to B.

Nowadays the Central Banks have been taken over by the public powers. They still moni-
tor the now heavily regulated private banks.
Very importantly, they still manage the quantity of money by implementing reserve
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requirements (no longer subject to discussion or voluntary agreement by any private

bank, but imposed): For each credit given, the commercial bank must deposit a certain
percentage with the Central Bank. This percentage varies according to the type, duration,
and recipient of the credit. E.g. for a foreign recipient of bad creditworthiness the per-
centage to be deposited would be much higher than for a local of good creditworthiness.
So for the 10,000 $ credit above say 2,000 $ would have to be transferred to the Central
Bank; in the next round only 8,000 $ come back, from which another 1,600 $ are with-
drawn and go to the Central Bank etc.
Capital Adequacy requirements: In addition to reserve requirements, a bank is required
to maintain a certain proportion between its own equity and the volume of credit given,
also differentiated by the type of credit.
You see that by implementing reserve requirements the Central Bank in fact fully controls
the money multiplier above. Not just cash itself circulates as money, but - since the 16th
century and earlier - also money substitutes like the papers issued by goldsmiths. Today’s
equivalent of them is the checking account.
For each paper issued, the goldsmiths would put down and away a certain part of the sum
in pure gold. For each deposit taken and plastic-card issued, the commercial bank must
deposit a certain percentage - which can be varied in response to economic conditions - in
money with the Central Bank.
The bottom line is this: The Central Bank is in full control of the money (pearl) supply. 51
Whether it be pearls themselves, or some kind of substitute-pearls which arise from cer-
tain institutional arrangements, does not matter. Because the Central Bank also controls
these institutional arrangements, hence the amount of substitute-pearls.

Management of the Interest Rate

And lastly, the Central Bank has the power to actively manage the interest rate, and it does so. It has
the power because it sits, so to speak, at the longest lever in the economy. Say the Central Bank wants
to lower interest rates. Then all it needs to do is buy bonds, and pay for them with their newly created
money. This will bid up the bond price, which is synonymous to a lower interest rate. Since the Cen-
tral Bank can create unlimited amounts of money, it will always prevail in the market.
Because people know that, the Central Bank may even content itself with announcing: “Interest rates
are too high, they should be 1 % lower”. When people will immediately act on this by frantically buy-
ing long term bonds before their prices rise, which subsequently - rises the prices of long term bonds!
So people bring the intended result about by themselves, without the Central Bank doing anything at
all. Or alternatively set certain specific interest rates, which it fully controls (such as the Central Bank
lending rate to commercial banks), 1 % higher. This may be enough to steer interest rates for loans in
the private sector where it wants them to be.
So: The Central Bank manages the interest rate, ultimately by buying and selling bonds, but also by
mere announcements.
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The Monetarist Po l i cy Experiment and Co n c l u s i o n s

Presently we have a thorough overview of where money comes from, and the place of the
Central Bank in the financial system. We will now put it all together. To do so we will
analyse one particular episode of economic policy undertaken in the US in 1980/81. The
reason for that is that this episode was initiated in order to curb inflation, a scourge which
became ingrained in the economic system in the 7 or so years before.
Then we will sketch how a successful, non-inflationary monetary policy would have to look
like. This is particularly important, because the suspicion of inflation will be the instinc-
52 tive response of anyone confronted with our policy of prospective demand creation.
Afterwards some smaller, miscellaneous points are discussed to round the money-discus-
sion off.

Now that we have learned about our own monetary constitution, we may ask: Is it more like
the island clay economy (no money, or money endogenous)? Or is it like the pearl-based type
( m o n ey exogenous)? The answer can be given immediately: That depends in practice on the
policy of the Central Bank. It would have the power to enforce a stringent pearl-only policy.
But if reserve requirements are rather lax, more and more clay-balls would circulate as pearl-
substitutes, and the economy would gravitate toward the clay ball type. We have seen in the
above that the existence of a pearl-only constraint would represent a very effective safeguard
against inflation - because it absolutely limits the amount of purchasing power that can
become effective for demanding goods. Whether it be the chief who finances additional
demand by debt and thereby drives up prices, or whether it is simply the case that entrepre-
neurs intend to up prices: the limited pearl supply that all additional demand will have to pass
through will foil any such attempts.
The bottleneck of the pearl supply must be able to cover the volume times prices of all tra n s-
actions. If the supply cannot accommodate the higher prices, something ‘s got to give - the
intended price increases will not be sustainable.
This was precisely what was implemented in the US in 1980, as it had long before been cam-
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paigned for by Milton Friedman. This policy approach is known as monetarism, because it
emphasizes the importance of the quantity of money. The policy consists in managing tightly
the overall quantity of money within the economy. It was taken for granted by monetarists and
all other economists alike, that if you manage the money supply, you cannot at the same time
manage the interest ra t e, and would have to let it go wherever it goes. It’s either one or the
As a matter of course, neither Milton Friedman nor anybody else factored in a permanent
q>1-case; at the time, the macroeconomic significance of this was unknown. For the mone-
tarists, money circulated exclusively as a counterp a rt for goods transactions.
Hence it is clear that the quantity of money must be strictly proportional to the goods’ price
level if volume stays constant. And since monetarists and all other economists assume that vol-
ume is given in the long run because they assume full employment, any increase in money sup-
ply over and above the economy’s growth rate is purely inflationary.
Let us not focus on the full employment assumption at the moment, but the other one, that
money circulates only to mediate goods transactions. The crucial assumption - unbeknownst
of c o u rse because taken for granted - is that economists assume that in the long run q=1.
Hence even if money circulates to mediate asset transactions, they occur at the book-value
prices, so the quantity of money is again pro p o rtional to goods’ prices (volume given). But we
know that when products are differentiated, q can go almost arbitrarily high, such that this
new, market-value component would bind additional money. 53
The only way out of this would be to argue that money circulates to mediate goods only, not
asset transfers, period. But then, when the older ge n e ration dis-saves, and sell their assets, what
do they sell them for? Other assets? Not so, the older ge n e ration draws down their assets in
order to consume goods. And by definition, in order to get hold of goods, they must get hold
of money. So the money-circulates-for-goods-only-assumption leads to a contradiction.
Let’s have a look of what happened during the monetarist experiment by using the following
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If only the overall money supply is held constant, you still have the flows designated here
by the round arrow. Money can freely circulate between the financial and the goods sphere.
What happens now if the overall money supply is set at a rather tight level?
The money circulating for financial transfers is much more reactive than the comparative-
ly inert economic goods circulation, because financial prices react instantly. Also note that
the goods circulation takes precedence, in a sense, because people have to eat, commute
etc., and at which prices they buy financial assets for what’s left takes pretty much second
So the overall money shortage will be felt in the financial sphere first. Financial asset
prices will come down quickly given the now lower amounts of monetarily backed demand
for them. This is synonymous with sky-rocketing interest rates, we know that.
There are three effects:
. The wealth effect: Higher interest rates lower the financial wealth, the market value of
all assets. A house that is worth 500,000 $ when interest rates are 4 %, may be worth
only 200,000 $ when rates jump to 14 %. People have a much lower financial net worth
if interest rates rise sharply, the cutback in consumption is likely to be significant.
. Credit financing becomes dearer: since nowadays much of consumption and investment
is credit-financed, and higher interest rates make leasing more expensive, less of it will
happen; result: again less demand for goods.24
54 . Higher interest rates set a higher standard for business investments, which must then
rake in a return over and above the - now higher - interest rate: This point is less
important here than as emphasized in mainstream economics, because mainstream
economics does not know of a potential gap between the interest rate (financial return)
and the return on capital of the firms. So that means higher rates always eat into real
investment. But if rates are low relative to the profit rate, and rise, but still stay
considerably below the profit rate, the effect on real investment may be very limited
or nil.
The third effect is nil, and the first two effects work hand in hand toward a constriction of
goods’ demand. The dampened demand for goods will also pretty much foil any prospects
for price increases. Firms will not even sell all their output at current prices, let alone
higher ones. The recession means people use less money in the goods sector, so some
money wanders back into the financial sector and rates come back down a bit automatical-
ly. This is exactly what one should expect, and also what happened in 1980/1 in the US.
The bottom line here is that inflation was successfully busted, as was to be expected, but
at the price of a recession, which was, at least by the monetarists, not expected in a truly
unpleasant magnitude, but did in fact occur.

Conventional economics would not admit this point; this is so because in their models what one person spends another
saves, so that these claims cancel themselves out. Superficially plausible, and it does contain a measure of truth, but it’s
not the end of the story. We swill deal with this more explicitly in the next chapter.
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Let us now see if we can do a little better than that. Firstly, note that the quantity of
money in the financial part of the economy is inflation-neutral with respect to goods’
prices. It is not neutral with respect to financial prices and real estate prices of course.
Second, financial asset prices have a direct and pronounced effect on consumption via the
wealth-effect (hence indirectly on the quantity of money needed in the real sector).
So - if your goal is to cap inflation, it would be best to proceed as follows.
Adopt a two-tiered strategy: 1. Set the target interest rate in the financial sector: The
quantity of money in the financial sector is a direct function of the interest rate; so by set-
ting the rate - a thing the Central Bank can do - the financial money supply is given as
well. It is not our goal to set it at any particular level. Our goal is to avoid slumps in finan-
cial wealth (=rate-hikes) because they trigger recessions. 2. The amount of money and
credit in the real sector for consumption and investment purchases can be set exactly at
target level by using the reserve-requirement policy-instrument.25 The reserve instrument
has the big advantage that it can be fine-tuned to the kind of credits that require certain
levels of reserves, like consumer-credits (real sphere), credits for share-purchases (finan-
cial sphere), credits for firms’ investments (real sphere) etc.
This is how a successful monetary policy would have to be conducted. Historically the old,
German Bundesbank - until a decade and longer ago - came closest to this. The Bundes-
bank did not content itself with setting interest rates, but implemented very tough mini- 55
mum reserve requirements, which it actively managed and mercilessly enforced. The track
record of the Bundesbank passes muster; beyond gold itself and next to the Swiss Franc,
the Deutsche Mark was one of the most stable fiduciary or paper currencies in recorded
history. Probably you will now be able to relate to the fact that in practice, it has never
been unusual for Central Bank practitioners to target interest rates as well as the money
supply. It is, in fact, the rule. The insistence of the monetarists on managing the money-
supply alone, inspired by theory, was always suspect among those practitioners. However
they could not prop up their practical know-how with a short-hand theory, and hence lost
this debate.

As has become apparent in previous chapters, debt is not the cleverest way to finance an
increase effective demand if there are unused resources. The two-legged strategy previous-
ly suggested was called prospective finance. Under our current monetary perspective
things may look roughly as follows. The creation of future-money would credibly get the
firms to anticipate more demand in the future, and get them to invest more now. It would
be the high road to full employment.
But barring that we can also try a more conventional low road. The state slowly and mea-

Interestingly enough, and contrariwise to received economic wisdom, we actually can wield the interest-rate (price) and
reserve-policy instrument efficiently and pretty much independently. The contradiction of setting price and quantity dis
appears when two markets are segmented: then you can set very well the price in one, and the quantity in the other.
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suredly expands effective demand, financed by money, respectively virtual Government

debt, but so that the elasticity to supply more goods is not overstretched - and inflation
avoided. To do that the state would initiate big, long-term projects which will take years to
finish, thus implying there are many more orders in the pipeline until their accomplish-
ment. Firms will then also start to invest to prepare for the subsequent orders, and unem-
ployment will start to decline. At this point - when the expansionary effects of additional
investment spending by the private sector are coming on as well - one has to be careful
with respect to inflation.
Creating future purchasing power does not, by itself, use up or crowd out present goods. If
the state goes on a spending spree now only in order to persuade firms that things will get
better, this will use up present real resources. The additional incomes of the now
employed and those working overtime will be spent for additional consumption; which will
in turn create yet additional incomes etc. - the so called multiplier effects. On the one hand
this is a good thing. However - there are also quite a few Government orders waiting in the
pipeline as well.
If we deal with no industrial excess capacity, this will likely prove too much too quickly. If
we want inflation-neutral growth, additional capacity building must have priority over
additional consumption. Fortunately we can steer this very well with the reserve policy-
instrument. We can cap consumption by imposing progressively higher reserve-require-
56 ments for any additional loans for consumption purposes beyond current levels. This
would achieve to keep interest rates for outstanding loans where they are now, while at the
same time prohibitively penalising yet more loans, so effectively ruling them out. In addi-
tion, we can lessen the reserve-requirements for real investment loans. If that is not
enough, administer temporary consumption tax hikes as needed.
Continue with this policy until full employment is achieved. Keep the economy there, and
steer against any incipient inflationary tendencies as above.

Let us round off the money-discussion by briefly mentioning a few side-points. While
monetarists and neo-liberal economists in general adhered to the concept that exogenous
money would be an adequate description of our reality, the Keynesian camp championed
endogenous money. The reason for this is that Keynes stressed in his 1936-publication26
the concept of the income-multiplier: The state spends 100 $; this is income for someone
else; who in turn - if the consumption out of income is 90 % - spends 90 $ of that
straight away; which is another additional income of 90 $ for someone else; who in turn
spends 81 $ and so on.
This line of argument suggests that the state can - with a relatively smallish impulse in
terms of debt-financed demand - get an expansionary process under way, because it is

General Theory of Employment, Interest and Money. The income multiplier was a concept originally developed by
a collaboration of Keynes, Richard Kahn.
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magnified considerably by the multiplier. This provides additional justification for deficit-
financed Government-outlays, because the deficits then need not be that large. A precon-
dition for this to work though is an absence of a binding monetary constraint, or one
would have to increase the money supply to make the feedback loops possible. The neo-lib-
eral economists like Milton Friedman argued precisely against this: The income multiplier
would be insignificant anyway27; hence increasing the money supply is purely inflationary.
But for us it DOES NOT MATTER how big the income-multiplier really is, because we
do not need to justify budget deficits by this argument.
Furthermore it DOES NOT MATTER whether money is endo- or exogenous. We have no
stake in this debate, as long as money is fiduciary, and can be made latently exogenous - i.
e. the Central Bank has the institutional power to control the money-supply if it wants to,
which it indubitably has.
The reason for money needing to be fiduciary and latently exogenous is:
. Fiduciary: For one the State must be able to finance a demand expansion at all (in the
face of unemployment, and cautiously/prospectively monetarily of course). If money
were non-fiduciary the state would have no possibility to do this. The state would need
to get hold of pearls or gold like any other actor within the economic system, and
could not increase aggregate demand to dissolve economic deadlocks.
. Latently exogenous: The Central Bank must be able to stem inflation by controlling
the money supply (instruments: interest rate-policy and reserve-requirements) 57

Conclusion: This makes our proposed policy much more general and robust, because it
does not rely on special assumptions.

Milton Friedman in A Theory of the Consumption Function, 1957, argued that the additional income you earn will be inter-
preted as an addition say to your yearly income. Hence you may very well save it for a holiday in 5 months time; or maybe
spend 1/365th the next day, but not the lot. Quite convincing I’d say. The counterargument is that you may be liquidity-
constrained, and would use the money quickly to buy some essential things or pay back debts. There will be some truth in
that as well, but the bottom line would still be that multipliers will definitely be much smaller than Keynes’ preconception
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A Sy n o p s i s of t h e E co n o m y a s a W h o l e

The following overview presents some basic features of the economy as we have discussed


The quantity of money circulates as a counterpart for goods transactions on the right side,
and financial transactions on the left side. If we have a time period of say a year in mind28,
not all financial assets will be transferred between the generations, but only a smallish
slice of them. This slice corresponds to the dissaving of the retirees, and is bought up by
the younger working people who save. The latter transfer money to the old, who use it for
immediate consumption.
If for any reason the savings rate of the economy rises, money is withdrawn from the
goods circulation, and flows into the financial circulation. In other words, they cut back
consumption - the volume of goods bought decreases, this is indicated by shaving the top
off the goods sector.
In economics in the classic overlapping generations model (as developed by Maurice Allais and Paul Samuelson), indi-
viduals just live for 2 periods - in the first they are young, in the other old. This would mean that in each period all
assets would be transferred. This would correspond to a time-resolution in this model of 35 years for a period if people
live till age 70. You will easily understand that at this granularity, you won’t see most of the interesting economic
features of reality.
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The financial prices react swiftly by going up. Since only a slice of the assets circulates per
period, the effect of the price change with respect to total assets in the economy is even
more pronounced. Financial wealth increases by a significant amount from level MV1 to
People are now financially richer, and will consume somewhat more. You can see that also
in the overview, the slice of assets transferred between generations is more valuable; this
slice is fully consumed per period, so there will be also more consumption. The magni-
tude of this wealth effect may be large: “At prevailing prices, South Korea’s land is worth
around ten times as much as its GNP; by contrast, Japan’s famously expensive land at the
height of its financial bubble was worth only five times GNP. [...] Even a modest rise in
land prices of, say, 5 % is enough to generate an investment profit equal to half the econo-
my’s entire output for a year. Anyone who owns land suddenly has money to burn.”29
But there is an inbuilt correction mechanism in asset prices: What goes up can also come
down. Say you think rough economic times are at hand and want to save more. Our eternal
bond-stock is worth say 200 (Coupon=10, i=5 %). Then it goes to 400 (Coupon=10, i=2.5
%). Would you still buy it, for, say 600 (Coupon=10, i=2 %)? If you buy it at that level,
and interest rates go up just half a percentage point, you have successfully obliterated a
third of your savings!
So, maybe not. At some level of financial prices, demand for them stops30. What will then
happen in practice is that people will hand back their cash, ultimately back to the Central 59
Bank, against short-term bonds; these latter are not subject to massive price changes, like
the eternal ones above, when interest rates change. The Central Bank balance sheet will
contract, and therefore the virtual Government debt, so that some of it will be trans-
formed into real, external Government debt. Alternatively, the financial sector can
autonomously restructure its overall balance sheet (the term structure of all outstanding
securities); e.g. by new investments not being securitized as IPOs (financed with eternal
securities), but by rolling over short-term securities.
The quantity π represents profits of firms. Like all other income, some of the profits are
reinvested, some are consumed, and some may be ‘financially invested’, as above. The dot-
ted line represents the book value MV0 of the invested assets, priced with the actual
installation costs of the firms (q=1). We have now two rates of return in the economy:
Profits π in relation to MV0, the profit rate of the firms. And the financial rate of return,
the same profits π with respect to MV2.
The financial return cannot fall below the operating return: If it starts to dip below, firms
will cut back real investments and just buy Government bonds. Typically, in reality, the
financial return is lower than the operating return. Often much lower.

The Economist, 3rd June 1995, Survey: South Korea, p. 17.
This is Keynes’ so-called liquidity-preference theory.
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This implies for one that real investments will always be financed. This is so because the
firms, having a high internal rate of return, can always bid slightly higher than the preva-
lent financial return to secure funds. So can the Government, due to unlimited powers of
taxation. So Government spending will likewise always be financed.
Hence this implies further that the amount of (debt financed) investment spending by
firms and (debt financed) Government spending per period is not limited by the volume
of intended savings per period. The firms can - and so can the Government - swap part of
the outstanding stock of financial assets into securities issued by them, and use the pur-
chasing power obtained for injection into the flow of present demand (think back to the
clay-ball model and our chieftain). What will happen in terms of our above model is this:
The firm or state issues additional paper yielding a bit more than market. The additional
paper will squeeze into the asset sector so all securities prices are marked down a bit, such
that the quantity of money is again sufficient to mediate the asset transactions.
If this were not so, basic features of reality would not be intelligible.
Because debt financed Government spending is indeed effective in raising aggregate
demand and economic output. Contrary to the Ricardian intuition, debt financed spend-
ing is almost31 as effective as money-financed spending.
Likewise, all profitable investment opportunities will be undertaken; if you have a viable
project yielding substantially more than the market rate, it will be undertaken.
60 Also, by the way, the financial market value of the assets over and above the book-value
line must be considered as outside purchasing power. This is in reply to an economic
debate about inside versus outside wealth; or to the notion that, on the financial market,
what is one’s gain is another one’s loss, hence there would be no net real wealth effects.
Refer back to the land-price example above: If the land in the country doubles in value,
who has lost? If the shares as quoted on the exchange double in value, who has lost? The
answer is no one. The addition to financial wealth is a net addition.
Our model also implies that there is no direct crowding out. Crowding out means that e.g.
if the state spends more than he has during some period by incurring debt, these funds
will not be available to private investment or consumption use. This presupposes that
there is, per period, a specific finite amount of loanable funds available - what B takes out
of it is not available to A. But, as we saw above, this is not the case.
Furthermore, there is a (potentially large) gap between the operative return of firms and
the interest rate. Needless to say, since classical economics (and neo-Keynesian economics
in the long run) does not know such a gap, in their framework crowding out always occurs.
But here, with differentiated products, if rates go up a bit, they may still be far lower than

Another technical remark: The higher public debt, if Government spending is financed by debt rather than money,
may mean future tax hikes. So that in anticipation of them, people may cut back their consumption, and save somewhat
more, if they want to bequeath a certain amount to their children. Or they may want to spend more now, if these future
taxes will be imposed on consumption? Or the future taxes will be offset by increased economic activity and employ
ment in the future? Or the Central Bank will transform in the future some of this debt into virtual debt? Who knows.
Empirically the effects of the composition of the financial assets on the wealth-effect are small. Almost by definition,
net financial wealth is the total at their respective face values. (This is a side-remark referring to an argument from
economist RobertBarro about debt).
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the operative return on capital. So if the interest rate is a minimum standard which physi-
cal investments must at least top, rising rates still may not crowd out any real investments.
And lastly, for once, let us assume full employment ourselves, but q>1.In that case debt-
financed state demand will be pretty much as inflationary as money-financed demand.
The Central Bank would have to hike interest rates potentially very significantly in order
to deflect present demand to ward off inflation. In Iceland e.g. you have presently full
employment and 13.7 % interest rates. While in other countries you may have some
underproduction and 0% interest rates, like Japan. The one is as “natural” as the other.

Bottom line
The most important policy-relevant topic to keep in mind here is the 2nd leg necessary to
complement the full employment strategy: This latter involves the creation of (future)
purchasing power, but not too much of this must spill over into the present, because that
would create inflation. Even if the future dated purchasing power is not officially available
as collateral for loans, people could arrange among themselves back-to-backloans privately
to use it now. In order to forestall this, the easiestway is to hike minimum reserve require-
ments for loans for private consumption allocated by the banks; this would involve a defi-
nite ceiling on such loans, and it is easy to implement too. This is the missing link for cre-
ating an inflation-neutral full-employment policy.
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I n te r n a t i o n a l As p e cts

Until now international aspects were not even mentioned; one may conjecture that if we
factor them in - keyword globalization - the solution to the economic problem sketched
above may no longer hold up. We shall see; let’s start with an example.
Say I am buying with my Euros Japanese products or securities. Since the Euro is not a
means of payment in Japan, the recipient of the Euros will immediately bring them to
her bank and exchange them into Yen. Since the Japanese bank has no interest either in
accumulating Euro-positions, it in turn will exchange them; and at the end of the chain is
62 always someone who wants the Euros in order to purchase something in Europe, either
goods or securities. After maximally a few days of changing hands the Euros will return
exactly to where they came from - to Europe. In contradistinction to real goods, and funni-
ly enough, the circulation of purchasing power denominated in some one currency is a
closed system.
This rule has only one exception until now, the US Dollar. This currency also circulates
permanently outside the sovereignty of the US Central Bank, e.g. as means of payment
for drug and many other deals.
Also many non-US citizens may want to hold and use it as a hedge against depreciation
and instability of their local currency. But then they would not want to hold it in the form
of cash, they would rather buy US Treasury bonds, in which case the money will ultimate-
ly also flow back to the US.
Still, a significant volume of US Dollars is indeed circulating permanently outside the US
without flowing back. This is positive for the US economy, because it is exporting its cur-
rency - the manufacture of which is extremely cheap, basically just printing paper - and
importing goods, services or claims on outside real wealth like non-US stocks. The benefit
of this net outflow of paper, and net inflow of real goods/outside claims into the US is
estimated by economists at around 0.5 to 1 % of Gross National Product per year. The
position of the US is rooted historically in it being the biggest free, capitalist market after
WW II, the industrial output of which was more than 50 % of world industrial output
back in 1946. Large fractions of the world were sealed off by an iron curtain anyway, and
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the other minor powers with their local currencies were marginal in comparison.
Large currency zones like the US and now also the Euro do have one edge though, when it
comes to international trade: they manufacture internally everything they need, including
high-tech products, which smaller countries such as say Zambia would definitely have to
import. The leading of an independent monetary policy targeting domestic parameters
implies an indifference toward the exchange rate of the currency; an indifference which
large currency zones can in principle afford. If a small country would create purchasing
power to lift itself out of economic misery, the recipients of this purchasing power may
be tempted to spend it mostly on goods manufactured outside this country. As mentioned
above, this is not an insurmountable problem because the purchasing power will promptly
come back 100 %. However if domestic demand is skewed toward imported products, this
means the exchange rate of the local currency will plummet in relation to outside curren-
cies. This is not a bad thing in itself because it acts as a corrective: Imported goods will
now become much dearer for locals, and demand will shift away from them toward local
products. For foreigners the country will become very cheap, so that they too will want the
local products of the country, say for commodity imports and purposes of tourism. This
is the route the currency will needs have to take in order to come back, if local products
were - initially - unattractive vis-a-vis foreign ones. However this also means that potential-
ly vital import goods will, temporarily, become expensive. Therefore an expansion of
domestic demand should be primarily and carefully geared toward domestic products, and 63
it should be made sure from the outset that the volume of essential import goods is cov-
ered already by a corresponding amount of exports, such as commodities or simple indus-
trial products like textiles. If this is the case, there will be no economic problem, and
there will be no rational base for suspicion of foreign investors, who cannot afford not to
participate in a boom once it unfolds.
Empirically, one can observe that investors were rather too light-hearted with lending capi-
tal to developing economies than the reverse - attracted by the nominally high yields and
the dearth of suchlike investment opportunities, if taken at face value, in their own back-
yards. The French lent at the onset of the 20th century avidly to Russia which promptly
revolutionized itself and repudiated debt; most leading international banks more recently
lent gladly to Mexico, Peru, Argentine etc. sums of which they will have written off their
balance sheets the larger part by now. Not that I would begrudge the flow of funds devel-
oping nations received (respectively, more precisely, their political ruling caste who pre-
sumably quickly transferred them right back to where they came from via their US Dol-
lar-denominated Swiss accounts), but it is entertaining to note how in the hard nosed busi-
ness world the scramble for profits time and again ups the ante to trump cautious realism.

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The argumentation of the preceding paragraph may have been, for most laymen, a little
too abstract in order to convince fully. So, to leave the somewhat unintuitive exchange
rates aside, we shall illustrate the issue differently. Let us look at the production of trad-
able and non-tradable products in some country. Tradable products are typically smallish
industrial products like fridges, textiles, cameras, computers, electronics of any kind,
CDs, DVDs, cars, sport shoes and the like. Non-tradables are par excellence services, pro-
vided locally: Pubs, restaurants, barbers, craftsmen, real estate, legal and advisory services
of any kind, fitness-centres, education, health care etc.
In the realm of tradables there is now an ever increasing productivity due to technical
progress: productivity meaning that per wo/man-hour input, more and more output is
being produced. This productivity-gain does not exist in the services-sector: The barber
can only shear one head at a time, the nurse can only care for one patient at a time, the
teacher can only meaningfully teach a class of a certain size and so on.
One may now naively conjecture that the industrial sector with its ever increasing produc-
tivity would sort of like push the services-sector against the wall.
Well, look at the facts: Electro-trash is unloaded in supermarkets at a discount, while the
money is being made in the services-sector - legal, craftsmen, real estate, etc.
The ever cheaper and easier manufacture of electro-paraphernalia lowers their value sys-
tematically; or, the other way round, you could say that services become more and more
64 valuable if expressed in terms of tradables.
Nowadays the majority of economic output is concerned undoubtedly with non-tradables:
services, to which we would have to add ancillary, non-traded manufactured input like
bricks and so on. Take Japan - a densely populated archipelago with little arable land and
even less as in next to nothing natural resources. In the eyes of many, a nation which built
its prosperity on selling cameras and other tradables to the rest of the world. Not so -
Japan is in reality more similar to a closed economy than almost any other OECD country:
In 2001 exports were just 9.73 % of GDP; from these one must subtract imports; the bot-
tomline figure for net exports is 1.3 %.32
The services sector alone accounts for 64 % of the Japanese economy (industry 31 %,
agriculture 5 %). Japan is well-off because the population is well educated and proficient,
and most of all because the level of internal effective demand is high.
In general it is not surprising, nor should it worry you, if the production of products with
less added value (tradable, industrial ones) is outsourced to so called low-wage countries or
imported from there. This is exactly analogous to the shrinkage of the agricultural sector
in the Western World when the Industrial Revolution got under way; 250 years ago, agri-
culture employed the vast majority of the population, in the order of 80 %, and now
employs 3-5 % only. A process which is favorable for wealth creation, because jobs with

Figures from the Laenderprofil Japan from the Statistisches Bundesamt published in 2003. Incidentally the net exports
figure (which is, of course, something totally distinct from the net surplus of a firm) is not a source of wealth at all,
rather the contrary, because it means more goods are leaving the country then entering it.
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lower added value are replaced with jobs with higher added value.
It is clear though that in times of chronic mass underemployment, that is not perceived in
this way, nor, indeed, is it so: For want of a dynamic domestic economy, no worthwhile
new jobs are being created for the ones in the industrial sector dropping out. It is impor-
tant though to recognize that this is not a problem of “globalization” as such, but solely
and entirely a home-grown problem: namely that of a deficient internal effective demand.

Let’s look at some basic stylized facts and examples. Norway - one of the richest nations
on earth. Most people would reckon they are rich because they have oil. Yet the oil
accounts for around 10 % of GDP; take the oil out, and Norway would still be among the
richest nations. For confirmation look at the neighbouring Iceland: An island with a mere
300,000 people - too few for creating high-tech centres or a domestic industrial hub; also
no oil, even vegetables have to be grown expensively in greenhouses. With a GDP per head
coincidentally 10 % less than Norway, Iceland is also among the most affluent nations on
earth, furthermore with a welfare system that most people would nowadays deem utopian
and impossible.
Now consider a hypothetical Iceland, having no industrial production what so ever, so that
all tradable products would have to be imported. Furthermore we presume that the cli-
mate is so inhospitable that no foreigner would even consider going there and spending his 65
money on local services. This leaves us with a seemingly insurmountable dilemma: The
country produces solely non-tradable goods, but needs to import tradables from outside.
That would not be possible, then. The Icelanders would try to spend their currency on
imported cars, stereo systems, pharmaceuticals etc., but no foreigner would accept their
money because no-one would ever want to buy anything there. The exchange rate of the
Icelandic money would drop to bottomless depths.
But in this reckoning one would have forgotten one thing: If the Icelandic economy would
have a dynamic domestic demand with profitable businesses, yielding high margins, then
many a foreigner would gladly invest say in the opening of a disco. The foreign money
flows, as usual, instantly back to where it came from, to finance the importation of techni-
cal equipment like stereo-systems, laser-shows, and an autocar, which are essential for the
operation of the business. The fact that the foreigner will never buy something in Iceland
is not a deterrent: The business accrues profits in Icelandic currency; when the foreign
investor wants to pull out, some other foreigner can step in and will do so, if there is a
profit to be made; and so on. This is similar to financing some longer term investment by
rolling over short-term-debt. You buy a machine you intend to use for 4 years, but with a
monthly credit - at the end of each month, you pay back the old credit by getting a new
one; someone else steps into the shoes of the previous short term investor.
In how far the above argumentation is correct is something you can judge by yourself if
you look at the exchange rates of small countries with little industry, like Switzerland, the
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real Iceland and others; these countries are certainly anything but cheap, nurses and wait-
ers earn wages on which they could raise a family. From this you can infer in which direc-
tion the economic causality runs.

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A Ve ry S h o rt E co n o m i c H i sto ry
The plot:

1789-1944 - Let’s roughly say Capitalism

1944 - ‘73 Deficit-Spending-”Keynesianism”
1973 - 1979 Stagflation
1980/1 Monetarist interlude
1981-present neo-Capitalism

Let’s have a look at how economic policies played themselves out in history, focusing on
the Western civilization.
In the Middle Ages economic life was organized in part by markets, and partly by custom
and convention. These conventions were not etched in stone but re-negotiated between the
citizens on a regular basis. So, for example the families of a village may negotiate in spring
who is ploughing which field this year (crop rotation), the burghers of some town may
negotiate in council the organization of the craftsmen, fixing reasonable wages, building 67
bridges or churches, or may delegate authority to an able individual from a distinguished
family among them to lead their army as king33 in order to defend themselves. Yes, these
societies were less rigid and socially stratified than ours, and potentially well organised
with a strong egalitarian and democratic element: the kings effectively served as war lead-
ers in the field, instead of just hanging out in colossal châteaux guzzling red wine, that
came later.
The last remnants of the old-style democratic, federalist Germanic tradition are the Euro-
pean-fringe Scandinavian countries and Switzerland, still well-ordered and well-off.
In most other places, convention - less and less subject to deliberation - rigidified into tra-
dition (by the Grace of God), and - with an ever increasing population - traditional rights,
in which increasingly more people had no part, became privileges, the rights of the few
(prerogatives). A number of technical innovations came along, like the printing press, and
the Age of Aristocracy - the Government of the few - came to an end when people were
fed up reading about these privileges, and decided to do away with them. Freedom became
the buzzword of the day; freedom from arbitrary privilege, from arbitrary taxation, from
arbitrary regulation. The free market was then a progressive and revolutionary formula,
because it implied the abolition of privilege.
What then happens in this market, though, is closely tailored to the distribution of wealth
Etymologically presumably related to kinship or kindred, referring to a family tradition of courage in the public service.
Initially the office was semi-hereditary; the king had to have the explicit consent and acclaim of the people to assume office.
His functions were to serve as judge, priest, and war-leader.
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which structures it, as we saw in the earlier Leverage-theory-chapter.

Luckily, back then, more and more technical innovations came along to fuel the economy,
creating new niches and opportunities for the deft and crafty. The steam engine powered
factories, railways, ships; the telegraph and many other inventions, creating demand
which absorbed in better times most of the available labour (but in part at appalling work-
ing conditions), and in bad times there was unemployment, poverty, destitution.
These bad times came along with bonny regularity. These apparent shortcomings of capi-
talism created the most important policy issue of the 19th century: the social question.
Conservative politicians like Bismarck in Germany introduced the first European labour
laws such as insurance for health 1883, for accidents in 1884, and a pension for old age in
1889. Sanitation of the cities, the provision of public schooling and suchlike measures
relieved the situation to some extent, but the problem of poverty remained a reality for a
part of the population also thereafter.
In 1929 the Great Depression set in; its overture was a slump in the market value of finan-
cial assets. This in turn made people more cautious, they cut back on consumption, hence
firms immediately also cut investments and so forth. There is nothing which would pre-
clude that from happening, and from continuing to happen (i.e. no macro-management of
the economy). The search for a supposed “real” or other, somehow more fundamental
underlying cause of the Great Depression by economists is vain, and effectively did not
68 yield anything material. We have amply explained it already in this text.
Unemployment quickly soared to 25 % in the U.S. and stayed there for the next couple of
years. A similar development was to be observed in Europe. The helpless politicians who
consulted the orthodox economists of the day exacerbated the crisis further by cut-backs
in spending.
The desolate economic situation in Germany paved the way to Hitler’s accession to power
1933. Poverty and its associated lack of a reasonable perspective in and on life has and will
always be the fertile soil on which political radicalisation feeds. Ah, nothing as effective as
hate to whip up the crowds. The magical formula - turn despair into rage: no better expla-
nation for one’s misery than pointing to a culprit. If you are poor it is because of them.
They win, you lose. Repeat as often as possible to rub it in.
Hitler never bothered with economics, he rather thought in the atavistic terms of soil and
race; but that was to his benefit because it shielded him from the economic errors of the
day. He immediately embarked on his re-armament and public works programmes which
were financed by deficit spending34. In 1936 Germany was back to full employment and
remained there.
This was done via so-called mefo-bills; but consider this just a different name for Government Bonds which the Central bank
takes on the balance sheet and forks the money over to the State who spends it. Here is an extract from the case of the prose-
cution in the Nuremberg-trial against Hjalmar Schacht, president of the Reichsbank and Minister of the Economy (Source:
Nazi Conspiracy & Aggression, Volume II, Chapter XVI, pp.738 ff.: Transactions in “mefo” bills worked as follows:
“mefo” bills were drawn by armament contractors and accepted by a limited liability company called the Metallurgische
Forschungsgesellschaft, m.b.H. (MEFO). This company was merely a dummy organization; it had a nominal capital of
only one million Reichsmarks. “Mefo” bills ran for six months, but provision was made for extensions running con
secutively for three months each. The drawer could present his “mefo” bills to any German bank for discount at any time,
and these banks, in turn,
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On the other side of the Atlantic events fortunately followed a more measured and reason-
able course, but were less successful economically. FDR “was elected President in Novem-
ber 1932, to the first of four terms. By March there were 13,000,000 unemployed, and
almost every bank was closed. In his first “hundred days,” he proposed, and Congress
enacted, a sweeping program to bring recovery to business and agriculture, relief to the
unemployed and to those in danger of losing farms and homes, and reform, especially
through the establishment of the Tennessee Valley Authority.
By 1935 the Nation had achieved some measure of recovery, but businessmen and bankers
were turning more and more against Roosevelt’s New Deal program. They feared his
experiments, were appalled because he had taken the Nation off the gold standard and
allowed deficits in the budget, and disliked the concessions to labor. Roosevelt responded
with a new prog ram of reform: Social Security, heavier taxes on the wealthy, new controls
over banks and public utilities, and an enormous work relief prog ram for the unemployed. “35
So Roosevelt couldn’t go through fully because the prevailing economic orthodoxy was
still against him. In 1937 unemployment rebounded again from 14 % to around 19 %. In
1940 the average official unemployment rate was still an unpleasant 14.6 %.36 But soon
thereafter, the necessity to go to war cut short any misgivings about budget deficits.
And lo and behold, unemployment completely disappeared wondrously almost overnight.
Since even hard-boiled economists could not completely ignore the obvious, after WW II
the economic orthodoxy had switched from capitalism to Keynesianism. 69
The Bretton-Woods-system regulated world finance and was in place from 1944-1971.
In the period of Keynesian demand management which ensued, all major industrialized
countries were pretty much able to maintain the economy in a permanent state of boom,
and unemployment completely disappeared for the next decades. Research on business
cycles was halted at universities, because they were considered a thing of the past.

Now this was pretty much the solution of the social question! The modern consumer soci-
ety arrived in swift strides: growth rates of 5 - 10 % were not unheard of (German and
Japanese economic miracle) and rarely dipped below 5 % until the 70s.
Take the case of Japan, particularly telling: A densely populated island without much nat-
ural resources. The Japanese achieved growth rates close and over 10 % in the 50s and 60s.
The boom was driven by 2 pillars: The almighty Ministry of International Trade and
Industry (MITI) coordinated industry and set continuously aggressively higher production
targets (=higher demand), which were routinely financed by new money and credit issued

could rediscount the bills at the Reichsbank at any time within the last three months of their earliest maturity. The amount
of “mefo” bills outstanding was a guarded state secret (EC-436). The “mefo” bill system continued to be used until 1 April
1938, when 12 billion Reichsmarks of “mefo” bills were outstanding (EC-436). This method of financing enabled the Reich
to obtain credit from the Reichsbank which, under existing statutes, it could not directly have obtained. Direct lending to the
Government by the Reichsbank had been limited by statute to 100 million Reichsmarks (Reichsgesetzblatt, 1924, II, p. 241).
Schacht has conceded that his “mefo” bill device “enabled the Reichsbank to lend by a subterfuge to the Government what it
normally or legally could not do” (3728-PS).
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by the Bank of Japan and its ancillary municipal banking arms.

The Japanese example is particularly revealing because it makes it hard to argue here that
the boom would be due to the free market (it wasn’t free), or would have happened any-
For it goes without saying that the believers in capitalism presupposing homogenous prod-
ucts will offer an alternative line of argument: The recovery in Germany in the 30s would
have happened anyway, even without Hitler and his intense war preparation.37 The post-
WW II 30 year boom is due to the free market and would have happened anyway. Of
course this is motivated by theory. Capitalism with homogenous products predicts the free
market should bounce back quickly to full employment, so if you firmly believe that, and
simply see no other way, you will try to build a case for it. How things will look to you in
social science often depends more strongly than in natural science on the underlying
assumptions made. Look again at the Q and the tech-bubble example in the appendix.
He makes the assumption that the financial valuations cannot differ markedly from book
value, so he seriously argues in 2000 that the recent soaring market values of the new-
economy-internet-boom are in effect fully covered by “large amounts of intangible capi-
tal”, whatever that is supposed to be in practice. Well we know what happened subsequent-
ly, so in hindsight this analysis appears laughable (not so laughable perhaps to people who
have lost their shirts on such beliefs), but it does illustrate how far you can go in your
70 counter-factual assessments.

I am not saying that the economy is always subject to latent unemployment. What follows
directly from the classical model with product differentiation is that economic output is
inert and behaves as an indifferent equilibrium, like a cup on a table: It tends to stay put
where it is. A divergence would need a new stimulus. Underemployment equilibria are pos-
sible long term. But likewise, if the economy is at full employment level; and if everyone
expects even further growth next year, and behaves accordingly, the economy will remain
in this state by itself. If the Government and the Central Bank react swiftly when the
economy starts to dip, then the size and frequency of these interventions may very well be
quite limited. So if you look at the 30-year-boom in isolation, you may argue it would have
happened anyway without making grossly unrealistic assumptions on the face of it. But
mind that that too doesn’t prove anything. You must not look at it in isolation, you have to
compare it with what went on before and after: i.e. with the busts of the 19th century hap-
pening every few years with regularity, the low growth rates then, the Great Depression
itself. This alone makes for a very strong case indeed. The case is further strengthened by
us being able to look behind the numbers and at the actual policy. The policy regime of
the Governments has indeed switched definitely after WW II to them explicitly leading a

Even the most vocal proponent of this proposition, Ritschl (1990) concedes “Continued fiscal and monetary expansion
after that date (1936) may have prevented the economy from sliding back into recession. We find some effects of the Four
Years Plan of late 1936, which boosted Government spending further and tightened public control over the economy.”
Some effects seem a bit understated, when you compare it to the American case of again nearly 20 % unemployment at
the same time, versus a neat 0 % in Nazi-Germany.
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stabilization-policy: averting crisis by countercyclical demand if needed. This is what

they explicitly commited to, and it was even codified in some cases into law.38
Lastly, the case is critically strengthened by theory, because the classical model itself
yields unemployment equilibria - with product differentiation. The latter at least can be
empirically verified, independently from special assumptions, and beyond the shadow of a
doubt. Hence there is no ground for excluding deadlocks, and to assert that the economy
will bounce back quickly and automatically. This assertion is now unfounded. In reality it
is also demonstrably not the case, viz. the Great Depression, or more recently, take Russia
or Argentina.

But back to our story. The long, ongoing boom started to induce cultural changes: the eco-
nomic climate was benign and predictable, most people did not have to worry about their
economic future. Material aspects became less important, they were mostly satisfied any-
way. Many people got rather more interested in spiritual issues, peace and love.
In the 1970s though the world economy steered into troubled waters, and the Keynesian
demand management seemed no longer to be effective. The appearance of the stagflation-
phenomenon - economic stagnation/recession hence unemployment in conjunction with
inflation - which according to the Keynesian economists of the day could not occur -
served to discredit them.
It is hard to understand why stagflation should be hard to understand. Say everyone in the 71
economy - with or without unemployment, that has nothing to do with it - believes the
inflation will be 10 % this year. All duly take this into account, mark up the prices and
wages accordingly, and the Central Bank obliges by increasing the money supply by 10 %,
so that all transactions can take place at the now higher prices. Voila. There isn’t any con-
tradiction in this. This situation would in effect not be materially much different from
0 % inflation (in practice the mark-ups won’t be that smooth, so some will win, some lose,
there will be associated costs etc.; I’m not a fan of inflation either, I’m just saying there is
no contradiction here).
The unemployment came from an inadequate policy response to the oil shock of 1973,
which also induced a dose of inflation. But we know from a previous chapter that once a
crisis and unemployment develops, excess capacity will vanish quickly. Then a surprise
expansion of demand will inevitably result in price increases because output is no longer
very elastic - capacity would have to be rebuilt first. Mere demand expansion is now no
longer sufficient, you need the 2nd leg of filling the firm’s order books medium term and
crowding out consumption by investment now. This crucial point was not realized at the
time - that was the mistake. The situation was exacerbated by inflation expectations.
People will start bickering over their share of the pie, mighty unions may be tempted to
push through exorbitant wage rises which are counter-productive and aggravate the situa-
E.g. In Germany 1967 with the Law for the Promotion of Stability and Growth of the economy.
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tion further, as a counterstrike, firms hike prices even more and so forth.
In addition to this choppy, unstable macro-climate which emerged, economic life in the
preceding decades got more and more burdened by overregulation, which understandably
created frustrations. Around every permanent employment contract, a cobweb of laws and
social security liabilities ever more intricate was strung, stifling economic initiative right at
their source - namely eco-friendly, basic productive effort i.e. work supplied by individu-
als, the very activity from which any economic development for the better would spring
from. In principle the constant micro-interventionism and regulatory paternalism would
not have been necessary, and certainly has nothing to do with good macro-management.
But only neo-liberal economists (while all others looked the other way) were vocal about it,
and hence profited accordingly in the public opinion. Yet you do not have to be an ultra-
libertarian to recognize that the baroque complexity of say the tax system serves no
rational purpose, has no added value, and can only be counter-productive - an ounce of
common sense would be enough to see this (not that this has gotten any better under the
neo-cons since the 80s to this very day, either).
Anyway the gospel of the neo-liberals got more convincing Anno 1979. The streets are lit-
tered with garbage since weeks, because the dustmen are on strike again, you have to
worry about losing your job, whilst you pay ever more at the supermarket-counter, and
your kids listen to punk-rock - no future. It clearly cannot continue this way. So Thatcher
72 came along, and then Reagan. The conservative counter-revolution began, and is in force
to this day. The priority back then when assuming office was to normalize public life - by
reigning in inflation, and, at least in theory, to relieve the overregulation of peoples’ lifes.
Also the state - again only in theory - relinquished an active demand management, and
counted on the market alone to bounce back to full capacity. We know that this belief is
unfounded; it is potentially the biggest mistake of economic policy you can make, so for-
tunately this didn’t happen because state spending typically even increased with the neo-
cons who championed previously neglected areas of spending such as military and so on.
Inflation was vanquished at the beginning of the 80s; the crude monetary policy employed
in America created an unnecessary recession in 1981 as discussed already above. However,
ballooning budget deficits to finance the arms race added some zest thereafter; soaring
financial asset prices fuelled by low interest rates made possible the casino-capitalism of
the roaring 80s in the US and Japan’s bubble economy at that time. But you know that the
paper-value of the assets can vanish as quickly as it appears.
This is what happened in Japan in 1990. To the surprise of many economists, Japan subse-
quently proved that zero interest rates were possible. The Japanese case proved further
that, even more astonishingly for orthodox economists, this did nothing to bring the econ-
omy back on an expansionary track. Exactly what one would expect, but completely
unexplainable within the context of orthodox neo-liberalism and neo-Keynesianism alike.
The world must be a pretty enigmatic place for the orthodox economist.
But back to our economic history. In all OECD-economies the economic climate got much
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harsher for the factor labour - many more hours of work to weigh in, secure jobs much
rarified, and real (inflation-adjusted) wages stagnating at best, more likely dipping.
Russia is still mired in poverty, Africa is, Argentina and others. In many regions of
Eastern Germany the unemployment rate is a dismaying 25-30 %; it is not hard to figure
the discontent, disillusionment and resentment behind these numbers. Whopping execu-
tive bonuses in a sequence of figures that most people would encounter in practice as tele-
phone numbers make an additional mockery of the plight of many people to get by in a
tough environment. Income polarization is exactly what to expect from the market
unleashed, as the leverage-chapter showed. It showed further that with insufficient effec-
tive demand, the simple-labour-sector will be hit first and hardest. The wages for the sim-
ple labour-type39 - like that of a barber, or security-personnel - are in East-Germany cur-
rently (AD 2007) 4.2 per hour, that is 672 gross per month. Not much to get by on. At
that rate you will have to hustle like a hamster if you merely want to achieve a basic
lifestyle with a telly; you may safely forget about kids. This is not what life used to be like
in the Western world in the 1960s, say. Because of a declining tax base due to widespread
un- and underemployment = the working poor, along with higher payouts in social securi-
ty, deficits became worse without necessarily providing much of a net stimulus, so an ever
growing mountain of public debt now towers above Europe and America.
This will necessitate yet more cut-backs in the future, in keeping with free market ideolo-
gy preferably for social matters. The sheer size of the public debt makes further deficit- 73
spending less and less thinkable. That is potentially very dangerous, because zero-interest
rates will not suffice to ward off the next Great Depression.
But Keynesianism has failed anyway, so while unfettered capitalism may not be perfect, it
is the only available option we have, and all we can do is hope for the best. That is what
people think; and if you don’t know about the option discussed in this book, it must be
halfway persuasive. Not any more.

Only a minority of the peoples of the earth live in economically reasonably well-organized
and secure circumstances. The majority live light-years behind of what would be organiza-
tionally and technically possible. Indeed, a lot of countries couldn’t do better if the
intended policy goal were macroeconomic self-mutilation.
It is within reach of even the poorest nations without natural resources (Japan has scarcely
any resources! The African country of Ghana was in the 1960s on the same economic foot-

To reiterate something we noted previously: When you look at statistics, you will see that many of those affected by un- and
underemployment are people without university degrees. In newspapers you may hence often read that the problem of
unemployment in industrialized countries would be one of education, at bottom. But, also at bottom, this is not only false,
it is an insult. There is nothing wrong with being a barber, we can’t all work as nuclear physicists or web-page designers. The
society needs motivated and friendly nurses, waiters, policemen, etc. And if our economy would not operate below full
capacity, which indeed creates a downward spiral for people offering this type of work due to excess supply=insufficient
demand, there would be more demand and the money to pay for it. For confirmation, go on your next holiday to say Switzer
land or Iceland and ask people with those kinds of jobs how much they make.
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ing as South Korea - both anything but resource-rich; and look at South Korea now - its
wealth per capita starts to equal European levels after not even 2 generations) to build
themselves up quite quickly if the economy were well-managed. This is so because no
country needs to produce by itself cutting-edge technology to be well-off (is Iceland a
high-tech El Dorado? Not so. Are they well off? Yep.), no more than you yourself would
have to produce hi-tech goods, or even understand exactly how high-tech goodies internal-
ly work in order to operate them and achieve an OK living standard. First and foremost,
necessities like the following are needed: Purified water; nutrition; housing; schools and
universities; infrastructure like roads, railways, electricity and digital communication net-
works, sewage, means of transportation. Note that all these are non-tradables, hence have
to be supplied from within.
No such country needs the latest super-computers; a netwo rk of linked PCs from a few
years ago will do equally well; excellent operating systems are ava i l able for free. It would
also be cheap to set up or tap into intern a t i o n a l ly already ava i l able resources in order to
create an electronic library of all scientific knowledge and cultural content, wh i ch stu-
dents in the whole country and beyond could use free of ch a r ge. Except for very specific
ailments such as malaria or AIDS, no high-tech medication or medical sector (like the
bloated medical sector in the obesity-stricken US which devours 16 % of its GDP) is
needed for the citizens to be healthy and attain old age: healthy nutrition, exe r c i s e,
74 hyg i e n e, and an unpolluted env i ronment plus basic medical and surgical tech n i q u e s,
along with traditional and basic We s t e rn medication will go a long way.
One gigantic untapped potential of the developing countries and regions of the world is
r e s e a r ch (think of the billions of u n d e r-educated people, many of whom can’t even
read). This would have a most beneficial impact on society as well. Te a ching materials up
to the latest scientific articles on all subjects could be made ava i l able for free. Languages,
litera t u r e, art, design, social-sciences, law, mathematics, theoretical engineering, and oth-
ers require little additional hardware or investments but the info rmation itself; so stu-
dents in developing nationscould quickly attain very high standards in these. Many other
fields - medicine, ge o l og y, chemistry, biolog y, agricultural and nutritional sciences,
physics, computer science, mechanical and electrical engineering - can also be taught eff i-
c i e n t ly on low-budget hardwa r e. Furt h e rmore the research can be specifically geared and
a pplied to local areas of interest: Like ch e a p, aesthetically pleasing and eco-friendly arch i-
tecture needing no heating or air-conditioning, improve local agriculture, waste manage-
ment, logistics and transportation, develop intelligent appro a ches to education and
schooling, research the medical pro p e rties of ava i l able plants, the possibilities to produc-
tively employ people are endless. The overall quite successful German economy for exam-
ple owes its tech n o l ogical and industrial prowess in no small measure to certain institu-
tions (like the Max-Planck and Fraunhofer institutes) which are intermediate bodies
between private industry and universities, specialising in applied research on currently
important topics.
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Yes, all these things would clearly be possible and within reach, if people would realize
that with idle resources there is no financial constraint.40


To explain it yet again, just to be sure: If say a university is built somewhere in the economy, that doesn’t mean other housing
somewhere else in the economy cannot be built. This were only so in the case of full employment. Hence you do not need to
finance the construction of the university by debt.
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A D i st a n t M i r ro r – Ar i sto t l e

Aristotle is interesting not only because he is the first to provide an analysis of the eco-
nomic; but also because especially today much could be learnt from him.
He has been read also by some economists, but apparently little understood, looking at the
way some utilitarian-neoclassical economists try to claim Aristotle as one of their prede-
cessors (you will shortly understand why). More discerning is the following misinterpreta-
tion of his thought: Aristotle does not offer any genuine, economic theory, because his
thoughts on exchange and markets are embedded in a normative context more akin to a
76 theory of justice - so for example Karl Polanyi: “...economic theory cannot expect to bene-
fit from Book I of Politics and Book V of the Nikomachian Ethics.” Or Finley: “Of eco-
nomic analysis there is not a trace”41.

Aristotle focuses his perspective on reproduction: individuals are not self-sufficient, and
therefore congregate in primary productive communities called ‘households’ in order to
satisfy more efficiently their material needs (Politics 1252a28, 1252b12).
But even though the household is a community of production, which can provide some
basic economic goods, this is not sufficient for what Aristotle calls the Good Life. So
households then are not self-sufficient - with respect to leading a truly civilised good life -,
and therefore many households congregate into the Polis - a well organized state, where
culture and sciences flourish.
This means that the whole - the Polis - reproduces itself via the deliberate, reflected and
reasoned decisions of the individuals which constitute it in view of leading a good life.
For Aristotle, and even more his predecessor Socrates, the free, ideologically unbiased and
democratic discussion among the citizens of how to achieve the aim of leading this good
life best was also the ultimate institution of arbitration - the tribunal of reason - for social
Contrast this view with “modern” economics being based on the paradigm of possessive

Both quoted according to Schefold (1994, p. 152).
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individualism, in which the proprietor is the basic element, and the web of mutual rein-
surance contracts between proprietors (aiming at the protection of their property) consti-
tutes the substrate of society.

Only the Polis is autarkic, i.e. self-sufficient, and constitutes the necessary reference
framework of economic analysis.
The economic problem is now how the material flows of goods have to be best organised
in order to foster the good life in the Polis. It is the latter instance from where the appro-
priateness of the material exchanges have to be judged.
The point is treated by Aristotle in the fifth book of the Nikomachean Ethics. Ethics
(Greek ethikos = customary) is concerned with the reasoned foundation of human rela-
tions, the giving and taking of social life, to which also the economic transactions belong.
You can guess from this already that the above interpretation by economists completely
misses the point, because ethikos is not to be understood as a purely moral sphere, which
would then be contrasted with a purely positive and scientific, factual sphere.
Even modern economics cannot limit itself by describing the iron laws of exchange
between proprietors, but must ultimately encapsulate some kind of appraisal or evaluation
of the outcome of economic affairs in society. If this evaluation is indeed missing (see
neoliberal income distribution theory above, in which market incomes are by definition 77
what the productive contribution of a person is worth), or is marginalized, you are in the
same measure pseudo-scientific and ideologically doctrinaire as you pretend to be a purely
positivist scientist.
Back to Aristotle: the solution to the economic problem is that the flows of goods have to
be structured in such a way that the material status of the persons undertaking the
exchange is reproduced by it.
Nicomachean Ethics (1133a23): “as therefore a builder is to a shoemaker, so must such
and such a number of shoes to a house; for without this reciprocal proportion, there can
be no exchange and no association”. Aristotle establishes here a relation between the social
status of the persons involved in the exchange, and states that the proportions of the
quantities of real goods exchanged must bear the same relation as the social status or
merit of the persons.
This is under no circumstances a moral exhortation: rather, it is a material law of conser-
vation of the social status quo. It gives the condition under which the social order can
reproduce itself such. The social merit or status of the persons are reproduced by the
flows of goods.

But what does Aristotle mean by social status? Since nowadays we have a quite different
conception of social status, which is - rather tellingly - equated with the factual power and
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riches of someone, it is useful to have a look at the economic life in Athens at Aristotle’s
The social merit of a person depends primarily in his contribution to the public common
weal. Rich people were expected to contribute proportionately more to it (the so-called
liturgies)42. On the other hand, an astonishingly high proportion of the citizens43 - about a
third - received in consequence a payment for their political or communal commitment,
which can take the form of participation in public assemblies, the theatre, or communal
offices of various kinds. Half of the Athenian budget was thus spent on communal festivi-
ties, buildings and activities.
The aim of economic action proper was to provide the material basis for each to lead a
good life within “normal” proportions: Greek cities have repeatedly passed legislation to
contain excessive private luxury. Note the clear-headed perception this presupposes of
wealth being rather a burden on the common weal and not a boon. It also presupposes the
distinction between real wealth, and purely virtual or financial wealth (more on this
By the way, unlike our plutocratic democracies, the original had a strong chance or more
direct component. Participation in certain political bodies and offices was assigned by
drawing lots (this principle has re-appeared in the jury-selection in anglo-saxon countries).

78 4.
Furthermore, in his Politics, Aristotle distinguishes between natural and unnatural modes
of acquisition. The latter he called deprecatorily chrematistics, meaning the sly and
cheaty kind of business-making44.
For one chrematitics is defined by the intention which is behind the economic activities: if
someone takes part in them not to procure the necessities for leading an ordinary, good
life, but to acquire abstract riches, then it is chrematistics.
Aristotle offers the example of the physician, whose goal is not primarily the health of his
patients, but maximum monetary gain; though he exercises superficially the art of heal-
ing, his work really is chrematistic.
Next to this argument directed at the motive, there is another one aiming at the inherent
nature of the activity. Aristotle distinguishes real, productive activities, and the subse-
quent proportionate exchange of useful goods from a kind of bargain where people make
gains from each other (Politics 1258b 1 following). Here we have the idea that the commer-
cial, monetary gain does not correspond to any useful, newly produced things. Or in other
words: a given quantity of goods is only redistributed, but nothing additional is produced
(zero-sum game).

For this and the following see Schefold (1994), p. 132 f., 145 f. and p. 178 f.
Excepting slaves, women, foreigners and peasants of course.
Interestingly, in the English language there is no direct term for chrematistics, whereas for example in German there is not
only its direct etymological descendant Krämertum, but also the vernacular Schacher. Since languages are also indicative of
a way of life, this would mean that the very concept of overreaching transactions hardly exists in the anglo-saxon culture.
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If the chrematistic physician perverts through his excessive drive for profit the art of heal-
ing, the latter form of chrematistics perverts the institution of money.
Money was instituted by convention (ancient Greek for currency is νοϖµο, designating
anything established by usage/convention) as a useful medium of exchange, particularly
for facilitating long-distance transactions.
Chrematistic dealer-traders now take advantage of price differentials through their trans-
actions, which are essentially not commodity-transactions based on real needs, but cun-
ning financial transactions, for maximising their wealth defined as a quantity of money
(1257 a 33 following).
Aristotle critizises the definition of wealth as a quantity of money, and, after reminding
us of the fable of king Midas: “Hence people seek for a different definition of riches and
the art of getting wealth, and rightly” (1257b17).
Aristotle defines wealth as a quantity of useful goods - useful for the household and the
state: “a supply of those goods, capable of accumulation, which are necessary for life and
useful for the community of city or household. And it is of these goods that riches in the
true sense at all events seem to consist. For the amount of such property sufficient in
itself for a good life is not unlimited...” (Politics 1256b).

If we now put all of this in the context of Aristotle’s conservation law of the social status
quo, or his principle of reciprocal exchange, we get the following: 79
Chrematistics is defined as being a non-reciprocal exchange; there is a wedge or asymme-
try between what the person procures to society, and what he or she gets out of it - name-
ly more.
This asymmetrical exchange is made possible by the perversion of the institution of
money, and becomes visible in an accumulation of money; an abstract “financial” capital
to which no useful, real goods correspond.
If the principle of proportionality, which is the condition for a sustainable, material repro-
duction of the community, is systematically contravened against, then the real flows of
goods will render the leading of a common, good life for the citizens of the community
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2350 years later, people have gained a substantial technological power over their natural
environment. But - in stark contrast to Aristotle or even the time of the Enlightenment -
no faith, not even the conception, that the social-economic architecture is malleable and
adaptable by intelligent design. The bustling facade of media-circus and high-tech is so
much clamor in front of a social-economic vacuum. The legendary founder of the Spartan
social order, Lycurg, aimed to remedy the vices avarice and waste by an equal distribution
of land and the substitution of Iron coins for Gold and Silver. In comparison to this intel-
80 lectual audacity (which was even acted on), we moderns are shamefully bereft of ideas or
judgment. Gold is since the 1970s no longer the basis of our monetary system, and this by
pure necessity, not design.
The economic system is in many parts of the world locked into a pathological, suboptimal
state of underproduction. The destitute have many basic needs, and are ready and eager to
work for it. The firms would welcome more demand, and could hire the people to produce
the goods wherewith to satisfy it at the going wage-rate. But demand and supply do not get
together. It would be easy to supply these basic goods, like housing, textiles, food, pure
water, streets, schools, kindergartens, hospitals, access to education like libraries, the web
etc. All of this does not involve any technological or copy-right issues, it can, indeed needs
to be manufactured domestically, by the people themselves, for themselves.
But it doesn’t happen. Unable and unaware that they could engineer it themselves, the
politicians and economists look for additional, effective demand from outside, like manna
from heaven, which would lift their countries out of economic stagnation. Maybe a stock
market boom, or the deus-ex-machina of growth led by exports. So what do we do when
we view the earth as a whole - do we have to wait for demand from the planet Mars in
order to create a functioning economy?
On the micro-perspective people may get excited by huge leverage incomes, and dishwash-
er-to-internet-millionaire-stories, but they should realize that these positional rents are not
openly accessible in the same way that you can be sure to master French perfectly, if you
work hard and apply yourself. This tends to create a commercial culture of unrest, where
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people observe constantly “what the market may want” in order to position themselves,
but only a minority will in effect be able to profit.
Instead of really being forward thinking, like it actually happens say in the arts and natu-
ral sciences, economic policy is staunchly rooted in the past. Since the politicians do not
know how to initiate the creation of new wealth, they are willing to preserve the existing
hubs of business activity, even if they involve environmentally very destructive side effects
on a global scale. Anyway, after a few years their successors will deal with it. This state of
affairs is also not helped by plutocratic elements in the political constitution, which make
the politicians dependent on private financing, a freeway to political corruption. So the
logging continues, the discharging of waste, the belching out of poisonous and climate-
changing gazes, day after day.
Given these stylized facts, some people will vaguely conjecture that there is a problem with
the current state of the global economy, but so far I haven’t seen anything in the way of
economically informed content.
The most visible critique of the neo-libertarian brand of economics which now rules the
world operates under the flag of anti-globalization; already a very narrow focus. And by
the way this is not new, but centuries old, economic theory starts out with mercantilism,
which worried much about international competition and advocated taxation of imports
and similar measures.
The two main economic measures proposed are45: 1) Taxation of financial transactions 81
inversely proportional to the holding period (Tobin-tax) and 2) heavier taxation of the
First to point 2: The eat-the-rich kind of approach has the basic flaw in that it supposes
that that which can be distributed to someone must first be taken away from someone else.
This is not true if we have un- or underemployment. Furthermore the indeed vast for-
tunes of the rich consist essentially in the paper value of real assets like buildings,
machines, offices etc.; real resources which are already efficiently used within the econo-
my. What you can take away from them and redistribute is their real, annual consumption.
But if you go back to the salary-table in the Leverage-chapter above (or take some real
world data), you will see that if you redistribute most of the very high incomes among all
people, the sum per head will be very small. Redistribution is not a workable way to make
everyone well off. This is not an ethical argument, it is pure mathematics.
And to point 1 from above: I cannot see how it would change or remedy any of the funda-
mental aspects of the real economy. So yes, some of the volatility in financial variables
will be eliminated, the state will have a few billion more revenue, and the international
banks will get a healthy profit-boost by structuring tailor-made solutions for their clients
to avoid most of this tax. So what? The real economy will still look exactly as it does now.
That taxation should be the remedy to the economic troubles of the world is, in itself, not
overly convincing. Furthermore this is the one area where Governments are already natu-
rally good at, and presumably don’t need any extra encouragement.
By the Association pour la Taxation des Transactions pour l’Aide aux Citoyens (attac).
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What is nice though is their motto “Another world is possible”. Yes it is, and in the next
two sections two solutions to achieve this will be presented. One pragmatic-capitalist, and
another one markedly different, a more Aristotelian society. Both are, however, perfectly
pragmatic in that they are not interventionist, and just involve fine-tuning of macro-eco-
nomic variables, which most people will not even notice; the economic daily life remains

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P ra g m a t ic – Ca p i t a l i st S o l ut i on of t he P ro b l e m of
U n d e r p ro d u ct i o n

Pragmatic-capitalist, we define the goal as: Eradicate un- and underemployment for good,
and keep the economy in a permanent state of economic boom, by keeping the level of
e ffective demand sufficiently high. By the way, it does not require a permanent growth of
the economy; of course, the economy will grow until the full employment output is
attained, but not necessarily beyond this point.46
The firms would gl a d ly produce more - and in a situation of unemployment there is ava i l-
able labor waiting in the line at the going wage rate - but the firms need to wait for the 83
demand (in money) for their additional output. The proletariat (why not use this old term
for the un- or underemployed) needs to wait for more and better jobs before it can effective-
ly demand i.e. buy more. Each side waits for the other. The strategy is the creation of
prospective purchasing power; in addition current consumption may have to be penalized
(by temporary taxes on consumption or higher minimum reserve requirements for credit),
so not to crowd out the manufacture of investment goods.
The implementation of this policy requires the bundling of certain competences in a new
institution, which we may call - analogous to the political powe rs - 4th or economical power.
C u r r e n t ly some competences are located at the Central Bank, and some in the Ministry of
Fi n a n c e, who currently pursue different and uncoordinated goals.
The Central Bank can steer the interest ra t e, but that is not a sufficient condition for
unleashing an economic boom. If people don’t buy (and they still haven’t got cash to bol-
ster up their needs so they can become effective), firms won’t invest however cheap interest
rates may be. Meanwhile the Finance ministry is busy collecting taxes and plotting new
The idea of prospective demand creation is as yet completely beyond the pale of the reign-
ing ort h o d oxy, but it would be merry tidings for any finance minister in a country opera t-
This is a relief because there is no known economic policy to bring about growth; this will make sense if you consider
that “the effects on productivity of Edison’s inventions should appear as a contribution of advances in knowledge -
not of capital, which should be related to saving” - New Palgrave Dictionary of Economics, article Growth
Accounting. This article notes as well that even investments into physical investment goods are only weakly related to
growth. There is really nothing else the state can do to force growth to happen. It is not a variable it can control; but it
can target effective demand.
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ing below potential.

So, the new institution has the mission to ensure 1) full employment at 2) no inflation.
This does not in any way undermine the independence of the Central Bank; on the con-
trary, it rather extends its competence and power. The new institution has the right to
issue future dated purchasing power, as the Central Bank currently has the right to issue
present dated purchasing power (= money). This future dated purchasing power can be
given directly to the people. In which case it would be in principle distributed equally,
because no person has a special claim on these newly created financial resources; the only
justification is an allocation differentiated by need. The future dated purchasing power can
also be allocated into the Government budget as a means of financing future-dated, but
already now decided-on Government spending47. Furthermore, the new institution has the
power to decree that temporarily, a part of the incomes in the economy will have to be
paid in future-money, not available right now for consumption spending. Lastly, it will also
have the power to impose a temporary consumption tax hike, to be fully able to prevent
demand from frothing over and creating inflation. This temporary consumption tax
increase is not available to the Government for finance of its outlays; the purchasing power
thus extracted from the economy will not be available to anyone, it will simply be annihi-
These powers will allow the new institution to keep the economy inflation-free and operat-
84 ing at full capacity, so that it will enjoy a permanent and sustainable economic boom.
This will also result in a significantly lower tax burden, which could then be kept at a level
similar to that of Switzerland - an environmentally-friendly country with excellent provi-
sion of public services, social security, and no structural unemployment.
A society which has a grasp of the workings of the economy, and has an institution which
can engineer the purchasing power so as to accommodate fully its productive potential, is
no longer dependent on the purchasing power which emerges from the private economy
alone, waxing and waning in its busts and booms. It can now afford to switch off the most
environmentally destructive externalities48, and choose to channel more labour into envi-
ronmentally sound and generally more healthy and reasonable products and activities.
In the pursuit of such activities, meteoric careers and fortunes can still be made. If noone
starves in the streets, why should we not want to incorporate into our society the adrena-
line-fueling elements of a party-lottery, where you could hit it big? There are all sorts of
ethnic traditions, so why not this one? Fine, I’m game.
It may be fairer to choose as a default the first route, i.e distribute it first to the people as a citizen’s baseline income, which
then the Government would have to explicitly tax. On the other hand, there is a case to be made for modern states to provide
efficiently and freely a number of public goods, like free education, healthcare, economic security. If the Government actually
does this, and does it well, then it may be entitled to the underproduction dividend.
If costs are not borne by those who generate them, but by a third party, this creates perverse incentives. E.g. a producer may
just make up or wrap up his wares from/in anything, and then toxic plastics are simply buried in landfills from where their
components seep into the water for decades ahead. Bravo! The free market is only working to the benefit of all if such costs
get internalized. To get that under way, a committee of scientists and engineers could put together a list of biodegradable
materials which can freely be used, or the firm, if it wants to use something else, must literally account for the recycling
process. These externalities impose a very significant real cost - first the wrong kinds of productive activities, and then yet
more work to clean up behind.
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E co n o m i c s fo r t h e G o o d L i fe

Surprisingly few have given it a go, at the genre of pragmatic economic visions, as founded
on reason rather than faith. In contrast to the more authoritarian and interventionist
schemes of the Plato-type, the Aristotelian liberal and enlightened tradition balances indi-
vidual autonomy with the common weal49. Only in the 19th century do we find another
small spate of platonic ones, the most prominent being Marxism. So Engels in his Social-
ism: Utopian and Scientific from 1880: “The proletariat seizes political power and turns
the means of production into State property. [...] Socialized production upon a predeter-
mined plan becomes henceforth possible.” We do not get to know anything specific, 85
though. It should be clear however that the transformation of a whole economy into a sin-
gle, centrally operated, gigantic uber-corporation would also be a logistic challenge of
gigantic proportions50. At least since doing the real world experiment has this become
clear. Now it is obvious that this could only even be envisaged with using the most
advanced and computer-assisted real time network planning techniques, optimization algo-
rithms and warehousing systems. There is no current research on this topic either, so we
cannot elaborate further. Anyhow even in such a system, some kind of indicator or index-
number could be assigned to the goods, which would express how easy or hard they are to
get in relation to other goods. When compared to the indicators of other goods, this can
be interpreted as a price. If we designate the decision-making by repeated feedbacks
between production, the people, and relevant research as a market; then the difference
between capitalist and socialist markets would be, that in the former the will of the indi-
viduals is weighed by an abstract medium purchasing power, a kind of economic plutocra-
cy, whereas in socialist markets equal voice per person would be the rule. Ideally submit-
ted directly, or delegated to some institutions “in the name of the people”. The point at

Weal or wealth are an old word meaning “good” (like well). The Aristotelian tradition (and following him Thomas Aquinas)
has formed the back-bone of the economic and social thinking of the catholic church, quite critical of capitalism in many
An ex-professor of mine used to tell how he was invited to the Soviet Union, to help them solve gigantic systems with mil
lions of interdependent equations which represented the input-output-matrices of all the diverse economic goods. It wasn’t
possible, unfortunately: It would have taken forever to do it by hand, and at the time in Moscow they lacked the computer
power to inverse these matrices.
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issue would then for most people be not so much markets as such, but rather the defini-
tion and distribution of the voting rights over goods (i.e. property rights and the distribu-
tion of purchasing power).

In his standard work, the founding father of economics, Adam Smith, wrote: “As soon as
the land of any country has all become private property, the landlords, like all other men,
love to reap where they never sowed, and demand a rent even for its natural produce”.
Rent - an income pocketed to which no productive contribution corresponds - is built on
some kind of absolute scarcity, impossible to outflank. Land is definitely a candidate crop-
ping up since the antiquity. Another one might be the possession of capital - popular
since at least the 19th century.
Our leverage-theory above generalized this: Leverage is a positional rent involving power
over capital. It can be based on direct ownership, in which case the power over capital is
absolute; this kind of power could, for example, be inherited. The power over capital may
also be constitutional; granted for a limited time, like the power of a manager with respect
to the company’s budget. Generally the manager doesn’t get to his or her position by
inheritance, rather by following a path through the network of the working world. This
career functions also as a training in which he will acquire private (as opposed to publicly
86 available one, as in schools) knowledge, contacts, reputation, and abilities, and the alle-
giance or trust which may qualify for the jump to the next position. So in fact rent does
not only exist on “earth”, there are many pockets of rent, of all sizes, strewn across the
Nowadays, rent is primarily based on information. Since the olden days of Coupon-cutters
and joint-stock-company-owners enjoying themselves on their estates behind English-yew-
hedges, while salaried directors at their service took on daily business, the ultra-rich are
now working hard in anonymous high-risers. This is borne out by the following chart51:

Source is Citigroup research 2005.
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An efficient and just economy is an economy without rents. Rent is inefficient because it is
in effect a transfer of resources from A to B without any, or any adequate service from B
to A - see Aristotle above. If in any economy it is possible to capture rents, people are
incited to do just that. But the energy expended to acquire them is lost overall, because
rents are a zero-sum-game. If you want a decentralized, intelligently designed economy,
property rights should be designed in such a way as to make rent-acquisition impossible.
This would involve a weaker, but of course no less clear or definite design of property
The most elegant way to achieve this is probably by a ceiling on personal lifetime con-
sumption, per period and overall. What one consumes are the real resources a person
draws from the economic pool, hence taxes should be based on this rather than anything
else. This is not hard to implement in practice: What is not saved must have been con-
sumed, and is subject to imposition or even a cap (financial authorities have all relevant
information already).
In the event of death or emigration from the community in which the person has operat-
ed, the assets beyond a certain ceiling are sold on the market and the proceeds go to the
community. Since this would be a major source of funding for the state, the tax burden on
working individuals with non-luxury consumption would be very light.
It is not in the economic interest of the state to throttle investments in the economy; some 87
may be purely financial investments and bring not much benefit other than inflating
financial prices somewhat, to which no real wealth creation corresponds. But there are also
real investments going on, which will be of great benefit to the community, like research
on medications, creation of better products, better logistics etc. It would be unwise for the
state to withdraw real resources from there. The state cannot see which kinds of invest-
ments are encapsulated by the securities which represent them financially, hence the
(temporary) owner of a going concern may dispose of it during her lifetime (but not with-
draw more than a certain amount for her consumption), just as the manager may dispose
of the budget of his company while in office. This power ends for the manager when he
leaves his position, and it ends for the owner of a going concern when she decides to retire
or dies. There is no prima facie reason to suppose that her offspring is especially qualified
in taking her position; the chief surgeon in a clinic is also not succeeded by his first born.
If there is a case to be made for a qualified child taking the position, he can convince the
local branch of his bank, or the savings-and-loan-agency of the community to finance the
acquisition of the firm, and thereby keep the family tradition alive.
If the ceilings on consumption and inheritance would be relatively lax, and if the state
would handle corporate outlays which strongly benefit personal life-style rather permis-
sively, such an economy might not look very different from the one termed pragmatic-cap-
italist. If they are very egalitarian, the economic climate would be markedly different.
There is now much less (personally) to gain, but also much less (personally) to loose. The
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economic climate would then resemble the one we now have in well-funded and well-func-
tioning research institutions. I say well-funded and well-functioning because, as a matter of
course, we need a 4th or economic power to dissolve macroeconomic deadlocks - should
they appear - as above. To get an idea, the salaries-schema that is currently applied by the
state is probably what the public eye views as adequate compensation for people who ren-
der the community good service. The salary-span would then peter out in the 200,000 $ -
400,000 $ per year range for higher level executive and other top jobs.52
Such a society would be economically more open and accessible to each individual growing
up in it; entrenched dynasties, which already largely occupy the environment, possess the
best bits, the finest lake-views and so on, do not exist in it.53
It would also be a society which can guarantee absolute economic security to all its mem-
bers and the highest living standard organizationally and technologically possible. You
could call it a meritocracy, socialism, or an Aristotelian society, where human and econom-
ic affairs are ordered according to reason. Perhaps too reasonable yet, for the current cli-
mate of opinion? Probably so; and maybe we will have to wait another 2350 years until
some essential truths in matters economical are realized and implemented again. That is
ultimately up to you out there - the people, respectively their elected representatives. I just
have exhibited - so as to have a choice - what is possible. So, choose well; take care.


Looking at the salaries of the German Chancellor and the American President. At these levels this society would not need an
iron curtain, nor would it have to fear that vital jobs remain undone because people cannot become (private) billionaires. The
most successful in any field have always been those who were primarily driven by enthusiasm. So the top talent in science and
technology will probably be retained, if they also have optimal conditions for research. The only ones who possibly won’t be,
because they would make even more money in foreign lands are top football players, racing drivers etc., but they are not
important for real wealth creation. It would be more beneficial for the people to do some sport themselves instead of watch
ing it on telly anyway.
Those bits will then be much cheaper, not available for purchase to foreigners, and presumably be used by more people with a
real interest in them. This is the case in Switzerland, the oldest and most direct democracy of the world: Real estate which
the community permits to be foreign-owned is expensive, while the majority, being only available to locals, is quite cheap.
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B i b l i o g ra p h y

Aristotle, Nikomachian Ethics and Politics, translated by H. Rackham, Cambridge MA,

Harvard University Press, 1943-44, available on The Perseus Project, at

B a r ron, J. M . / U m b e ck, J.R./Waddell, G.R. The Link Between Seller Density, Price
Elasticity, and Market Prices in Retail Gasoline Markets, preliminary draft 2002

Citigroup-Research, Citigroup Global Markets Equity Strategy - Plutonomy: Buying Lux 89

ury, Explaining Global Imbalances, 2005

Engels, Friedrich Socialism: Utopian and Scientific 1880; in Marx/Engels Selected

Works, Volume 3, p. 95-151; Progress Publishers, 1970; also available on

Hall, Robert E. The Stock Market and Capital Accumulation, National Bureau of Eco
nomic Research, May 2000

Lerner, Abba P. Functional Finance and the Federal Debt, Social Research, Vol. 10,
February 1943, p. 38-51

The New Palgrave Dictionary of Economics, Ed. J. Eatwell, M. Milgate, P. Newman, The
MacMillan Press Ltd., England 1987; Article Growth Accounting, p. 572

Nuremberg-trial proceedings from 1946: Nazi Conspiracy & Aggression, Volume II,
Chapter XVI, pp.738-767

Nutt, Gary Operating Systems - A Modern Perspective, Addison-Wesley 1997

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PISA (Programme for International Student Assessment) Learning for Tomorrow’s World
- First Results from PISA 2003, published by the Organisation for Economic Co-
Operation and Development (OECD), downloadable under

Ricardo, David Principles of Political Economy and Taxation, 1st edition London 1817
(quoted after a reprint by Prometheus Books 1996)

Ritschl, Albrecht Deficit Spending in the Nazi Recovery, 1933-1938: A Critical

Assessment, Journal of the Japanese and International Economy 16 (2002),559-
582. Also available on

Sargent, Thomas J. Macroeconomic Theory, Academic Press New York 1979

Schefold, Bertram Wirtschaftsstile Band I: Studien zum Verhaeltnis von Oekonomie und
Kultur, Fischer Verlag, Frankfurt 1994

Schiantarelli, F and D. Georgoutsos Monopolistic Competition and the Q Theory of

90 Investment European Economic Review 34 (1990) 1061-1078

Smith, Adam An Inquiry into the Nature and Causes of the Wealth of Nations, 1st edi
tion from 1776

Tobin, James Liquidity Preference as Behaviour towards Risk, Review of Economic

Studies, Vol. 25, February 1958, p. 65-86

Tobin, James A General Equilibrium Approach to Monetary Theory, Journal of Money,

Credit and Banking Feb. 1969

Tobin, James Money and Finance in the Macro-Economic Process, Nobel Memorial
Lecture, 8th Dec 1981
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A p p e n d i x o n Miscellaneous Eco n o m i c Tr i v i a

Tobin’s Q and Stock Prices in more Detail - An Illustration

We investigate now in more detail the difference in the two levels of returns, the financial
return and the profit rate of the firms.
Unlike the purely financial investor, the owner-entrepreneur can transfer her funds direct-
ly into the firm and earn on them the operative return on capital. To make the case even
stronger54, we can assume that she has more than enough funds to invest: she can place
them in the firm, where they yield the profit rate, or she can buy, say, Government bonds
which yield the current interest rate. Now, if we assume that the profit rate were higher
than the interest rate, it seems intuitively obvious that she would shift her funds from 91
bonds into stocks so long as the stocks offer a higher rate. Obvious, one might think - and
yet this is a fallacy.

54 Fundamentally it doesn’t matter whether she has more or less funds, or what the financing of the firm
(debt-to-equity-ratio) looks like (aka the Modigliani-Miller theorem).
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In order to make this more palpable let us illustrate what happens in the case of an inter-
est rate drop with a numerical example55. The interest rate - ou independent parameter - is
initially 10 %, and is supposed to drop to 5 %, then 2 %.

We assume that the entrepreneur just inherited the firm, with a book value of 175.95 mil-
lion; lets be generous and top it up with some additional cash to 200 mill.
The first column corresponds to the initial equilibrium position and maximises her net
worth: the interest rate is 10 %, the firm’s profit rate is 16.5 %, and the value of her port-
folio is 314.3m. She places 24 in bonds and 176 in her firm. If she would place the whole
200 in her firm, the value of her portfolio would drop to 311! The absolute amount of the
firm’s profit would rise, but the firm’s profit rate would fall and therefore the stock price.
The overall effect would be negative, so contrary to any intuition you may initially have,
she doesn’t do that.
Note that initially the stock price is equivalent to Tobin’s q, but not any more in subse-
quent periods. This comes from the financial leverage-effect (not the same as my leverage
theory of income distribution from above): She finances comparatively more lucrative
additional investment with progressively cheaper borrowed funds (the 3rd line, the loan or
deposit, switches from positive to negative), so the share price soars upward. The cost of
92 leasing capital falls sharply with the interest rate, so she gets rid of some of the work-
force, which are substituted by machinery.
This substitution of people by machinery happens after each interest rate decrease. Above
it is pictured before and after - first the rate decrease happens, and in the next column the
substitution effect.
What you really have to understand is that all green columns are equilibrium-positions:
No further adjustments will be made, they are already an optimum satisfying any Tobin-
ian no-arbitrage condition.
The goal of the entrepreneur can (in accordance with elementary optimisation theory) be expressed thus:
max profit with production function
with Y: quantity produced (goods prices are assumed constant); K: capital stock; L: labour
employed during some period; w: wage; r: interest rate; δ: depreciation rate; π: profit; α, a: parameters.
We have a profit extremum if the derivatives of profit changes with respect to capital and labour changes are zero:

If we set them to zero, add (r+δ) to the first one and w to the second one, then divide the first by the second and solve for K
we get: .
The * indicates that for equilibrium values of K and L this equation must hold. Firms are constrained by effective demand Y
which is for them a given; we can solve the production function for K: , then substitute the
expression in the production functionto get the profit-maximising, equilibrium value of L.
Any parameters will do, I took a=1.3, δ=5 %, α=0.25, w=1.1, Y=117. The stock price would be (π/r)/K.
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Q a n d t he Te c h B o o m

You may think that in the good old empirical tradition of science, people would have
noticed whether q can be permanently above 1 or not. Well, consider the following: “The
value of a firm’s securities measures the value of the firm’s productive assets. If the
assets include only capital goods and not a permanent monopoly franchise, the value of
the securities measures the value of the capital. Finally, if the price of the capital can be
measured or inferred, the quantity of the firm’s capital is the value divided by the price.
A standard model of adjustment costs the inference of the price of installed capital. I
explore the implications of the proposition using data from U.S. non-farm, non-financial
corporations over the past 50 years. The data imply that corporations have formed large
amounts of intangible capital, especially in the past decade...”
No offense, but it is in my view significant that it is not an apprentice who has written
this, but an eminent, well-established economist with a PhD from MIT teaching at Stan-
ford - because it betrays the kinds of intuitions which underly economic theory.
Firstly it is not just through a monopoly franchise as bestowed by the State that capital
market valuation may differ from the production cost of capital goods (an extra-economic
event enforced from the outside by state legislation), but plain old product differentiation
is sufficient. This is a known result published by Hayashi in 1982. These types of intu- 93
itions are typical though, as already exposed in Tobin’s case56. So our economist then
infers that since q=1, the high share prices must be reflecting equally high real productivi-
ty gains of some mysterious intangible nature, having materialized in parallel with the
soaring prices of tech-stocks. This paper was published in May 2000, and justifies the high
valuations of the new economy.
The magnitudes involved are staggering; look at the following graphs.
Firstly the financial value of the securities:

By the way, Hayashi politely attributes the following to Tobin: “The alternative theory, suggested by Tobin, is that the rate
of investment is a function of q, the ratio of the market value of new additional investment goods to their replacement
cost.” I am sorry but this is actually not what he said, from his first papers on the subject in 1969 up to his Nobel lecture,
he consistently speaks of average q, or the market valuation of all capital goods, as the excerpts quoted in the main text
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And here we have the corresponding formation of the mysterious intangible capital justi-
fying it:

Quote: “Figure 8 shows the resulting values for the capital stock and the price of installed
capital, q [...] Most of the movements are in quantity and price vibrates in a fairly tight
band around the supply price, one.”
Yeah, right; I hope you weren’t advised with respect to investments by a classical econo-
94 mist during the tech-boom...

Buchanan and Lerner on Functional Finance

That Deficit Spending became in the minds of people the only instrument to finance an
expansion of effective demand is, in effect, almost unbelievable. For the neo-liberal econo-
mist the economy is always in full employment (a strange position that one as well, with
regard to reality and all that, but let’s move on). For the neo-Keynesians unemployment is
cyclical, so economic activity oscillates around the full-employment level, so that makes
deficits at least somewhat more consistent because there would be hope to paying them
back during the next full employment episode. A hope which would have to be laid to rest
straight away if unemployment can be permanent. However, even in the case of cyclical
unemployment, there is no need to resort to deficit spending; people could have realized
that. Did they? Here is an extract from the economist and Nobel laureate James
Buchanan, who has at least fully realized this (but doesn’t elaborate because he is rather
an adherent of the full-employment school of thought):
“As noted earlier, the classical principles are starkly simple, and are based on the essential
similarity between the government and the individual account. The Keynesian logic reject-
ed this analogy. [...] If, indeed, the Keynesian orthodoxy of public debt were valid, econo-
mists and finance ministers would have discovered the fiscal equivalent of the perpetual
motion machine. [...]
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The Keynesian argument was driven by a stance on policy that viewed public debt as the
only means of financing demand-increasing deficits during periods of depression. The
primary policy instrument of Keynesian economic policy was the budget deficit, and there
was an elementary failure on the part of pro-Keynesian economists to recognize that
demand-enhancing deficits could be financed with non-interest bearing money creation. If
this macroeconomic objective is the only justification for the creation of budgetary
deficits, it becomes totally unnecessary to impose the future-period taxes that debt interest
reflects. Money creation in such settings carries with it no future-period burden.”
That Keynesian economists have not realized this is not entirely correct; there was one
who did (Abba Lerner, 1944). And again, unbelievably, he is universally reckoned to be the
founding father of the Deficit Spending type of economic policy!
However if we actually read his article where he first exposed is ideas, we see that it is not
via the debt and deficits that the state procures the means to prop up effective demand.
Here are some excerpts of his original article from 1944, where for the first time the
financing of the Keynesian demand management was described..

· Taxes and Government demand should be set with the view of achieving full employ-
ment: “If total spending is allowed to go above this there will be inflation, and if it is
allowed to go below this there will be unemployment.” Taxation especially is not the pri-
mary instrument by which the state procures the means he can spend: “Its main effects 95
are two: the taxpayer has less money left to spend and the government has more money.
The second effect can be brought about so much more easily by printing the money that
only the first effect is significant. Taxation should therefore be imposed only when it is
desirable that the taxpayers shall have less money to spend, for example, when they would
otherwise spend enough to bring about inflation.”
· “...the adjustment of public holdings of money and of government bonds, by govern-
ment borrowing or debt repayment, in order to achieve the rate of interest which results
in the most desirable level of investment”; note that Government debt is not issued prima-
rily to procure the means to finance Government expenses, but rather a tool (open market
policy) to manage the interest rate; the reason is the same as for taxation above. Increasing
the supply of Government bonds “might be desirable if otherwise the rate of interest
would be reduced too low [...] and induce too much investment, thus bringing about infla-
· “...the printing, hoarding or destruction of money as needed for carrying out the first
two parts of the program.” Or, in another passage: “When taxing, spending, borrowing
and lending (or repaying loans) are governed by the principles of Functional Finance, any
excess of money outlays over money revenues, if it cannot be met out of money hoards,
must be met by printing new money, and any excess of revenues over outlays can be
destroyed or used to replenish hoards.”
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You recognize that the central means of financing Government demand to achieve and
maintain the full employment level is in fact money-financing. This is consistent with the
existence of permanent unemployment, a case which he very likely took for granted (even
though he doesn’t explicitly state it), with first hand experience of the Great Depression
freshly in memory.
Here are a few more extracts with examples:
“In the third place, there is no good reason for supposing that the government would have
to raise all the interest on the national debt by current taxes. We have seen that Functional
Finance permits taxation only when the direct effect of the tax is in the social interest, as
when it prevents excessive spending or excessive investment which would bring about
inflation. If taxes imposed to prevent inflation do not result in sufficient proceeds, the
interest on the debt can be met by borrowing or printing money. There is no risk of infla-
tion from this, because if there were such a risk a greater amount would have to be collect-
ed in taxes.
This means that the absolute size of the national debt does not matter at all, and that how-
ever large the interest payments that have to be made, these do not constitute any burden
upon society as a whole. A completely fantastic exaggeration may illustrutate the point.
Suppose the national debt reaches the stupendous total of ten thousand billion dollars
(that is, ten trillion, $ 10,000,000,000,000), so that the interest on it is 300 billion a year.
96 Suppose the real national income of goods and services which can be produced by the
economy when fully employed is 150 billion. The interest alone, therefore, comes to twice
the real national income. There is no doubt that a debt of this size would be called “unrea-
sonable”. But even in this fantastic case the payment of the interest constitutes no burden
on society. Although the real income is only 150 billion dollars the money income is 450
billion - 150 billion in income from the production of goods and services and 300 billion
in income from ownership of the government bonds which constitute the national debt.
Of this money income of 450 billion, 300 billion has to be collected in taxes by the gov-
ernment for interest payments (...), but after payment of these taxes there remains 150
billion dollars in the hands of the taxpayers, and this is enough to pay for all the goods
and services that the economy can produce. Indeed it would do the public no good to have
any more money left after tax payments, because if it spent more than 150 billion dollars
it would merely be raising the prices of the goods bought. It would not be able to obtain
more goods to consume than the country is able to produce. [...]
First, full employment can be maintained by printing the money needed for it, and this
does not increase the debt at all. [...]
Fourth, as the national debt increases it acts as a self-equilibrating force, gradually dimin-
ishing the further need for its growth and finally reaching an equilibrium level where its
tendency to grow comes completely to an end. The greater the national debt the greater is
the quantity of private wealth. The reason for this is simply that for every dollar of debt
owed by the government there is a private creditor who owns the government obligations
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[...], and who regards these obligations as part of his private fortune. The greater the pri-
vate fortunes the less is the incentive to add to them by saving out of current income. [...]
When the government debt has become so great that private spending is enough to pro-
vide the total spending needed for full employment, there is no need for any deficit
financing by the government, the budget is balanced and the national debt automatically
stops growing.”
Even though he correctly recognized a centrally important point when we deal with struc-
tural unemployment, there are 2 practical problems with his policy. If there is no industri-
al excess capacity, increased demand for consumption goods will create inflationary ten-
sions even in the presence of high unemployment - the higher the unemployment, the
more capacity would need to be built first. What is needed is prospective demand: Fill the
firms order books; and take measures to temporarily crowd out consumption while capaci-
ty is built up.
The second point relates to the power of taxation of the Government. In his case with the
enormously large public debt, the high road to neutralize the spending of the interest paid
on it (which the Central Bank finances first by money creation) would evidently be to tar-
get interest and capital revenues and tax directly away. A problem appears if the Govern-
ment does not have the power to do so - namely to tax capital revenues or wealth itself, i.e.
because some of it may be hidden. The state may have easy access to tax the revenue of
employees, because they cannot hide it. But a factor labour overburdened with taxation 97
will be dearer to firms, hence won’t be conducive to more employment either. With this
policy one may soon steer into dangerous waters.

How to Pay for the War

The dilemma of underemployment, the solution of which was discussed above (turning
more labour onto the production of investment goods while avoiding their production to
be crowded out by demand for consumption goods coming from the additionally employed
labour), is equivalent with the one England was facing in WW II: Turning more labour
onto the production of war materials while avoiding its production to be crowded out by
demand for consumption goods coming from the additionally employed labour.
Keynes examines the issue in How to Pay for the War 57, published in The Times on the
14th and 15th November 1939.
Keynes examines the three possible scenarios:
1. Elimination of the latently consumptive purchasing power by inflation (Op. cit., p.44):
Disadvantages of this method are for one “the ‘vicious spiral’ of rising prices and wages”,
and also: “A rising cost of living puts an equal pro p o rtionate burden on every one, irrespec-
t ive of his level of income, from the old-age pensioner upwards, and is a cause, therefo r e, of
great social injustice. Moreover it is large ly futile unless we recast our wage system. The rise
in prices helps only to the extent that it is greater than the rise in wages.
Also in J.M. Keynes, Collected Works, vol. 22 - Activities 1939-1945: Internal War Finance, p. 40 ff.
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But there are today many wage rates linked by agreement with the cost of living, so that
the two move together.”
2. Tax away the latently consumptive purchasing power. But (Op.cit., p. 45): “The price reme-
dy and the taxation remedy are alike in depriving the working class of any benefit from their
increased earnings. Yet a large portion of the earnings now in question represents increased
effort on their part. The third remedy is free from this objection.”
3. He calls his proposition ‘Compulsory Savings’(Op.cit., p. 46 ff.):
“The community at war cannot allow the individuals of the working class to make a greater
immediate demand on the national resources than hitherto; and it may have to ask of them a
reduction. But that is no reason why they should not be rewarded by a claim on future
resources. For the individual that is what wealth is. If it is physically impossible to reward the
labour of the working class by immediate consumption, we should welcome and not reject the
opp o rtunity thus given to make its members individually wealthier.
The third remedy, therefore, is to distinguish two kinds of money-rewards for present effo rt -
m o n ey which can be used, if desired, to provide immediate consumption, and money the use
of which must be deferred until the emergency is over and we again enjoy a surplus of produc-
tive resources - that is to say, current cash on the one hand and on the other a blocked deposit
in the Post Office Savings Bank. [...]
Each individual may dislike postponing his own consumption, but he will gain from a similar
98 postponement by his fellows. If every one spends, prices will rise until no one is better off. The
increased earnings of the working class will not have benefited them one penny, but will have
escaped through higher prices and higher profits, partly into taxation and part ly into the sav-
ings of the entrepreneur class. Here, therefore is the perfect case for compulsion; for general
compulsion will benefit all its victims alike. A chance is given us to use the opp o rtunity of war
finance - an opp o rtunity always missed hitherto - to increase the individual resources of the
working class and not merely of the entrepreneur class.
The following are the details of my proposal:
1. A percentage of all incomes in excess of a stipulated minimum income will be paid over to the
Gove rnment, partly as compulsory savings and partly as direct taxes. The percentage taken will
rise steeply as the level of income increases. [...]
4. The sums credited in the Savings Bank, which will carry 2 1/2 per cent interest, will be blocked
for the time being, and will not be available, generally speaking, for current expenditure or as secu-
rity against loans. But the holder will be allowed to use them to meet pre-war commitments of a
capital nature, such as instalments to a building society, or for hire-purchase, or to meet insurance
premiums. He can also use them, with the approval of a local committee, to meet exceptional and
unavoidable expenses, arising, for example, out of illness or unemployment. They would be avail-
able to meet death duties.
5. The deposits will be unblocked and made freely available to the holder, probably by a series of
instalments, at some date after the war. The appropriate date for release would have arrived when
the resources of the community were no longer fully engaged. Such releases would help us
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through the first post-war slump, and would give us time to concert more permanent plans. [...]
I see much social justice and social effeciency in this system. At present our resources of
production fall short of our needs; the time will come when the position will be reversed;
and it is therefore only sensible to reward current effort out of future surplus capacity.
Meanwhile we retain a reasonable incentive to present effort, and the commitments of the
community among its own members are spread a little more equally.”

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© Copyright Claus-Peter Pfeffer, April 2007. All rights reserved.

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