Ricardo and Von Mises

Ricardo’s Theory in Principles of Political Economy (p.511)

This is more clear-cut than the definitions of later writers.

But as always with Ricardo, it is a long-period doctrine, with the emphasis on permanence.

It assumes the usual classical assumption that there is always full employment. If there is no change in the supply curve of labour in terms of productivity, there is only one possible level of employment in long-period equilibrium.

It assumes ‘ceteris paribus’, that there is no change* in psychological propensities and expectations other than those arising out of a change in money supply. In such a case, there is only one rate of interest which will be compatible with full employment in the long term.

Ricardo and his successors failed to see that even in the long term:

• the volume of employment is not necessarily full but is capable of varying
• to every banking policy there corresponds a different long-period level of employment so that there are a number of positions of long-period equilibrium corresponding to different conceivable interest policies on the part of the monetary authority.

Ricardo is correct if applied only to the money supply created by a central bank. It is true that interest rates would not change if the central bank held money supply at a fixed amount.

But if the central bank changes the money supply, such as by buying of selling bonds*, then the rate of interest at change. Ricardo expresses this in his quote above**.

Under my notions, there are only two possible long-period positions:

• full employment
• employment level corresponding to the interest rate at which liquidity-preference becomes absolute (in the event of this being less than full employment)

The interest rate policy of the central bank will change the money supply. This makes it a real determinant into the economic scheme.

The last sentences of Ricardo’s statement shows that he was overlooking the possible changes in the marginal efficiency of capital according to the amount invested. But this again is for him to be consistent with his theory compared to those of his successors.

If the quantity of employment and the psychological human propensities are taken as given, then there is only one possible rate of accumulation of capital. Consequently, there is only one possible value for the marginal efficiency of capital.

Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits.

Professor von Mises: Interest is the ratio between the difference in the price of consumer goods to capital goods

His notion was adopted from him by Professor Hayek and Robbins.

According to them, changes in interest rate can be identified with changes in the relative price levels of consumption-goods and capital-goods.

By a somewhat drastic simplification, the marginal efficiency of capital is taken as measured by:

the supply price of new consumers’ goods = the supply price of new producers’ goods

This ratio is then identified with the interest rate.

• This makes a fall in interest rate favourable to investment.
• Therefore, a fall in the ratio of the price of consumers’ goods to the price of producers’ goods is favourable to investment.

Through this, a link is established between:

• increased saving by an individual and
• increased aggregate investment

Increased individual saving will:

• reduce the price of consumers’ goods, and
• a lesser fall in the price of producers’ goods

This means that a reduction in interest rate will stimulate investment.

A lowering of the marginal efficiency of capital has the opposite effect to what the argument assumes because investment is stimulated either by:

• raising the schedule of the marginal efficiency or
• lowering the interest rate

Professor von Mises confuses the marginal efficiency of capital with the interest rate.

• It causes their conclusions to be exactly the wrong way round.

This is incorrect. It is based on a confusion of the effect on capital formation of:

1. higher or lower prices of consumers’ goods, and
2. a change in the rate of interest.

Decreased spending and increased saving reduces consumer goods prices, relative to that of producers’ goods.

But this, in effect, means a lower interest rate. A lower interest rate stimulates an expansion of capital investment in fields which at higher rates would be unprofitable.

Author’s Footnotes

1. Marshall uses the word “capital” not “money” and the word “stock” not “loans”

Interest is a payment for borrowing money. “Demand for capital” in this context should mean “demand for loans of money for the purpose of buying a stock of capital-goods”.

But the equality between the stock of capital-goods offered and the stock demanded will be brought about by the prices of capital-goods, not by the rate of interest. It is equality between the demand and supply of loans of money, i.e. of debts, which is brought about by the interest rate.

2. This assumes that income is not constant.

But it is not obvious in what way a rise in the rate of interest will lead to “extra work”. Is the suggestion that a rise in the rate of interest is to be regarded, by reason of its increasing the attractiveness of working in order to save, as constituting a sort of increase in real wages which will induce the factors of production to work for a lower wage? This is, I think, in Mr. D. H. Robertson’s mind in a similar context.

Certainly this “would not quickly amount to much”; and an attempt to explain the actual fluctuations in the amount of investment by means of this factor would be most unplausible, indeed absurd. My rewriting of the latter half of this sentence would be:

“and if an extensive increase in the demand for capital in general, due to an increase in the schedule of the marginal efficiency of capital, is not offset by a rise in the rate of interest, the extra employment and the higher level of income, which will ensue as a result of the increased production of capital-goods, will lead to an amount of extra waiting which in terms of money will be exactly equal to the value of the current increment of capital-goods and will, therefore, precisely provide for it.”

3. Why not by a rise in the supply price of capital-goods? Suppose, for example, that the “extensive increase in the demand for capital in general” is due to a fall in the rate of interest. I would suggest that the sentence should be rewritten= “In so far, therefore, as the extensive increase in the demand for capital-goods cannot be immediately met by an increase in the total stock, it will have to be held in check for the time being by a rise in the supply price of capital-goods sufficient to keep the marginal efficiency of capital in equilibrium with the rate of interest without there being any material change in the scale of investment; meanwhile (as always) the factors of production adapted for the output of capital-goods will be used in producing those capital-goods of which the marginal efficiency is greatest in the new conditions.”

4. In fact we cannot speak of it at all. We can only properly speak of the rate of interest on money borrowed for the purpose of purchasing investments of capital, new or old (or for any other purpose).

5. Here the wording is ambiguous as to whether we are to infer that the postponement of consumption necessarily has this effect, or whether it merely releases resources which are then either unemployed or used for investment according to circumstances.

6. Not, be it noted, the amount of money which the recipient of income might, but does not, spend on consumption; so that the reward of waiting is not interest but quasi-rent. This sentence seems to imply that the released resources are necessarily used. For what is the reward of waiting if the released sources are left unemployed?

7. We are not told in this passage whether net savings would or would not be equal to the increment of capital, if we were to ignore misdirected investment but were to take account of “temporary accumulations of unused claims upon services in the form of bank-money”. But in Industrial Fluctuations (p. 22) Prof. Pigou makes it clear that such accumulations have no effect on what he calls “real savings”.

8. This reference (op. cit. pp. 129-134) contains Prof. Pigou’s view as to the amount by which a new credit creation by the banks increases the stream of real capital available for entrepreneurs. In effect he attempts to deduct “from the floating credit handed over to business men through credit creations the floating capital which would have been contributed in other ways if the banks had not been there”. After these deductions have been made, the argument is one of deep obscurity.

To begin with, the rentiers have an income of 1500, of which they consume 500 and save 1000; the act of credit creation reduces their income to 1300, of which they consume 500 - x and save 800 + x; and x, Prof. Pigou concludes, represents the net increase of capital made available by the act of credit creation. Is the entrepreneurs’ income supposed to be swollen by the amount which they borrow from the banks (after making the above deductions)? Or is it swollen by the amount, i.e. 200, by which the rentiers’ income is reduced? In either case, are they supposed to save the whole of it? Is the increased investment equal to the credit creations minus the deductions? Or is it equal to x?

The argument seems to stop just where it should begin. 9. The Theory of Money and Credit, p. 339 et passim, particularly p. 363. 10. If we are in long-period equilibrium, special assumptions might be devised on which this could be justified. But when the prices in question are the prices prevailing in slump conditions, the simplification of supposing that the entrepreneur will, in forming his expectations, assume these prices to be permanent, is certain to be misleading. Moreover, if he does, the prices of the existing stock of producers’ goods will fall in the same proportion as the prices of consumers’ goods. 11. Economic Reconstruction, p. 233