Re: investment and unemployment

[GGard97342@xxxxxx]

In a message dated 03/04/2000 15:56:41 GMT Daylight Time,
matthew.johnson@xxxxxxxxxxxxxxxxxxxxxxxxxxxx writes:

> Geoffrey Gardiner: two questions.
>
>  it seems as though you are implying that investment is fundamentally
>  inconsistent (in its motivations at least) with employment.  as you point
>  out this may not be the case in the short run.

The point I was trying to make was that Kahn was wrong to suggest that
investment automatically increased employment.

With regard to existing products, investment in new plant and machinery will
normally make production more efficient, and if that lowers prices, demand
will tend to rise and there may be little downward effect on employment.
Brunel's invention of automatic block-making did not raise demand because the
demand for the product was determined by other factors. Blocks were only part
of the equipment of a ship, so the effect on the price of the final product
was tiny. Cheapening the price of blocks did not increase the demand for
naval warships. Consequently the laying off of the workers at Fox and Taylor
reduced overall demand by the amount they were no longer receiving in wages.
The same effect will apply in all cases where demand is price inelastic, such
as in food production.

It is an important point as it also applies in the case of all reductions in
government expenditure. Those who call for cuts in government expenditure do
not realise that they will reduce by the same amount the demand for their own
products which were previously sold to the workers now laid off as a result
of cuts. No benefit for the community as a whole is achieved by cuts in
government expenditure until the resources which are rendered unemployed are
given new productive work, and that will require new investment which must be
financed by newly created credit. Individuals may benefit from the tax cuts
made possible by cuts in expenditure, but others will lose by the same
amount. I call what happens "bottom slicing the economy", as it is the poor
who probably suffer most.

The key to the avoidance of unemployment as a result of investment in more
highly productive plants is new credit creation which will finance new
equipment in new industries for the displaced workers to use, and also to
finance consumers of the new products. Consumer finance is just as important.
Indeed without it there cannot be a profit. (That really needs explaining but
it is a too lengthy explanation for this posting.)

I believe we should therefore refer to the "credit multiplier" not the
"investment multiplier".

I fully realise that I am suggesting that every textbook of economics is
wrong, and that every successful candidate in an economics exam has given a
wrong answer when he tackles the inevitable question about the investment
multiplier.


>
>  snip:
>  >So there may have been a temporary increase in employment
>  >from 110 to 410, followed by a reduction to ten.  The final effect was
>  >highly deflationary.
>
>  i do not really have a problem with this, as it had always seemed a bit
>  suspect to me as an undergraduate.  but now that i have become
>  institutionalised, i would appreciate some insight into how i might
>  reconcile this with my typical orthodox education.  (which has never
>  questioned the idea that employment follows investment like noght follows
>  day)
>
>  so as the cataltst for unemployment, this investment leads to unemployment,
>  hence wage deflation?.   considering that it is by no means clear that
>  investment will respond to an increase in the rate of interest, then how
>  does the rise in the rate of interest work to inter alia, reverse the
>  deflation.

Investment (by which I mean real investment, not the purchase of financial
assets) will take place when interest rates are, a) low enough to tempt the
entrepreneur, and, b) high enough to tempt the bank to create credit. a) was
the theme of a paper published in the Bankers Magazine of London by A H
Gibson in January 1923. Gibson produced 121 years of data to show that
movements of wholesale prices were positively correlated with long term
interest rates, and he deduced that the reason was that when bond yields were
low, investors sought higher returns from equity investment which had the
effect of lowering prices. He expected food prices to fall as the result of
enormous investment by British investors in foreign food production in the
years 1908 to 1913. The effect of this investment had been delayed by the
shortage of farm workers caused by their recruitment into the armies of the
Great War. Half the investment had been in railway systems to get the crops
moving.

Keynes researched the effect of short term interest rates and found a similar
but weaker correlation. Nowadays it is very strong. Gibson's discovery was
contrary to received wisdom which insisted that high rates of interest caused
prices to fall, so Keynes named the effect "The Gibson Paradox", and said,
"The Gibson paradox - as we may fairly call it - is one of the most
completely established empirical facts within the whole field of quantitative
economics though theoretical economists have mostly ignored it." They still
do!

But Keynes missed my point b). There has to be a profit in lending, and at
the time he was writing there was an interest rate cartel the effect of which
was to inhibit banks from creating credit when interest rates were very low
because it was not profitable. Naturally bankers are more eager to lend when
interest rates are high, and there is a thing we call "the endowment effect"
which makes a rise in interest rates strongly profitable for banks.

For a business, interest is a cost like any other, and if it increases, the
extra cost must be reflected in prices. Higher interest rates may cut demand
and that increases unit costs, another incentive to raise prices. The general
effect of high interest rates is therefore "stagflation" a combination of
price inflation and economic stagnation.

Also when interest rates are very low banks will seek better returns from
lending in countries where the rates are higher, so that at home there is
deflation and recession. You may recognise Japan's present predicament. This
effect was first noted by Thornton in 1803 and was repeated by Tooke in 1844,
when he shot to pieces the theory based on reply number 678 to the Althorp
committee of 1832 by J Horsley Palmer, the Governor of the Bank of England,
that raising interest rates lowers prices. Actually other answers of Palmer
showed that the answer to 678 was nonsense, the result of armchair
theorising, for Palmer admits that in 1825 a rise in interest rates had led
to increased lending, not less.

Modern monetarism is entirely based on question 678. So it is wrong.

The Chartered Institute of Bankers controls the copyright of Gibson's papers,
and they have given me permission to post them on the internet, and I hope to
arrange for that to be done as soon as I can find the time to write an
introduction and do the scanning.
>
>  the implication in your piece seems to be that the increase in the rate of
>  interest somehow stopped (or slowed) the increase in productive skills (or
>  investment!), thereby ending the deflationary trend.

Yes it ends price deflation but not, of course causes deflation of the
economy. Investment slows, especially if the high interest rate causes a high
exchange rate. We tend to use the word deflation in two meanings.

There are other reasons why raising interest rates causes price inflation.
One unique to Britain among European countries is that as nearly all house
purchase lending is done at variable rates of interest, a rise in interest
rates causes a strong demand for higher wages.

My answers are an abbreviation of a whole book. I hope it is all clear.  I
must warn any students reading this to be very circumspect about using my
arguments in examinations. The examiners will not be pleased to see different
answers from those which got them their firsts. If you try them on a tutor
and he disagrees, ask him if he has read "The Treatise on Money." If he says
he has you will know he is mendacious, as the quote above from Keynes comes
from page 178 of volume two.

Geoffrey Gardiner

5 April 2000, Knutsford, England