Wages, Prices, and the Demand for Money: Keynes Got It All Wrong

Markets clear. Or so was the accumulated wisdom in the half century before John Maynard Keynes. The British economist proposed a novel theory of economics in 1936 based on the opposite premise: markets don’t clear. While Keynesian theory is quite complex and his book widely regarded as unreadable, in his system, chronic idleness of useful resources is the rule. In Keynes’s world, the market can find a market-clearing price through decentralized adjustments for most preferences among most goods. But two particular preferences are problematic in that the price system does balance supply and demand. The two troublemakers are time preference and the reservation demand for money. Those two bad actors cause the market process to fail for everyone else.

The British Austrian school economist William H. Hutt was an underappreciated critic of Keynes. In Hutt’s The Keynesian Episode: A Reassessment, he distilled the obscurantism of “the new economics” into a series of clear propositions. When reduced to its essence, Keynesian economics is compelling in its absurdity. In Keynes’s version of reality, there are Good Preferences and Bad Preferences. The bad ones are so troublesome that an increase in either one can cause entirely different useful resources to lose the ability to command a money price altogether. The effect is so strong that a productive worker may become idle, not due to his own lack of skill or sloth, but due to someone else’s attempt to save. When a resource is stuck in this idle state, the owner and buyers cannot find a common ground.1

Time preference is the lower valuation that people place on a good in the future compared to the present. Time preference frustrates market clearance through the paradox of thrift. According to this construct, attempts by all savers in the community to save more in aggregate fail. Their attempts do not result in greater realized savings. It works this way: saving reduces spending on consumption but somehow leaks demand out of the system instead of creating a demand for something else (such as capital goods). Wikipedia explains: “[A]n increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower total saving.”

Prior economic teaching had identified time preference—the choice between provision for present needs and future needs—as the originating cause of interest. Reservation demand is the demand that the owner of a good exercises by not selling it or by holding out for a higher selling price. This preference itself is largely irrational, driven by what Keynes saw as an excessive and irrational preference for liquid assets. Interest in Keynes land is entirely caused by the reservation demand for money.

Saving and investment in the Keynesian story are unrelated activities—not two sides of a single market. Because investment is interest rate sensitive, an increase in the reservation demand for money can cause the interest rate to be too high, attracting more savings which are not realized as investment. Investable resources thus remain unused.

Hutt took the other side of this. To his thinking, “time preference and so-called liquidity preference are no different in principle or in practice from all other economic preferences.”2 He asks this:

Why should two particular expressions of preference concerning ends, namely, that between the present and the future (thrift), and that between the services of money (liquidity) and all other services, or the response to those preferences in the form of certain ways of using the scarce means available, give rise to unemployment?3

Hutt—and Keynes—were largely dealing with the problems of surplus labor in 1930s Britain, in which the sellers of labor were represented by labor unions (or simply unemployed people with unrealistic wage expectations). Hutt wrote many times about the problem of surplus, whether unemployment in labor markets, inventories, or capital goods. He placed the responsibility for chronic surplus largely on sellers who would not lower their asking price. In most cases of surplus, the seller was usually asking for a price above what potential buyers would or could pay. While there are buyers making an offer in almost any market, for anything that is useful, if the buyer does not agree, then no exchange will take place.

Hutt thought that where there is a surplus, it was the seller who needed to come down to meet the buyer, rather than the buyer offering more. The business firm works on behalf of the consumer. They will make a wage offer based on the contribution of the worker toward the price the consumer is expected to pay for a product. Under depressed conditions, the consumer may be willing to pay less. Entrepreneurs may be even more cautious about the selling prices they expect. But, at some price, said Hutt, “there is always complete absorptive capacity for all potential productive services which have value.”4 The wage expectations of unemployed labor at the time were unrealistic if under the existing conditions businesses could hire the idle workers and make a profit only at a lower wage than the unemployed were asking.

Hutt blamed the failure of the market price system to clear labor markets on the political power of labor unions. By using the threat of strikes and organized violence with the tacit approval of governments, they were able to contract a nominal wage which looked good on paper. But in practice the wage was not paid, because it was not affordable to the businesses where the workers might find employment. Hutt also took to task welfare systems that incentivized people not to work.

Idleness of useful things was not due to irrational money hoarding or miserly oversaving. It did not require a new theory of economics. It did not require a falsification of Say’s law. It only required that the price system be allowed to do its job. Hutt wrote, “The origin of such ‘economic disturbances’ must be attributed, I suggest, solely to the factors which prevent the value system from performing its coordinative task.”5 Anything which has value has a money price at which it can be sold. All useful labor and capital goods can contribute to production when priced for market clearance.6

For there are no economic ends, and no entrepreneurially chosen means which are incompatible with “full employment”. Entrepreneurs will never fail to use the full flow of productive services if the price mechanism is allowed to work or made to work. The only “collective behavior” to be set right is that of the propensity to resist price adjustment.7

F.A. Hayek in taking on this same point wrote:

[Keynes] has given us a system of economics which is based on the assumption that no real scarcity exists, and that the only scarcity with which we need concern ourselves is the artificial scarcity created by the determination of people not to sell their services and products below certain arbitrarily fixed prices.

Changes in any preference do not cause valuable resources to remain priced out of use so long as other prices can adjust. A wage that worked yesterday may be too high today in light of changed conditions. Entrepreneurs motivated by loss avoidance must stay on top of the market and adjust their offers and their asking prices. Workers must seek alternative employment when their line of business is in decline if they do not wish to accept a lower wage, or work for a lower wage if they wish to remain in a declining industry.

Keynes was confused about the difference between a preference that caused resources to be unused and the inability of the system to adapt to a change in that preference. Keynes’s theory blamed the former cause, Hutt, the latter. Hutt showed that changes in time preference do not inherently cause useful things to lose all value within the price system. Even when people save more, all useful things can still participate.

Certainly, while abnormal provision for the future [an increase in time preference] is in progress, a bidding down of the relative prices of goods of short life expectancy, in relation to the prices of goods of long life expectancy, will occur (the impact upon prices varying in proportion to the life expectancies of assets and the degree of versatility in the assets stock and in labor’s efforts and skills). But, as I have already insisted, all large autonomous changes in human preferences require far-reaching coordinative adjustments and hence large changes in relative prices.8

When people wish to save more, the most useful employment of many things will change. Wages will fall in the consumption goods industries, reflecting the fall in value of the final product. Demand for labor will increase in the capital goods sectors. Workers may need to change jobs—even change industries—and adapt to a new line of work in order to receive the highest wages. Existing inventories may need to be sold at a lower price than expected. A large number of small—or even large—adjustments will follow on. Yes, if those prices do not fall where they must, then surpluses of those goods will accumulate. While Hutt does not focus on shortages and scarcity pricing due to a price not rising quickly enough when there is more demand, shortages can also arise.

The production of goods proceeds through stages. The outputs of each stage can be fully absorbed into the next stage if priced properly. The product at each stage will be profitable as long as prices of inputs and outputs are adjusted and so long as businesses are adapting what they produce to what people want, not what they used to want. Hutt explains:

When prices are coordinatively determined, then, not only are final prices fixed in relation to money income and consumer preferences, but the prices of services and intermediate products at all stages of production are fixed in relation to expectations of demand at the next stage. Prospective prices at the next stage of demand are in turn derived from predictions of demand at subsequent stages, including the ultimate demand for the final product. [??]

Keynes missed the need for these adjustments because of the excessive aggregation of his model:

It was partly through the clumsiness of the macroeconomic approach that Keynes came to believe that the idleness of valuable productive resources (he stressed labor) is caused by factors other than the mispricing of the flow of services and products. For instance, the clumsy concept of the price of labor, conceived of as the hourly money wage (a sort of average wage rate of labor of all kinds), is, in a large part of the argument, taken as constant. And when Keynes did think in terms of this “price” having a crucial task, he seemed to assume that the adjustment required to induce full employment is an equal percentage reduction in all wage rates and secondly to assume that rises or falls in the general level of wage rates correspond to rises or falls in the general flow of wage receipts.9

Reservation demand for money is the other problem child in the Keynesian world. In Hutt’s terminology, this is the preference for the services of money compared to the services of nonmoney. The active investment that market actors make in their money balances provides the useful service of “availability.” By this Hutt meant that money can easily be exchanged for other goods. Having some of it around gives the holder choices and options. People can choose to invest more in money in order to have more choices in the future.

Money demand increases when some individuals raise the ranking of some additional units of money in their preference scales from lower to higher than some other goods. Hutt also identified the speculative purpose for investing in a greater money balance. Some people expect money prices of some goods to be lower in the future than they are now and plan to buy more in the future than they are able to at current prices.

Then what of reservation demand for money? Is it so problematic as Keynes suggests? Keynes saw an increase in reservation demand for money as a fall in aggregate demand, for which price adjustments could not compensate. It would create a systematic discoordination between savings and investment. Hutt explained Keynes’ position as, “at times people may cease demanding nonmoney services and goods because they demand … the service of money.”10

Individuals and firms are able to adjust to changes in both the supply of and demand for money according to Hutt. Those who want to increase cash holdings will reduce money expenditures and attempt to increase their money income through some mix of lower offering prices for things they buy and lower asking prices for their services. If roughly the same number of people wish to increase their money demand as decrease it, then there is no systemic change; existing money balances are shifted. Some people end up with more cash, others with less. If there is an overall shift in preferences by most people toward holding money, this cannot be accommodated by some people holding more and others the same if the money supply is not growing. Instead, prices will generally fall. This allows everyone’s money balances to increase in real terms. With lower prices, existing money balances are worth more even with the money supply unchanged.

The fall in prices is not separate from the increase in money demand, but is the means by which the change in money demand is realized. A large increase in money demand requires many price changes across many markets. As with changes in time preference, as long as there are no institutional barriers to price movements, all productive assets and labor can remain in productive use. Hutt argues:

It is wrong to blame speculative changes in the demand for money, still less autonomous changes in it, for the strains which as yet uncoordinated major value changes create in the economy; for to do so is to confuse a response to a disturbing condition with the disturbing condition itself.11

While saving preference and the demand for money are the most important preferences in the market economy because they both affect nearly every other price, the price system, said Hutt, is fully capable of adapting to changes in either one. He wrote:

[W]hen Keynesians blame thrift, they are turning attention away from the failure to adjust prices to changing preferences; and when they blame hoarding (liquidity preference), they are turning attention away from the failure of governments to tackle the problem of unstable price rigidities.12

Keynes’s arguments rely on the assumption that prices cannot change. There is no other way for markets to be stuck in a chronic surplus. The assumption of price rigidity was not clearly stated, and is often difficult to untangle from the complexity of the Keynesian system.

Keynes attributed the persistence of idle resources in Britain to what Hutt called “imaginary defects” in the market. His theory aimed to show that changes in time preference and money demand could throw the whole system into discoordination. The Keynesian system was an attempt to overturn a half century of progress in economic theory demonstrating that a decentralized, self-corrective market process in which individuals and firms pursue their own ends resulted in a coordinated supply chain from producers to consumers.

• 1. W.H. Hutt, The Keynesian Episode: A Reassessment (Indianapolis, IN: Liberty Fund, 1980), p. 105. Italics are original to all quotes from this book.
• 2. Hutt, Keynesian Episode, p. 106.
• 3. Hutt, Keynesian Episode, p. 105.
• 4. Hutt, Keynesian Episode, p. 153.
• 5. Hutt, Keynesian Episode, p. 165.
• 6. W.H. Hutt, A Rehabilitation of Say’s Law (Athens: Ohio University Press, 1974), loc. 1661, Kindle.
• 7. Hutt, Keynesian Episode, p. 165.
• 8. Hutt, Keynesian Episode, p. 174.
• 9. Hutt, Keynesian Episode, p. 111.
• 10. Hutt, Keynesian Episode, p. 138.
• 11. Hutt, Keynesian Episode, p. 165.
• 12. Hutt, Keynesian Episode, p. 107.