Online Primer

By Noah Nissani

Copyright 1996 -- Authorized free distribution of non-modified copies for non-commercial purposes.

 

Chapter III

POLITICAL ECONOMY -- Part II (Conclusion)

Contents:

Symbols
Formulas
1. Salary and Prices
2. Money
3. Quantity of Money, Circulation and
Gross National Product (GNP)

4. Monetary, Cost, and Demand Inflation
5. Trade Cycles. Keynesianism versus Monetarism
6. Epilogue
Notes

Chapter I    Chapter II   Chapter IV    Chapter V

 

Symbols:

B=Bulk of merchandises and services exchanged by money in a given period. It includes raw material and work, together with finished goods.
p = Average price per unit of B.
G= Goods and services marketed by final users in a given period.
P=Average Price per unit of G.
C=Average cost of production, transport and marketing per unity of G, through the entire chain of intermediaries from raw material to the final user.
S=Average salary per hour.
R=Capitalists' revenue.
RE=Relative Efficiency.
M=Marginal Cost. Cost of production of factories that do not return gains.
H=Man-hours actually employed in producing G.
H'= " that would be required in producing G through a chain of factories working at marginal cost.
V= Average times that unit of money passes from one hand to another in exchange for commodities, services, or work in a given period.

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Formulas

P x G = H'x S (1a), C x G = H x S (1b),
R = (P - C) x G = (H' - H) x S (1c),
P x G = H x S + R (1d), S/P = G/H' (1e),
R/S = (H'-H) (1f), R/G = (H'-H)S/G (1g).

Q V=p B (3a) p B = k' P G + S H (3b),
Q V = k' P G + S H. (3c), Q V = k' P G + S H'- R (3d)
Q V = (k+1) P G = (k+1) S H' (3e), G=(G/H) H (3f),
(G/H')H' (3f').

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1 Salary and Prices

Marginal cost (M) equals price (P) by its very definition i.e., the cost per unit at which goods are produced by factories without returning any gains. Certainly, the cost of production is divided between salaries, raw material, machinery, fuel, etc.. However, the cost of each of these elements is finally resolved at the salary level, through the respective marginal cost of a chain of intermediary stages (1). Hence, the purchase value of a given amount of goods (G) equals the man-hours (H') that would have been invested in producing it, from the raw material to the user's hands, through a chain of real or virtual factories working at marginal cost, multiplied by the average salary (S), i.e., P G = H' S (1a). Whereas the actual cost of production of the given amount of goods equals the average salary multiplied by the actual man-hours (H) employed in the real chain of factories, i.e., C G = H S (1b). Therefore, the capitalists' revenue (R) along the whole process is calculatedby subtracting (1b) from (1a), and is expressed by R=(P-C) G =(H'-H) S (1c). And from equations (1a) and (1c) results P G = H S + R (1d), i.e., the purchasevalue of the aggregate goods (G) equals the aggregate salaries plus thea ggregate capitalists' revenue.

Equations (1a) and (1c) show that prices and capitalists' revenue are directly proportional to salaries, S/P=G/H' (1e) and R/S=(H'-H) (1f). Therefore, a general salary increase at constant G, H' and H results in a proportional increase of prices and capitalists' profits. The salary/prices and profit/prices ratios remain constant, and only a devaluation of money is achieved. This result is not so obvious to general public, and the widespread belief that a general salary increase can improve the living standard of the masses is widely exploited by ignorant or with less-than-noble intentions politicians. As a matter of fact, only an increase in productivity, i.e. in the G/H' ratio, can improve the purchasing power of salaries, as has been the case from the beginning of the industrial revolution, by means of ongoing innovation in tools and methods of production.

On the other hand, a sectoral raising of salaries increases the prices of some products, entailing a devaluation of money proportional to the increase of the average salary. Therefore, the purchasing power of some workers will augment, to the detriment of those whose salaries were not augmented. It can also harm the profits of some enterprises to the benefit of others, but it can hardly affect the real value of the aggregate capital's gains, which will remain proportional to the average salary.

Work is a conglomerate of services or crafts, each of them having its own supply and demand market. Hence, in a real free-market its price would have to fluctuated with the supply-demand balance. However, work differs from the other commodities in many aspects:

1) The aggregate value of work nearly equals that of all other commodities put together, and hence its economic weight is critical.

2) It is the ultimate raw material of every other commodities and therefore its price determines all other prices.

3) As a result of trade union pressure and labor laws, salaries are easily increased when demand exceeds supply, but rarely lowered when supply exceeds demand. This makes it difficult to reestablish the market equilibrium after an economically excessive raising of salaries. For this reason there exists a wide consensus among economists that a less of five percent rate of unemployment leads to an unstable economy, which may end in inflation. What might otherwise lead to an oscillation around the economic level of wages, results from the elimination of the lowering phase of the wage oscillation in a constant inflationary process.

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2. Money

Economy is based on specialized production, in which everyone puts on the market specific goods to be exchanged for goods produced by others. The difficult exchange of, for example, a cow for a suit, is facilitated by the existence of an intermediary merchandise, which must possess two fundamental properties:

a) A stable and known exchange value with respect to the other merchandises, what makes it universally acceptable.

b) A high value/weight ratio, that makes it easily portable.

From earliest times valuable metals such as gold and silver have fulfilled the function of this intermediary merchandise. This began in the form of pieces of metal broken and weighed out in presence of the seller (2), and later as metal coins of conventional value. Afterwards, the coins were replaced by metal-backed paper-money issued by trustworthy banks in the form of banknotes exchangeable for metal on demand.

The exchange value of metal and metal-backed money was dependent on the supply and demand of gold and silver in the world markets. Therefore, they could not fulfill in a totally satisfactory manner the requirement of a stable value. And so it happened, that in the last part of the 19th century, prior to the discovery of gold deposits in Alaska and South Africa, the increasing gold demand caused a general lowering of prices, i.e, a deflation which was not less detrimental than its counterpart, the inflation that followed in its wake with the discovery of these new and rich gold deposits toward the beginning of World War I. Furthermore, gold-backed currency has no more reliability than that of the institution or government issuing it, and the condition of being "gold-backed" has been repeatedly violated each time a non-conservative monetary policy was adopted.

It is only in recent times that the gold-backed currencies have been substituted by "fiat" ones, i.e., by currencies whose reliability is based on a conservative monetary policy aimed at stability of prices. This currency stability is measured by the constancy of the prices of a somewhat arbitrarily defined basket of goods. In spite of the arbitrariness in the selection of the basket, and of some questions that arise from the variable quality of these goods, this method provides a better monetary stability than that which could be achieved by metal-backing of currency.

International agreements determine financial sanctions for those nations whose currency suffers a level of inflation that surpasses a conventional standard. But perhaps the most serious penalty incurred is the damage that inflation inflicts to the national economy, and the rejection of unstable currencies in international transactions. Those nations whose currency is not internationally accepted are forced to maintain stocks of foreign currencies to finance their imports, instead of enjoying the highly remunerative export of their own currency.

Today it is widely accepted, as a modern complement of the liberal principle of separation of powers, that to assure a non-inflationary monetary policy the power of to issue money must be kept separate from that of using it. While the use of money remains a function of the legislative and executive powers, the issuing of money is presently being transferred to an autonomous Central Bank, which is responsible for its stability. It is still a debated question whether the Central Bank must also be responsible for full employment and economic growth. The supporters of extending the Central Bank function to these two additional areas point out their close dependency on monetary policy. The opponents object that the matters of full employment and growth are better handled by labor legislation and tax policy. Their transfer to the Central Bank would force it to deal with them by monetary means, what would lead to contradictory demands from the monetary policy.

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3. Quantity of Money. Circulation and Gross National Product (GNP)

Money includes in addition to the coins and bills issued by the government every other real or virtual intermediary merchandise used in commercial transactions, such as checks, promissory notes, account transfers, credit cards, commercial credit etc.. Quantity of money is then the aggregate purchasing potential of the people, enterprises, and institutions at a given moment. The difference between the quantity of money, and the governmental- issued currency is basically created by credit. In practice, credit counts for many times the main part of the means of payment, and bills and coins are scarcely used except for minor retail purchasing.

As an illustration, in 1968 the total of bank deposits in the United Kingdom amounted to 12,110 million pounds, while the amount of issued bills and coins was only 3,572 million. Of the latter nearly 700 million were held in the banks' safes, and something like 2,800 million were in circulation (3). Therefore, there were at the public disposal 2,800+12,110= 14,910 million pounds (4), of which 11,338 million pounds were credit-money issued by the banks. To this sum one must still add the credit offered by commercial firms, which constitutes a significant part of the aggregate means of payment, i.e., of the quantity of money.

To understand the mechanism of money issued by banks, let us assume that all the payments are performed by check or credit card, so that the sums are simply transferred from one bank account to another. This assumption, which is becoming truer with every passing days, only simplifies the explanation allowing us to overlook the percent of issued money held in cash by the public. Hence, it is assumed that the total of issued currency (X dollars) is deposited in the banks. The banks loan this sum to their clients by crediting it to the clients' accounts. Hence, 2X dollars are now deposited in the banks, and only half of them are loaned.

When the deposit's owner makes use of the money, owned or borrowed, it simply passes from one account to another, therefore there is a remainder of X dollars at the banks' disposal for new loans. After this disposable remainder has been loaned there would be 3X dollars in bank deposits and only 2X of them loaned. This process could continue ad infinitum, were it not for the Central Bank demand that the banks must retain in cash a certain percentage of the deposits. This cash reserve, called liquidity, amounts in the above example 700x100/12,110=5,78 percent of the deposits (5). It is by varying the liquidity, that the Central Bank controls the quantity of credit-money issued by the banks. (6)

A process similar to that in which metal coins were replaced by bills in the past, is occurring in our own day, when checks, account transfers, and credit cards seem close to completely displacing the circulation of government currency. Bank deposits are today a currency-backed money issued by banks, similar to the gold-backed paper-currency issued by the government in the past.

An approximate calculation of the quantity of money needed by the market can be made by means of the following simplified model. Let's assume that all the employees receive their salaries on the first day of the month. Therefore, the last day of each month an amount of currency equal to the aggregate monthly salary must be present in the bank accounts of the employers, in order for to be transferred the next morning to the accounts of the employees. During the month the currency returns to the employers through a chain of service providers, shops, etc., and the monthly cycle begins again. Hence, the number of employees multiplied by the average salary gives an approximate value of the minimum quantity of money required.

An economic parameter of no less importance than the quantity of money is its velocity of circulation. If in the preceding calculation the monthly salary is substituted by a biweekly one, the quantity of money needed would be half of that previously calculated. This half-quantity of money would run a complete cycle twice a month, from the factory to the workers, from them to the retail shop, the wholesaler, and once again to the factory. Nevertheless, the aggregate value of the transactions effected in a given unit of time would remain unaltered.

"Money circulation" is defined as the product of the quantity of money (Q) by the number of times (V) on average that an unit of money passes from one hand to another in a given period. Hence, it follows that Q V=p B (3a), where B is the aggregate merchandise (7) involved in the transactions, and p, the average price per unit of B, is an identity by the very definition of its terms. V and B are relatively stable parameters of the market, which cannot be directly influenced by a change in Q or p. In practice, the quantity of money (Q) is the only one of the above four parameters that can be directly changed by the government. Therefore, an increase of Q not balanced by a change of B or V, will necessarily lead to an increase of p. Such an unbalanced increase in quantity of money, which entails the raising of prices, is termed "monetary inflation".

The aggregate merchandise (B) involved in commercial transactions in a given period, includes finished goods and services (G), together with the raw material, fuel and work (H) used in its production. It also repeatedly includes the same goods as their pass from the factory to the wholesaler, to the retail shop, and finally to the user. When it is desirable to avoid this repeated counting, the aggregate goods and services purchased by final users (G) must be used in place of B. From the respective definitions of B and G it results that p B = k' P G + S H (3b), where P is the average price per unit of G, and k' is a coefficient of proportionality between the aggregate value of G, and that of B excluding work, which appears in a separate term (S H). Therefore, from (3a) and (3b) results Q V = k' P G + S H (3c), which using 

Assuming that at a given distribution of relative-efficiency (RE) among the factories of the market, the capital's revenue (R) is proportional (8) to the amount of the goods marketed (P G),we obtain k' P G - R = k P G. Now making use of P G = S H' (1a) it follows that Q V=(k+1) P G (3e) and QV=(k+1) S H' (3e'). From the equation (3e), and being V a relatively stable parameter of the market, it follows that any increase in G requires an augment of Q or a reduction of P. Therefore, an issuing of money proportional to the increase in production must be carried out in order to maintain the stability of the purchasing value of money.

The aggregate final goods G is the product of the average actual productivity or efficiency, i.e., the average goods/man-hours ratio G/H, by the actual aggregate man-hours H, G=(G/H) H (3f) or also G=(G/H')H' (3f'), where G/H' is the marginal productivity, and H' the amount of man-hours that would be employed in producing G if all the factories of the market would work at marginal cost. Equations (3f) and (3f') are closely related and in a competitive market, as it was explained in the previous chapter, any increase in G/H entails an increase in G/H'.

In the case of an increase in G which results from an increase in G/H' at constant H', equation (1e) (S/P = G/H') shows that the increase in marginal productivity entails a similar increase in the salary/prices ratio. In the inverse case of an increase of G caused by an increase in H', at constant marginal productivity G/H', it results from QV=(k+1)S H' (3e') that a proportional increase of Q is needed to avoid a reduction of salaries. From QV=(k+1)P G (3e) it is clear that such an increase of Q does not entail any change in prices. So that immigration, which is one of the main causes of manpower increase, allows for a non-inflationary issue of money that may be used to facilitate its absorption without charge to the taxpayer.

The money value of the annual production of final goods and services G, is named Gross National Product, GNP=P G, and it is also frequently referred to as Gross National Income, GNI, and defined as the sum of annual aggregate salaries and gains, GNI = H x S + R. From equation (1d) results GNP = GNI. For GNP to have an economic meaning, either P must be expressed in a stable currency, or the effect of inflation must be deducted. An increase in GNP that results from an increase in G, is termed economic growth. It may result from an increase either in productivity (G/H), or in the amount of man-hours (H). In the first case it implies an increase in GNP per capita, which is closely related to the living standard of the masses.

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4. Monetary, Cost, and Demand Inflation

Inflation and some of its causes and effects already have been elucidated in the preceding sections. So, what remains to be done here is to summarize, arrange and supplement the facts and ideas concerning this complex and problematic aspect of economy.

A currency of unstable value results in a general raising or lowering of prices that disturbs the economy at all its levels, from home-budget management to industrial planning. When prices continuously vary, consumers lose their ability to evaluate prices, and tend to pay as much as they are asked to pay. On the other hand, shopkeepers worried that they will be forced to pay for the replacement of the merchandise more than they are receiving for it, tend to raise prices. The combined outcome is catastrophic to the family budget.

Industrial and commercial management is based on long term planning. The clothing industry, for example, must offer summer merchandise to retail shops during the winter and partially collect its value the coming autumn. Therefore, the prices in the wholesale catalogs distributed in January must take into account the expected value of money in September. The retailer, in turn, must add the expected surplus he will be called to pay for the following winter's merchandise, otherwise, the real value of his capital would decrease. The uncertainty with respect to the inflation rate in the future increases the risk in every industrial or commercial transaction, and forces a risk factor to be included in the prices. In such long term planning, any difference between the expected and the actual inflation rate, no matter in what sense, may lead to the bankruptcy of enterprises, merchants, and families.

Inflation is a chain-reaction phenomenon, self-fed not only by the inflation expectation, as was illustrated in the previous paragraph, yet also by the demand of wage indexation that it brings on. The link between salaries and the cost-of-living index causes a temporary increase of some prices resulting in a general augment of salaries, which in turn causes a general increase of prices and so on. This chain reaction is so dangerous that it is universally accepted that wage indexation can never be 100%. The difference between the indexation and 100% acts as a waning factor that does not eliminate the self-rising effect but prevents a total economic collapse.

Inflation is not a disease but a symptom of various economical diseases, and its seriousness and the means of action against it vary with its cause. An accepted classification of inflationary processes according to their causes divides them into monetary, cost, and demand inflation.

Monetary Inflation:

Accordingly to eq. Q V=p B (3a) an increase in quantity of money (Q), over the amount needed to balance an increase in the aggregate transactions (B), necessarily entails an augment in prices (P), which is called "monetary inflation." It may be caused either by government deficit expending covered by issuing currency, that is, government-backed counterfeiting of money, or by an increase in bank or commercial credit. The graveness of a monetary inflation caused by deficit expending depends on the cause of the budget deficit, which may be either a transitory increased expenditure, an inflated government bureaucracy or services that exceed government revenues, or merely a large budget/GNP ratio.

a. Inflation caused by transitory expenditures:

Israeli examples of monetary inflation caused by transitory expenditures are those that followed the Iom Kippur and Lebanon wars. (The first of them was combined with the worldwide "cost inflation" caused by the raising of the price of petroleum.)

After the cause of the transitory expenditure disappears, it is relatively easy to disable the remaining self-feeding inflationary process by means of monetary measures. This explains the relatively easy success of the Israel National Unity government in reducing the severe inflation caused by the military action in Lebanon (1982-86) to a remainder rate of 10-12 percent.

b. Inflation caused by inflated bureaucracy and/or government services.

All bureaucratic bodies tend to expand, and people demand the amplification of government services when it is not clear, that they will be called upon to pay for them. Hence, this kind of inflation is much more difficult to deal with, on account of the electoral impact of massive dismissal of government employees and reduction of services.

The above-mentioned annual remainder rate of inflation of 10-12 percent in Israel, which continues to be more or less stable from the late 1980s to today (1997), can be attributed to inflated bureaucracy and services financed by deficit expending. In the last years, this relatively stable situation was seriously aggravated by the political motivated raising of government salaries, when the public favored the opposition. According to equation S/P=G/H' (1e), such a raising of salaries (S) exceeding the productivity (G/H') increase would have to result in an inflationary increase in prices (P). Though the inflation was restrained by the Bank of Israel raising of the interest rate, which is a powerful yet harmful means of controlling inflation that has a double effect:

i) It discourages the use of credit, reducing the quantity of credit-money and balancing the currency issued by the government. A similar effect also could be attained by raising liquidity, (i.e., raising the portion of deposits that banks must retain in cash.) Both ways harm industry and commerce, which must pay a high interest rate and cut down the credit needed for their normal activity.

ii) The high interest rate attracts a flow of foreign currencies causing revaluation of the national currency, and favoring import to the detriment of local industry and export. Imported goods, not balanced by similar amount of exports, augment the quantity of goods (G) at public disposition in equation (1e) (S/P=G/H') (11), preventing a rise in prices (P), yet increasing the deficit in the balance of payments.

A similar effect of inflation control by increasing G with imported goods also may be attained by reducing customs taxes. Therefore, the raising of interest rates combines the effects of increasing liquidity and lowering customs taxes. In addition, it provides by means of the attracted flow of foreign currency for the momentary covering of the deficit in the balance of payments, giving the feeling of business as usual, making it even more dangerous.

Returning to the Israel case, the annual rate of the deficit in the current balance of payments jumped from 1,770 in 1993, to 7,120 million dollars in the first half of 1996 (12). Namely, a jump from 1.8 to 7.2 percent of the Gross National Product (GNP). Since the Israeli government budget amounts to nearly 50% of the GNP, an increase of say 20% in government salaries will result in an immediate growth of nearly 10% in the Gross National Product (remember that GNP equals Gross National Income (GNI), as it was shown in Section 3.) The consequent diminution in the contribution of the harmed private sector to the GNP will be felt only after a lag that can be more than one/two years long. In the meantime, even an increase in the economic activity of the private sector may be perceived as a consequence of the increased purchase power of government employees. Therefore, in spite of the disastrous effects of the high interest rate on industry and export, and the unsustainable deficit rate in the balance of payments, a false sensation of "economic growth" and welfare is created.

From a strictly economic point of view the solution is very easy: Either return salaries to their previous level or dismiss an equivalent number of government employees. In practice, the trade unions and electoral demands make both options very difficult. The only other way to reduce the deficit expending is to cut down on the goods and services purchased by the government from the private sector. Namely, to continue paying employees salaries while restricting their activity. This leads to a reduction of private gains, which lowers government receipts and partially balances the decrease in government expenses and demands new budget reductions.

The return to a normal interest rate is liable to cause a reversed flow of foreign currency followed by national currency devaluation, an increase in imported raw material prices, and a consequent cost inflationary process. Furthermore, since a large part of the surplus foreign currency has been used in covering the deficit in the balance of payments, the remaining reserves may be insufficient to satisfy the demand of foreign currency, resulting in a total collapse of the economy, as has happened recently in Mexico and Thailand.

Summing up, the interest rate is a powerful tool for controlling currency stability when dealing with minimal inflationary or deflationary deviations. It is a matter of controversy, if in the case of severe inflation, which demands a considerably high interest rate over a long period, if the medicine is not more harmful and dangerous than the disease.

c. Inflation caused by a large Budget/GNP ratio:

Unavoidable incorrect evaluations of future government receipts and/or expenditures often result in deficit expending. The larger the Budget/GNP ratio, more significant their inflationary impact.

The expected 1997 Israel National Budget/GNP ratio is nearly 50% -- more than twice the USA Federal Budget/GNP ratio. The latter quadrupled from 1934 to 1952, during a period in which Keynesianism (9) and Marxism, both supporting government intervention in economy, were on the offensive, while Liberalism was on the defensive and withdrawing. During this period, USA federal taxes jumped from 4.8 to 18.9 percent of the Gross Domestic Product (GDP=GNP excluding income originated in foreign countries) and remained at this level until today. (10)

It was alleged that the extreme imbalance in the 1996 Israeli budget partially originated in an erroneous evaluation of the expected government receipts.

After WW2 a number of factors led many nations in the developing world and the developed world periphery to a disastrous level of monetary inflation:

a) The totalitarian ideologies in vogue at the time convinced rulers that they could and should do all in order to benefit their subjects. This led to a populist policy of "concern" for the poor, which favored inflated bureaucracy, army, and police, and enhanced the power of ambitious rulers.

b) Keynes' and his followers' theories allowed for deficit expending in order to prevent economical depression. Schematically these theories advocated inverting the classical formula "Capital, Work, Money" into "Money, Work, Capital." Instead of capital invested in new factories and jobs resulting in increased production and flow on currency, money issued would pay for the work, and the latter would create capital.

Although Hitler succeed in vitalizing the destroyed German economy by using the above inverted formula, all other attempts to emulate this performance led to disastrous outcomes. The cause seems to reside in two factors present in the German case, yet absent in the others. First, due to temporary factors the Germany GNP was below its actual potential. In these circumstances an electric-financial shock was sufficient to get the German economy moving. Second, the iron discipline of the Hitlerian regime did not allow any deviation from the central goal.

c) What makes monetary inflation a favorite of irresponsible rulers is that it is a hidden tax taken from the workers' wages without them being aware of the fact. Theoretically it is taken from anybody who is caught with money in his hands or accounts. In practice, only wage-earners are the payers of this tax, since industries and shopkeepers forward it to the customers by including it in the prices. Workers are not aware that it is the government that is taking the money from their pockets and blame the shopkeepers for their budgetary difficulties.

Cost Inflation.

"Cost inflation" may originate either with salary increases or by raw material shortage. According to equation S/P=G/H' (1e), any salary (S) increase that exceeds the increase in productivity (G/H'), entails the raising of prices (P). It also requires, in accordance with equation Q V = k P G + S H. (3c), an increased quantity of money (Q). If the government does not provide the required additional currency, merchants and factories are forced to expand commercial credit in order to avert sales reduction, which results in an augmented number of promissory notes and post-dated checks that circulate as currency. Hence, in a "cost inflationary process" the increase in quantity of money is the consequence and not the cause of the raising of prices and salaries.

The inflationary increase in salaries may result from either trade union demands, government populist politics, or competition between employers in a period of economic expansion and low rates of unemployment. The latter is the kind of inflation that can menace a nation, in opinion of economists, when unemployment is lower than 5 percent. For legal, political, and psychological reasons wages can easily shift up, but hardly down, which prevents the market from reestablishing the equilibrium, after an excessive increase.

An example of cost inflation caused by a shortage in raw material, was the worldwide inflation of the 1970s, generated by the petroleum crisis. A fast increase in petroleum demand associated with political reasons led to a sudden rise in its price, which affected the cost of production and price of merchandise. Additional man-hours had to be applied to searching for new sources and to the exploitation of wells that were previously non-profitable. It implied a raising of petroleum marginal cost forwarded to the marginal cost of every other goods. Perhaps for the first time from the beginning of the industrial revolution, marginal and actual productivity (G/H' and G/H) halted their continuous rise, and effected regression. Salary/Price ratio (S/P=G/H' (1e)) and purchasing power of the masses fell off followed by consumption diminution, and general recession. The world faced a new kind of inflation combined with recession that raised new doubts about the correctness of Keynes economical theory based on the experience of the 19th century and the world depression of the 1930s, where recession and inflation seemed never to appear together.

This sort of inflation differs from those previously discussed, in that it is of economical nature, i.e., associated with a change in goods/man-hours ratio and not in a mere change in money value. Hence, no monetary measure, and no salary/money adjustment, can return the purchasing value of salaries to their previous level. The salary indexation, which has some justification in the previous cases, is here totally ineffective and prejudicial.

The diminution in the bulk of merchandise involved in commercial transactions (B) caused by the decrease in productivity (B/H) balances in the present case the quantity of money required by the increase of prices (Q V=p B (3a)). Therefore, the issuing of money is neither the cause nor an unavoidable outcome of this inflationary process. Nevertheless, the discontent caused by the diminution of the Salary/Price ratio, reinforces the demands for salary increase, which in turn leads to a secondary monetary inflation.

In the normal evolution of the process, workers dismissed from consumption industries are absorbed by petroleum and affiliated industries, as well as by industries searching for new sources of energy and energy-saving methods. Finally, after a period of depression and unemployment the market is expected to reach a new state of equilibrium, though at a lower living standard.

Demand Inflation.

Demand inflation, which already has been considered in Chapter I when dealing with "Saving and Investment," is caused by an increase in consumption with detriment to saving and investment. It may be originated by a false illusion of wealth provoked by inflated value of shares and real estate and/or a sensation of security derived from full employment. Consequently, the prices of goods of consumption rise, while the investment sector shows symptoms of recession.

If this situation continues for a sufficiently long period, investment workers may be dismissed. In a totally fluid market, workers would be displaced from investment to consumption, the increased demand for goods of consumption being satisfied, and prices restored to its previous level of equilibrium. However, the time-reaction delay between dismissing from investment to absorption by consumption industries may cause the recession to extend to the consumption sector, ending in a global depression. Such a process may offer a possible explanation for the world depression of the 1930s that followed the boom of the 1920s.

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5. Trade Cycles. Keynesianism versus Monetarism

The free-market possesses recuperation mechanisms that restore it to equilibrium when it is broken. In this aspect it is, therefore, similar to physical systems, such as pendulums or strings, which oscillate after deviating from their state of equilibrium. An alternate series of economic peaks and troughs, that occurred during the 19th and beginning of the 20th centuries, suggested the idea that they are the result of intrinsic oscillating characteristic of free-market, and gave birth to the Trade Cycles theory. This way of thinking was reinforced by the contemporary development of the wave theory in physics, which culminated with James C. Maxwell's (1831-79) identification of light with oscillations of electromagnetic fields. From the now obsolete Trade Cycles theory remains the classification of economic states in boom, recession, depression, and recuperation, corresponding to the peak, lowering, trough, and rising portions of a sinusoidal wave.

The worldwide crisis of the 1930s, which followed the boom of the "Roaring Twenties," strengthened the belief in endogenous causes of trade cycles and the search for a way to counteract their harmful effects. It was upon this background that the theory of the British economist John Maynard Keynes (1883-1946) (13), founder of the Keynesian school, appeared, advocating government intervention in economy in order to balance the effects of the trade cycle. In Keynes opinion, when the market shows symptoms of recession intensified economic activity of the government, could cut the oscillating process and prevent the phase of depression and unemployment.

Keynes' main scientific contribution was introducing dynamics to the scope of economics thinking. Whereas his predecessors concentrated their efforts in analyzing states of equilibrium and the transitions between them, Keynes dared to deal with changing situations, and their actuating forces. However, the time factor, of vital importance in dynamic phenomenons, was not sufficiently understood by Keynes and his followers.

From more recent research on the supposed trade cycles and their possible causes, serious doubts about their mere existence appeared. Presently, it seems more likely that the apparent "oscillations" are caused by fortuitous external agents, such as wars, drought, technical advances, or even psychological factors, which unpredictable affect the economy, rather than being an intrinsic free-market characteristic. Hence, only government activity synchronized with these external agents might attenuate their effects. However, the government only is able to act after the effects are perceived. Namely, after a lag that may be, in Milton Friedman's opinion, as long as eighteen months (14). Therefore, any government tentative of economic intervention would have the character of mere random disturbances.

For example, let us assume that the market shows symptoms of recession associated with unemployment in the consumption sector. Accordingly to Keynes theory, government must increase its economic activity in order to reinforce consumption. However, government activity requires funds that must be taken either from capital and workers' income by means of increased taxes, or by the issuing of bonds or currency. Whichever the way of collecting the required funds, it always will be to the detriment of private saving and investment. Hence, government intervention will result in investment industry recession, job-creation failure, and increased unemployment. However, the firing of investment workers will take place after a sensible delay during which employers will try to understand the cause of their difficulties, and to find less drastic solutions. Hence, in the meantime government intervention can result in a transitory period of welfare and abundance, inducing a collective mood of security that allows for spending and the contraction of debts, disregarding saving and prudence, that aggravates the coming recession in the investment sector.

In a Keynesian fluid market, in which the lags between causes and effects are not correctly evaluated, the increased consumption demand associated with investment recession would result in a transfer of workers from investment to consumption. Though, the absorption of the dismissed investment workers may demand enlargement of existing factories, a task that would require considerable time, and would be made more difficult by the reduction in investment resources resulting from the government deviation of money toward consumption. Consequently, there could be a considerable lag before the market could satisfy the demand for goods of consumption and a demand inflation associated with unemployment can occur. Furthermore, the diminished consumption of the dismissed investment workers may extend the recession to the consumption sector, resulting in a global depression.

Accordingly to Keynes and followers, government must now resort, in the presence of unemployment, to a new wave of government spending. Their attitude is based on the assumption that the unemployment originated in the present insufficient money circulation, while in fact it is the outcome of excessive government spending in the past. Clearly, a new wave of government spending will aggravate the situation by increasing inflation, causing a new reduction in saving and investment and increasing future unemployment.

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6. Epilogue

The ineffectiveness of government intervention intended to balance economic fluctuations, together with a better understanding of the role of the time-reaction lags in the economic processes, has led to the substitution of the Keynesian theory by Monetarism. The latter theory, whose main supporter is the American economist Milton Friedman (1912 - ), limits the role government in regulating economy to the preservation of currency stability.

The Keynesian school gave legitimation to deficit spending, budget expansion and widening fiscal policy, and led to increasing government activity to the detriment of private initiative. The Keynesian ideas found the ground prepared for them by the proliferation of totalitarian ideologies during the first half of the century. The result was an increasing portion of the Gross National Product ransacked by the governments of all Western nations.

The American Federal Government receipts from income taxes, which were in 1936 (when Keynes' main book appeared) only 1.7 percent of the Gross Domestic Income (GDI) (i.e., GNI excepting income from foreign sources), in 1952 reached 14.1 percent. And the total Federal Government's revenues rose in the same period from 4.8 to 18.9 percent of the GDI. From that time to the present day the total Federal Government's revenues expressed in percent of the GDI remained more or less stable (15). By means of issuing currency and bonds the 1994 Federal Government Budget rose to nearly 22 percent of the GDI (16).

For comparison, the 1997 Israel Budget is expected to amount to 47.3 percent of the Gross National Income (17), i.e., from each NIS gained by individuals and companies nearly 0.5 NIS is taken and spent by the Israeli government. To this budget municipal taxes, government companies and monopolies must be added, which makes the Israeli economy an approximated realization of the Marxist dream.

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Notes:

(1) "If we consider as the producer the capitalist who makes the advances, the word Labour may be replaced by the word Wages: what the produce costs to him, is the wages which he has had to pay. At the first glance indeed this seems to be only a part of his outlay, since he has not only paid wages to labourers, but has likewise provided them with tools, materials, and perhaps buildings. These tools, materials, and buildings, however, were produced by labour and capital; and their value, like that of the article to the production of which they are subservient, depends on cost of production, which again is resolvable into labour. The cost of production of broadcloth does not wholly consist in the wages of weavers; which alone are directly paid by the cloth manufacturer. It consists also of the wages of spinners and woolcombers, and, it may be added, of shepherds, all of which the clothier has paid for in the price of yarn. It consists too of the wages of builders and brickmakers, which reimbursed in the contract price of erecting his factory. It partly consists of the wages of machine-makers, iron-founders, and miners. And to these must be added the wages of the carriers who transported any of the means and appliances of the production to the place where they were to be used, and the product itself to the place where it is to be sold." "The Principles of Political Economy"(1848), John Stuart Mill (1806-73), Book 3: Chapter 4.

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(2) In Biblical Hebrew "to break" and "to buy" are both expressed by the same word "shabar".

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(3) "Macro-Economics", F.S. Brooman, George Allen & Unwin Ltd., London (1971).

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(4) If this amount includes fixed term deposits, which are not withdrawable on demand or transferable by checks, they must be deducted from the aggregate means of payment.

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(5) Differentiation must be made between current and fixed term deposits, as well as between long and short term credits.

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(6) In Israel there exists a special form of bank credit, the authorized overdraft, which must be added to the total bank deposits when calculating the actual quantity of money at public disposal. It differs from the habitual forms of credit in that it is an amount of money at the disposal of the bank customer without being previously recorded in his account. It is a potential credit, for which the customer only pays interest when and for the amounts he actually uses.

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(7) B includes every material, virtual, or spiritual value or service out of money. Hence, V does not include the exchanges of one kind of money for another, such as the withdrawal of cash from bank accounts, or the payment of a debt, which implies the replacement of credit-money by cash or bank deposit.

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(8) Capital's Revenue/GNI ratio in USA during the period 69-93 was lower than 8.5 percent. (From a New York Times article reprinted by Haaretz 11.8.97.)

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(9) Keynes theory is more explicitly exposed in Section 5.

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(10) Tax History Project at Tax Analysts. Source: Office of Management and Budget, Budget of the United States Government, Fiscal 1988, Historical Tables.

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(11) Equation (1e) was established under the assumption of a closed market in a state of equilibrium. It is valid also in an open market in a state of equilibrium where imports must equal exports, and hence G remains unaltered and equal to the aggregate of local production of goods and services.

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(12) Haaretz 15.9.97.

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(13) John Maynard Keynes (1883-1946) British Economist: "General Theory of Employment Interest and Money" (1936). Other Keynes' works

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(14) Milton Friedman (1912 - ) American economist, who has written among others works: "The Quantity Theory of Money -- A Restatement" (1956); "A Theory of Consumption Function" (1957), "The Lag in Effect of Monetary Policy" Journal of Political Economy, Oct. 1961; "Capitalism and Freedom" (1962), "Free to Choose" (in collaboration with his wife Rose) (1980). He won the Nobel Prize in 1976.

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(15) Tax History Project at Tax Analysts Source: Office of Management and Budget, Budget of the United States Government, Fiscal 1988, Historical Tables.

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(16) USA Annual Shareholders' Report

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(17) Haaretz 10.8.97.

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