Knut Wicksell

The Theory Of Divergences Between Saving And Investment

Great influence was exercised in the first place by Knut Wicksell over the brilliant group of Swedish economists which includes the names of Ohlin, Lindhal, and Myrdal, who are responsible for some of the most interesting theoretical investigations of 1920-40. His ideas have also met with great, though tardy, recognition among the economists of other lands. There is a striking resemblance between the problems he brought forward and those connected with the name of Keynes. But Wicksell's position as leader of a school of economists is somewhat peculiar. The Swedish economists who claim fellowship with him all begin by proclaiming their disagreement with his fundamental theses. In particular, his doctrine concerning the influence exerted on price movements by the discrepancy which appears at certain times between the bank rate of interest and what Wicksell calls the "natural rate" of interest is rejected by them all, by Ohlin as well as by Myrdal and Lindhal. He himself, however, has made only a very tentative application of this idea. He formulated it in the first place to explain long-term price movements. But when it came to actually interpreting either the prolonged rise between 1895 and 1910 or the great fall that began in 1930, he reverted to the abundant gold production in the Transvaal for the first, and to the intensity of the production of goods after the war for the second. In other words, he eventually adopted the traditional view on this point. Ohlin felt justified in saying that Wicksell always looked upon his own contribution as a doubtful hypothesis, and was never as convinced as his pupils of its validity.

So too Wicksell gave up applying his conception to the interpreta­tion of crises, and on this point expressly adopted Spiethoff's theory, and to some extent Aftalion's, though he never mentions the latter and seems not to have known him.

It is impossible, when reading Wicksell, not to be struck by these contradictions and hesitations on the part of an intellect that yet gives proof of rare dialectical and logical vigour. His influence springs rather from the way in which he has put certain difficult problems and his criticisms of solutions already suggested, than from the origi­nality of his own solutions. The principal question that has aroused his curiosity is how long-term price movements, whether upward or downward, are started and continue. Adopting in principle Walras's doctrine of price equilibrium, and favouring also the ideas of Bohm-Bawerk on the rate of interest, he finds great difficulty in accounting, by these theories alone, for certain price fluctuations which during the last fifty years have characterized and dominated economic develop­ment. He sees here some contradictions that had not previously been noted.

His first book, called Geldzins und Giiterpreise (Interest and Prices), appeared in 1898, and is directly connected with the impassioned discussions that arose out of the prolonged fall in prices that marked the years from 1873 to 1895 and provoked so many complaints, especially from the agriculturists. Many economists who were hostile to the quantity theory, especially in Germany and France, refused at that time to attribute this fall to the stagnation or reduction of the annual production of gold. One of the arguments employed against the probability of a monetary influence was drawn from the deep fall in the discount rate observed at that time, and the simultaneous accumu­lation of gold in the issuing banks. How, asked the opponents of the quantity theory, could we speak in such circumstances of a scarcity of gold? Now, Wicksell declared himself an adherent of the quantity theory—the only theory, he said, which had so far accounted for the undoubted influence of money on prices. So he started to search for an interpretation by which to explain the paradox of a fall in prices accompanied by a very low discount rate when that rate seemed, on the contrary, a sign of monetary abundance that should make prices rise. That is the first problem that engaged his attention and led him to examine all existing explanations of the way in which a rise or fall of prices is brought about.

It may be said at once that the explanation of this apparent paradox is really simple enough. The fall in prices means of necessity a diminished need for specie, so that it accumulates in the banks. At the same time the demand for credit is nominally less than before for transactions of the same amount, because goods and services fetch lower prices. Wicksell, however, does not mention this explanation. What happens, according to him, is that the discount rate, though it seems very low, is higher than what he calls the "natural rate" of interest, which he defines sometimes as corresponding to the yield in kind of real capital and sometimes as the rate that equalizes the supply of savings and the demand for them. Hence arise losses for the entre­preneurs and a fall in the price of products. This explanation is itself merely the application to this particular problem of a general solution to which he was led by his reflections on the wider problem of the origin of general rises and falls in prices. As we shall shortly meet with the problem again in another form, it will be enough to say that he draws a distinction here between two cases: one where the movement is due to variable relations between the production of gold and that of goods (for Wicksell has always upheld the quantity theory on this point), and the other, which is "extremely important in practice" (Lectures, II, p. 208), where this movement "is not due to a change in the supply of gold or to an increased demand for goods from the gold countries." It is this second case that perplexes him and leads him to think that the price movement arises from a divergence between the discount rate and the ' natural' rate of interest. Unfortunately he does not tell us what these movements are that are "extremely important in practice" and that are due neither to increased produc­tion of gold nor to that of goods. All that we know is that he was not thinking of crises. It is impossible, too, to verify his hypothesis, since the ' natural' rate is a mere figment of the brain and is not actually in existence on any market.

It is useless to dwell any longer on an explanation that is rejected even by Wicksell's followers. We mention it here—and will dwell on it no longer—only to call attention to its strangeness, and to show the direction in which Wicksell's curiosity led him when it was aroused by dynamic problems very different from those solved by the Classical theories of equilibrium.

A second problem to which Wicksell rightly drew attention, and which economists had almost all neglected, is one that arises whenever there is a general fall in prices. He puts it in the following terms: "Clearly the fact is here overlooked" (when a fall in prices begins)

that the purchasing power which on this assumption would be reduced in the case of the sellers of the former goods would be increased to a corresponding degree in the case of the buyers. If the latter have only to offer a smaller part of their income in order to satisfy their need for the goods or classes of goods in question, then they have a correspondingly greater amount left for their demand for other goods, and it is not impossible that these other goods . . . would rise in price and thereby perhaps compensate for the fall in price of the cheapened goods.

The contradiction in logic thus noted (very opportunely) by Wicksell is precisely the same as that dealt with by Keynes at the beginning of his important book on unemployment. He there poses the question why the re-employment of income liberated by the fall in the prices of certain products, which should normally take place, is not forthcoming, and why the total demand for products (and therefore the general price-level) and the number of workers employed do not remain always the same despite this fall. In other words, how can a general fall in prices remain and extend after it has started, and why is it not stopped at the beginning, since the aggregate purchasing power in the hands of the public has not changed?

Actually, the contradiction is solved easily enough. We have no assurance, in fact, that the income of consumers that is set free will be translated immediately and without delay into a new demand exerting a compensatory upward effect on the prices of other products. It is the rapidity of circulation of money or income that matters here. Now, we know from observation that this rapidity of circulation is very unequal. The owner of the liberated income may very well wait for a time before making use of it. The consumer speculates on a fall of prices just as the producer speculates on a rise. A fall in some products leads him to think that others may fall also. He is led to postpone his purchases of other commodities, and the logical compensatory rise expected by Wicksell does not take place, at least not at once. During this period of delay those business firms, or some of them, that have been hit by the fall in selling-prices will make efforts to reduce their costs, and the result will be either unemployment or a fall in wages before consumers have decided to transfer elsewhere their liberated purchasing power. Hence arises a diminution in the aggregate incomes of the working-class and the entrepreneurs. This diminution of incomes (and, therefore, of the aggregate demand for products), and the new fall in prices that will accompany it, will extend the circle of firms that were hit first, and the movement is thus enabled in a cumulative manner to affect more and more sections of the economic system. In short, there is a velocity of circulation of incomes, whose slackening diminishes the total amount of income spent in a given time. This reduction brings in its train falls in price that are added to the original fall, so as to strengthen it and prolong it until production and total demand have found a new equilibrium at a lower level of prices in general.

The solution of the problem that worried Wicksell is, therefore, simple enough, so long as we are not led astray into a purely logical discussion of its terms but consider in detail, by a microscopical examination, as it were, the reactions caused by the original fall in prices, taking due note of the times within which these different reac­tions occur. This has been very clearly shown by Ohlin and Haberler, the former in two noteworthy articles in the Economic Journal, and the latter in a note in his account of the theories of crises. But Wicksell does not take this line: he thinks he has found another solution, which he was the first to suggest and in which Keynes in his turn found, at one time at least, a way of safety. Starting from Walras's conception of saving, Wicksell declares that normally the amount of incomes exceeds that of consumption. The difference between the total incomes received and the total consumed (i.e., spent on consump­tion goods) constitutes savings, which are invested in business enter­prises or in goods intended to increase future production. These two streams, one of consumption expenditure and the other of savings expenditure, absorb together the sum total of incomes and form two continuous and parallel streams flowing side by side. So long as the amount of investment by the entrepreneurs coincides with the amount of saving by the savers, there is no reason, says Wicksell, for any change in prices in general. On the other hand, if the sums invested by the entrepreneurs exceed the amount of savings (which will happen, for instance, if bank credit is more freely extended by the banks to entrepreneurs, especially if it is granted at a very low rate of discount), then we shall find the incomes of the entrepreneurs, and therefore those of their collaborators—especially the workers—increasing, and along with their incomes their consumption expenditure. We shall then see a general rise in the prices of consumable commodities, which must be attributed in the last analysis to the inequality between saving and investment which is the prelude to a general rise in the price-level. To avert this rise, therefore, it is sufficient to maintain equality between saving and investment. The method to be adopted if this is to be successful is to keep the discount rate high enough to prevent exces­sive investment by the entrepreneurs. Conversely, if the investments of the entrepreneurs are less than the savings that are created, then a fall in prices will take place, and this should be met by a fall in the rate of discount.

This conception is obviously disconcerting to minds accustomed to the theory of the equilibrium and mutual dependence of prices, which implies, in fact, that a rise in prices may begin on the market for consumption goods as well as on the market for investment goods. Ohlin discerningly called attention to this in his introduction to the English translation of Wicksell's first book. He even admits that as a result of war-time experience Wicksell did not retain complete faith in the conception just summarized. "During his last years," he says,

Wicksell came more and more to doubt the solidity of what had been regarded as the corner-stone of his monetary theory—the idea that if the money rate coincided with a normal rate of interest, which brought about equality between savings and investment, the commodity price-level would remain constant.

He draws the conclusion, then, from some of Wicksell's sentences, that he did admit at the end of his life, though without actually saying so, that even in a case of equilibrium between saving and invest­ment, as generally understood, there might occur a rise or fall of prices. And so he concludes that one of the fundamental elements of Wicksell's original theory would have to be abandoned.

But whatever Wicksell may have thought of his own theory, and however unacceptable it may be to his followers and those who remain faithful to the theory of the mutual dependence of prices this distinction between saving and investment has played a con­siderable part in the economic controversies of recent years, particu­larly in the ideas of Keynes, and it was expedient to show how it originated.

Such, then, are the salient points in the views of a writer whose function was mainly to point out the difficulties in current theories and to seek for solutions, though he himself attributed to his solutions no other value than as suggestions constantly subject to revision. Until the end of his life he never ceased to be obsessed by this prob­lem of the great price movements, and by the desire to find methods by which price-levels could be stabilized. It is enough for us to have shown here the importance that he attached to the phenomenon of saving, to which, as we know, so many writers attribute a predominant influence in the development of crises, though they are far from agreeing about its mode of operation. To this mode of operation we must now return.