Explaining National Income

The final chapters of the 1945 draft, covering saving and investment, prices and money, and the banking system, are clearly less polished than the ear­lier ones.^[lxvi] The chapter on saving and investment begins by telling the reader that the most important fact about saving and investment was that, in a modern industrial society, they were undertaken by different people and were undertaken for different reasons.

This capricious, volatile behavior is understandable when we realize that investment opportunities depend on new discoveries, new prod­ucts, new territories and frontiers, new resources, new population, higher production and income. Note the emphasis on new and higher. Investment depends on the dynamic and unpredictable elements of growth in the system, on elements outside the economic system itself: technology, politics, optimistic and pessimistic expectations; governmental tax, expenditure and legislative policies, etc.³⁶

“As far as total investment is concerned,” Samuelson wrote, “the system is in the lap of the Gods.”³⁷ Like Keynes, he concluded that there was no assurance there would be sufficient investment, though he got there using arguments drawn from Hansen.

In contrast, the main determinant of saving was income, there being observable patterns in consumption. He illustrated these in a diagram that showed how spending on food, shelter, clothing, recreation, education, and saving would rise with income. Total consumption was thus explained as the sum of a number of components, each of which was related to income, which he supported by citing the statistical work done by the National Resources Committee on consumer expenditures that had been the basis for his work at the NRPB.³⁸ The diagram was then simplified by omitting all curves other than total spending, and its importance was stressed by also providing a graph which showed saving and investment against income and placing it on the cover of the book.^m

In this last diagram, saving was determined by the multiplicity of fac­tors listed earlier, and income was adjusted so that saving equaled invest­ment.

This chapter on saving and investment was arguably the most innova­tive in the book.ⁿ Freeman and his co-authors also had a chapter with the title “Saving and Investment,” but its content bore no relation to that of Samuelson’s. Freeman's text had been rich in definitions, but though it made a clear distinction between saving and investment, and although it offered a long discussion of what caused saving and explained alterna­tive ways in which savings could be invested, there was no analysis of how they were related. Saving and investment were as much classificatory devices as analytical concepts. What the student encountered was a series of principles. Some were beliefs about businessmen’s attitudes, such as “Safety of the principal is of primary importance: investors look chiefly at the certainty of the future income.”³⁹ Others appeared to be empirical generalizations, such as “The amount of intentional saving is controlled by the size of the national income and its distribution,”⁴⁰ or simply classifi- catory schemes (that saving might result in the creation of unproductive goods, durable consumers goods, business assets, or idle funds).⁴¹ Others were theoretical propositions, though not presented as such, as with the proposition that “Credit expansion by commercial banks may compel real saving.”⁴² Unlike Samuelson, his predecessors had not made clear distinc­tions between economic theory and propositions about how real-world markets operated.

In contrast, using the diagram with which the book was to become asso­ciated, Samuelson showed why the market would not necessarily generate the right level of investment to ensure full employment, the argument to which his conservative critics took exception. Other conservative doctrines that Samuelson sought to undermine were the view that inflation was neces­sarily harmful, and the “mystical belief” that the money was valuable because it was backed by gold. He explained how inflation redistributed wealth from creditors to debtors, and hence between economic classes. Mild inflation kept “the wheels of industry... well lubricated,” making it possible for every­one to benefit: creditors were compensated by receiving higher interest rates than if prices were constant. However, rapid rises in inflation would dislocate production, though he explained that there were few cases of hyperinflation except during wartime or in the aftermath of war.

As for money, though dollar bills might say “silver certificates” or “redeem­able in lawful money,” this meant nothing other than that you could change a $10 bill for a “crisp new bill” or for a mixture of $5 and $1 bills.° Money had a high value because it was kept scarce. If a government issued more than was demanded, then its value would fall—there would be hyperinflation— but as long as it did not, it would retain its value. Samuelson argued that, like individual prices, the overall price level was determined by supply and demand—by the level of national income in relation to full employment. Money was relevant because it was one of the factors affecting spending and saving. Writing in 1945, Samuelson was well aware of the importance of household assets for consumption, for during the war American families and businesses had accumulated cash and liquid assets to the tune of $200 bil­lion, which might lead to higher spending after the war. Even though it involved a detour into the past, the text would hardly have been complete without an account of the quantity theory of money—the theory that the price level was proportional to the money supply, which was the doctrine that Milton Friedman was to resuscitate in the 1950s. The problem with this theory, Samuelson claimed, was that prices were not proportional to total spending, and total spending was not proportional to the money supply. The famous “equation of exchange” (money supply times the velocity of circula­tion equals the price level times the quantity of output) was a truism—it was true simply because the velocity of circulation was defined as the ratio of money income (PQ) to the money supply.