406. Harrod to H. D. Henderson , 20 November 1934 [a]

20 November 1934

Dear Henderson

I have just read your masterly state paper on increasing productivity. [1] I ought to have done so long ago. But I placed it [b] on a pile of documents not requiring immediate attention and it has lain there all too long.

I entirely agree with its general tenor. And I am confident that the emphasis which you attach to the agricultural revolution and to the increasing tendency to speculative investment is right. [2]

You will expect from our previous conversations that the part I find least convincing is that relating to the possibility of over saving. You content yourself with the view that the rate of interest would fall towards zero. [3] But I am not so happy.

I would point out that your arguments, with which I agree, to the effect that modern inventions are not so labour-saving [4] (and \ not so consumptive of saving {excuse use of word in 2 senses!}) as they seem strengthen my position.

The question of risk-bearing deserves special attention. The processes of "waiting" and risk bearing are inextricably interwoven. In the modern world owing to the growing instability of the aggregate turnover and to growing instability also of particular industries owing to the less stable demand of rich people, the risk factor is tending to grow. This is true of a wide range of industries. Now in any industry the risk factor is especially associated with processes taking time. However unstable demand industries with no plant need not undertake risk: they employ purely fluid resources which can be turned to something else if the demand falls off. If the risk factor increases this is a force making against roundabout processes and it may be stronger than the stimulus to roundabout processes which would be caused by a fall of interest to 1%. In fact the fall of interest does not serve its purposes of getting savings consumed in investment if there is a rising risk factor attached to investment. 1

Ah, you may say, but if my contention of over-saving were true we should at least expect the interest of gilt-edged [c] securities to fall to the equilibrium level, 1% or whatever it may be. This is true in a general way. But there may be special circumstances which completely frustrate the working of this natural law. The real world consists in an alternation of booms and slumps. In the boom there are de facto high profits. I suggest that in that phase the prices of gilt-edged are kept up by competition. If on average high returns are in fact earned on risky investment, people will not be content 2 with a very low return on safe investment. In the slump on the other hand there is the phenomenon which Maynard has emphasized that savings are partly used to cover business losses. In pure theory producers do not work for a loss. The factual importance of losses in a slump is extra-ordinarily strongly born out [d] by some figures quoted for the U.S. in the Nov. issue of the First National Bank's review. [5] You may say that my argument is illogical because if these risks are real, as they are, in the boom people ought to prefer 1% on gilt edged to speculative investments at whatever yield. But there the factor of optimism may be at work. And in these days are even gilt-edged really free from risk?

I believe there is a case for the view anyhow worth examining that variations in capital construction depend almost entirely on variations in the sense of risk; and that variations in the gilt-edged rate have little influence in industry proper. 3 No doubt there are exceptions such as housing, [6] but they may not be enough to absorb current savings. Put one way my contention is that we have to have severe slumps now-a-days, because if and when the community works up to capacity it naturally saves so much that there is no vent for these savings.

What I should like to do would be to take the great capital consumers and find out how far their demand is dependent on gilt-edged rates. I dont know whether you think that to be a possible type of investigation that our projected institute might carry out! 4 [7]

I am still not clear as to your answer to my dilemma regarding the U.S. in 1927-9. [8] I take it that this fact is fairly clear, that there was a tendency to over production of capital goods. 5 Further I assume that we desiderate 6 that total production should have been no less than it was. In that case we must wish that there had been greater consumption. 7 But, per contra, you say that people were spending too much, spending out of capital gains in excess of their income. How the dickens are these points of view to be reconciled? 8

My view is this. They were really not spending enough. But if it had not been, I grant, for capital gains, they would have spent still less. I grant that the "sense of riches" caused by capital gains caused them to spend more than they would otherwise have done and sowed the seeds of recession when the stock market crash came. But by depriving them of the afore-mentioned "sense of riches" in 27-9 you would not have solved the problem: for then they would have spent still less, which would mean either incomplete utilization of productive resources, i.e. lower aggregate production, which is no solution, or a still greater excess of production of capital goods.

Do you say that without the "sense of riches" or such apparently profitable opportunities for investment, they would have spent more? 9 This seems very doubtful.

It is clear that we want to prevent any such thing as the stock market boom because that inevitably sows the seeds of reaction. But I dont think it is enough to do that.

I am inclined, very tentatively, to put forward this solution. One of the natural ambitions of man as he grows richer is to set aside something to give him an "unearned" livelihood however small. People like Runciman repeatedly say that they wish the whole working classes to do this ultimately and have a paradise of small capitalists. [9] This is a goal which I think is eminently attractive. But there is a great obstacle. So long as only the rich could afford to do this, it was possible to give them a source of unearned income by constructing capital equipment equal in value to their saving which would yield the prospective income. But I dont think that process can, as hoped, be continued indefinitely. There is a technical limit to the profitability of this capital equipment. Then to satisfy the urge to save, I should issue to would be savers certificates of indebtedness constituting drafts on the future income of the society as a whole. 10 As that rises with increasing productivity, not all the increment goes to producers but part--through taxation--to the holders of the certificates. This is analogous to what happened in the past, but with this difference. In the past holders of the certificates were in fact the owners of productive capital equipment. In the future this will not be possible.

The alternative is to reduce the rate of interest towards zero and say in effect--"you cannot save. This human boundary to acquire an unearned income by accumulation could be given effect in the past, because of the demand for capital equipment, but is now out of date. Have no fear, because you will always be able owing to high current productivity to earn a decent livelihood." [10]

Perhaps the second alternative is nearer what the socialists would like. What I am suggesting is that the only other possibility is to have permanent under-employment which by reducing income reduces savings sufficiently to keep the equilibrium rate of interest positive. Is this nonsense? 11


R. F. H.

  1. 1. "Increasing Productivity and the Demand for Labour", memorandum written when Henderson was the Secretary of the Economic Advisory Council, 12 December 1933; published in The Inter-War Years and other Papers. A Selection from the Writings of Hubert Douglas Henderson, edited by H. Clay, Oxford: Clarendon Press, 1955, pp. 126-50.

    2. Henderson, "Increasing Productivity ...", §§ 21-27 (pp. 137-41) and § 41 (pp. 147-48), respectively.

    3. Henderson, "Increasing Productivity ...", § 9 (p. 130), expounded and defended the orthodox argument that

    • Just as, in the case of a particular commodity, any serious disequilibrium between demand and supply brings into play the corrective influence of changes in price, a lower price tending to diminish supply and to stimulate demand, so changes in the rate of interest correct maladjustments in the relation between savings and investment. If at any time the volume of savings exceeds the investment outlets for them, the rate of interest falls, and the effect of a lower rate of interest is, on the one hand, to discourage saving and, on the other hand, to stimulate capital enterprise. There cannot, therefore, be a chronic tendency towards excessive saving; for, if there were, the rate of interest would fall steadily towards zero.

    4. Henderson, "Increasing Productivity ...", § 19 (p. 137) argued that

    • in so far as technological progress is relevant to the present crisis, the trouble is more likely to lie in a dearth than in an excess of important labour-saving discoveries. After all, [...] a labour-saving machine must be made before it can be used, and the making of it will represent, as a rule, an aggregate of man-hours of work many times larger than the annual economy in labour which it will effect when used.

    5. The reference is probably incorrect, and the source could not be identified.

    6. Henderson, "Increasing Productivity ...", § 9 (p. 130): "There are, in addition, consumers' capital goods, of which houses are the outstanding instance, the demand of which would be very greatly increased if money could be borrowed on very easy terms".

    7. In November 1934, Harrod submitted to the Hebdomadal Council (of which he was a member) a "Memo. On Economic Studies in Oxford", where he maintained that "the establishment of an Economic Institute is indispensable for further progress" (the memorandum is reproduced here as essay 15 ; for this passage in particular see [jump to page] ). This institute was meant to encompass the Institute of Statistics (on which see note 7 to essay 15 ) and to be part of a broader Institute for Social Studies. It was meant to provide assistance to economists excogitating new theorems in the field of pure economic theory, but among its scopes Harrod also listed the collection of micro- and macro-scopic statistics, which would give quantitative content to theoretical concepts.

    The specific topic of the influence of the rate of interest on the decisions to extend capital equipment and stocks became indeed one of the main subject of inquiry of the Oxford Economists' Research Group (which was in indirect offspring of the process of re-organization of Social Studies in Oxford: see note 1 to letter 430 ). In a later letter, Henderson illustrated the proposed modus operandi of the future OERG with reference to the influence of the bank rate upon trade activity (see letter 433 on [jump to page] . This aspect of the OERG inquiry is also mentioned in letter 700 , [jump to page] ). Henderson himself discussed the results of the inquiry in "The Significance of the Rate of Interest", Oxford Economic Papers I, October 1938, pp. 1-13.

    8. There is no written trace of a discussion between Harrod and Henderson regarding the period preceding the American recession; this may thus have constituted one of the subject of the "previous conversation" Harrod mentioned a few paragraphs earlier.

    9. The ideal of a nation of small capitalists was a common theme of centrist-liberals: see M. Freeden, Liberalism Divided. A Study in British Political Thought 1914-1939, Oxford: Clarendon Press, 1986, p. 253.

    10. This point seems to have been raised in a proposed--but aborted--Addendum to the Royal Institute of International Affairs's Report on The Future of Monetary Policy (1935) (see letters 370 , [jump to page] and 385 , [jump to page] ). Henderson was also a member of the Chatham House group on International Monetary Problems, where he and Harrod certainly had occasion to discuss these matters.

    1. a. ALI, four leaves four pages, in HHP 22A/6.

      b. Ms: «in».

      c. Ms: «gilt edged».

      d. Ms: «out out».

      e. Ms: «value.».

1. I agree: subject to possibility of additional use of consumers' capital goods [Henderson's pencilled note in the margin].

2. Does this mean that they will blow their savings, or force up prices of ordinary shares [Henderson's note in the margin].

3. Except that the "sense of riches" applying to the business <would> as well as to individuals [Henderson's comment in the margin].

4. I should like to see this inquiry very much; but the question should be framed, so as to include reference to "encouraging influence of appreciation of capital value". [e] [Henderson's comment in the margin].

5. Yes [Henderson's note in the margin].

6. No. I don't quite <+> this, but nearly so [Henderson's note in the margin].

7. Yes [Henderson's comment in the margin].

8. I answer: stable conditions w[oul]d. be <entailed> 1) producing less capital goods, 2) producing more consumers' goods, 3) producing very slightly less of the two together.

The "sense of riches" led to the slight excess under 3), without that "sense", and other things being equal, I agree there wd. have been depression in 1927-'9, because of my "underlying deflationary factors" [Henderson's note in the margin].

9. No. [Henderson's comment in the margin].

10. Sure present savings certificates would do this? But what wd. you do with the purchasing-power released. [Henderson's comment in the margin].

11. Well, that wd. involve the national debt to be wiped out fairly soon, & wd. put a different complexion on state expenditure policies. [Henderson's comment in the margin].

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