The Abandonment of the Wages-Fund Doctrine Made Possible the Acceptance of Keynesianism and the Policy of Inflation, Deficits, and Ever Expanding Government Spending

The tragedy of the relationship between classical economics and the exploitation theory has not only been that errors and confusions in classical economics have supported the exploitation theory and thereby the assault on capitalism and advancement of the cause of socialism. That would have been bad enough. The further tragedy and irony has been that because this support was perceived as necessary and inescapable—as based on the essential nature of classical economics—the opponents of the exploitation theory—that is, the defenders of capitalism from the late nineteenth century on, who had the most to gain from the knowledge provided by classical economics—felt obliged to discard virtually the whole of it insofar as it could not immediately be validated on the basis of the neoclassical principle of diminishing marginal utility, or otherwise independently of classical economics’ basic framework.

Thus, along with “the labor theory of value” and the “iron law of wages,” they discarded such further features of classical economics as the wages-fund doctrine and its corollary that savings and capital are the source of almost all spending in the economic system. (The wages-fund doctrine held that at any given time there is a determinate total expenditure of funds for the payment of wages in the economic system, and that the wages of the employees of business firms are paid by businessmen and capitalists, out of capital, which is the result of saving; not by consumers in the purchase of consumers’ goods.) Two generations later, the abandonment of the wages-fund doctrine and with it, classical economics’ perspective on saving and capital, made possible the acceptance of Keynesianism and the policy of inflation, deficits, and ever expanding government spending. In similarly paradoxical fashion, and with just about the same time lag, the abandonment of the classical doctrine that cost of production, rather than supply and demand, is the direct (though not the ultimate) determinant of the prices of most manufactured or processed goods led to the promulgation of the doctrines of “pure and perfect competition,” “oligopoly,” “monopolistic competition,” and “administered prices,” with their implicit call for a policy of radical antitrust or outright nationalizations to “curb the abuses of big business.” Thus, along these two further paths, the errors of classical economics in support of the exploitation theory have served in the assault on capitalism and to advance the cause of socialism. But this time, it was with the implicit support of those who had abandoned classical economics because of its service in the advancement of socialism, and who now, precisely because of that abandonment, were themselves making possible the advancement of socialism, however much they may have believed themselves to be incapable of acting in such a destructive way.

Indeed, so strong has been the conviction on the part of the defenders of capitalism that classical economics is permeated with support for Marxism, that even to suggest such a classical doctrine as that cost of production can be a direct determinant of price, is to invite one’s own censure for allegedly being sympathetic to Marxism—as well as for allegedly being ignorant of all that economics has taught on the subject of prices since 1870. Not surprisingly, in the great majority of cases, this hostility to classical economics on the part of the defenders of capitalism has kept them from any serious study of it.

--George Reisman, Capitalism: A Treatise on Economics (Laguna Hills, CA: TJS Books, 1998), 474-475.