Sunday, 7 October 2007

Douglas's A+B Theorem

By: Socred - B.A., SCMP

Douglas’s A+B theorem is probably the most simple, yet most controversial, of all of Douglas's ideas. Oftentimes, too much emphasis has been placed on this theory amongst Social Crediters themselves, but the theory itself is essential for understanding Douglas’ monetary policies. The theorem is a truism; however, the controversy lies in the nature of the “B payments” which Douglas identified. The theorem is stated by Douglas as follows:

“In any manufacturing undertaking the payments made may be divided into two groups: Group A: Payments made to individuals as wages, salaries, and dividends; Group B: Payments made to other organizations for raw materials, bank charges and other external costs. The rate of distribution of purchasing power to individuals is represented by A, but since all payments go into prices, the rate of generation of prices cannot be less than A plus B. Since A will not purchase A plus B, a proportion of the product at least equivalent to B must be distributed by a form of purchasing power which is not comprised in the description grouped under A.” (C.H. Douglas, “The Monopoly of Credit”)

Douglas was an engineer, and a cost accountant.. As a scientist, he started with an observation, and formed a hypothesis. This is different than many orthodox economists who form a hypothesis, and then try to make the facts fit their theory. Douglas’ A+B theory is a simple statement of fact, and the accounts of any business will verify this fact. The confusion amongst orthodox economists lies in the nature of the B payments, and what causes them.

The critics of the theory generally fall into two categories by arguing: 1) B payments are really income, so there is no differentiation between A and B payments or 2) B payments are either past, or future, income. Let’s address both these criticisms individually.

The first criticism, which states that B payments are income, implicitly assumes the quantity theory of money. According to this theory, all money received by firms is income and can be used to purchase other goods and services. The theorem states that the quantity of transactions, multiplied by the quantity of money, equals total purchasing power. On the surface, this theory seems to make sense, but upon further investigation, it is not a reflection of reality. In reality, firms have costs that must be repaid. These costs can ultimately be traced back to bank debt because all money originates as debt. If a company receives $10 for its product, and assuming accumulated costs of $8.50 to acquire and sell this product, then only $1.50 is actually profit to the company, and potential income. The $8.50 must be used to cancel debts, or replace working capital. All of the $10 received by the company is not income. The fallacy was pointed out in "The Alberta Post-War Reconstruction Committee Report".

“The fallacy in the theory lies in the incorrect assumption that money "circulates", whereas it is issued against production, and withdrawn as purchasing power as the goods are bought for consumption. “ ( “The Alberta Post-War Reconstruction Committee Report of the Subcommittee on Finance")

The truth is that money does not “circulate” but instead operates in an accounting cycle, and B payments are monies on their way back to the bank, thus completing the cycle. Therefore, B payments do not exist as income to anyone. Income, by contrast, is flowing from the bank, and reaches individuals through the media of wages, salaries, and dividends. The argument that B payments are income is a complete fallacy based on the erroneous assumption that the circulation of money increases its purchasing power.

The second criticism, which has more credibility, will be seen to be a complete fallacy when the concept of time is introduced. Although not all B payments represent previous, or future, income (something we will touch on later), it is true that a proportion of the B payments are represented by past and future incomes. However; income and prices must be regarded as flows, and as Douglas stated:

“The mill will never grind with water that has passed, and unless it can be shown, as it certainly cannot be shown, that all these sums distributed in respect of the production of intermediate products are actually saved up, not in the form of securities, but in the form of actual purchasing power, we are obliged to assume what I believe to be true, that the rate of flow of purchasing power derived from the normal and theoretical operation of the existing price system is always less than that of the generation of prices within the same period of time.” (C.H. Douglas, “The Monopoly of Credit”)

It is obvious that future incomes cannot be used as present incomes (excluding momentarily credit from an extraneous source, which is a mortgage on future incomes). These future incomes are profits (interest on loans representing bank profit), which become future incomes via dividends paid to individuals. The fact that profits partially cause the gap between income and prices forms the supposed justification for the socialist argument against profits. However, nobody will do something unless it in some sense of the word profits him. Also, profits only represent a portion of the gap between income and prices. Douglas did not seek to eliminate profits, instead he wanted to compensate for the gap between income and prices which profits helped create.

"The essential point to notice, however, is not the profit, but that he cannot and will not produce unless his expenses on the average are not more than covered. These expenses may be of various descriptions, but they can all be resolved ultimately into labour charges of some sort (a fact which incidentally is responsible for the fallacy that labour, by which is meant the labour of the present population of the world, produces all wealth). Consider what this means. All past labour, represented by money charges, goes into cost and so into price. But a great part of the product of his labour -that part which represents consumption and depreciation - has become useless, and disappeared." (C.H. Douglas, "The Control and Distribution of Production")

Past income used for consumption represents a substantial portion of the gap between income and prices. The belief that incomes disbursed in the past for capital production are all saved up in order to defray the costs associated with those incomes as they make their way into the cost of future consumer goods is a complete fallacy. People tend to spend their income on consumer goods in a relatively expeditious fashion. This money is collected from the consumers by businesses through the agency of prices. The upper limit of prices being governed by the laws of supply and demand, or what the item will fetch. This income, recollected by businesses, forms a part of their profit, assuming they can sell their product above cost. These profits can be distributed as income in the form of dividends, but is most often re-invested back into the company, and therefore, do not exist as income to anyone.

“Consider the nature of these B payments. They are repayments collected from the public of purchasing power in respect of production not yet delivered to the public. If the wage earners in process ‘I’ use their current month’s, i.e. May’s, wages to buy their share of one current month’s production of consumable goods, they are using money distributed in respect of production which will not appear as consumable goods till October. They are in fact involuntarily reinvesting their money in industry, with the results previously explained” (C.H. Douglas, “The Monopoly of Credit”)

Therefore, it can be seen that the criticisms of the A+B theorem are based on the fallacy known as the quantity theory of money, or they fail to take into account the effect of time on income and prices (i.e. they are static). Incomes and prices are flows, and any analysis into their nature must account for the dimension of time. Since prices include all payments made to individuals as income (A), as well as all overhead charges (B), we must understand what causes these overhead charges in order to understand why prices rise faster than incomes when regarded as a flow.

"It is now necessary to see to what extent this conception of overhead charges can be extended, and I think that a little consideration will make it clear that in this sense an overhead charge is any charge in respect of which the actual distributed purchasing power does not still exist, and that practically this means any charge created at a further distance in the past than the period of cyclic rate of circulation of money. There is no fundamental difference between tools and intermediate products, and the latter may therefore be included." (C.H. Douglas, "The New and The Old Economics")

The cyclic rate of purchasing power of money can be calculated by calculating the average amount of deposits held by depositors in banks relative to the amount of clearings through the banks, minus the amount of "Butcher-Baker" transactions. Douglas referred to any transaction that broke a chain of repayments as a "Butcher-Baker" transaction. When a butcher receives money for his product from his customer, he must repay debts owed to the slaughterhouse for the meat, who in turn must pay debts owed to the farmer, who pays debts to the banker (all money originating from the bank as a debt). If the butcher buys bread from the baker with the money he has received from his customer, then he has broken the chain of debt to the slaughterhouse, farmer, and ultimately the banker; and therefore, these transactions leave a trail of debt, and must be deducted when calculating the cyclic rate of purchasing power, because the monetary cycle has not been completed. Douglas calculated the average cyclic rate of purchasing power to be approximately two and a half weeks in Britain ("The Old and the New Economics”). Therefore; any cost anterior to three weeks, must form a part of the gap between income and prices. Douglas spoke of this fact when questioned before the Alberta Agricultural Commission.

"Well, that question of course is outside what I was speaking of this morning, but I have no objection whatever to answering it shortly. The best way of understanding what the speaker has referred to as the "A plus B" theory is to look at the matter in this way: The purchasing power of the general community is practically 98 per cent, I think, taken over all products, bank money. The actual deposits in banks under what are sometimes called "normal times" (I don't know what normal times are, but they are frequently referred to so we will assume that there are normal times) the deposits remained fairly constant. For instance, in Great Britain since the war they have reached around between 16 and 18 hundred millions of pounds. Now there is quite obviously a circulation of those deposits through the agency of costs. They are distributed for wages and so forth and they come back to the same source through the agency of price. That is the way the existing financial system works.

Now all business in the world at the present time is carried on on the theory of the balanced budget, including governmental business. Therefore, you must have a right, or period of cycle through which this money which starts from the banks goes out through cost and comes back again to the banks through the agency of price; there must be a time that that cycle takes. Now we have as a matter of fact means of calculating that time, and in Great Britain the average is somewhere in the neighbourhood of around about three weeks. Now, so long as a charge is incurred and liquidated inside that period of three weeks it can be liquidated by that cycle of the flow of purchasing power, starting from the banks, going out through costs and coming back again through prices. So long as the whole transaction of costs and prices is involved in a period of about three weeks, there is no difficulty involved in the prices and the costs being equal, but any item of cost which is outside that period of three weeks we will say cannot be liquidated by that stream of credit which is constantly in circulation at a period rate, we will say of three weeks.

Now we know there are an increasing number of charges which originated from a period much anterior to three weeks, and included in those charges, as a matter of fact, are most of the charges made in, respect of purchases from one organization to another, but all such charges as capital charges (for instance, on a railway which was constructed a year, two years, three years, five or ten years ago, where charges are still extant), cannot be liquidated by a stream of purchasing power which does not increase in volume and which has a period of three weeks. The consequence is, you have a piling up of debt, you have in many cases a diminution of purchasing power being equivalent to the price of the goods for sale. It is frequently said, "Your theory must be absurd because we know that there are periods in which purchasing power is in excess of the price of the goods for sale, for instance at the end of a war." What people who say that forget is that we were piling up debt at that time at the rate of ten millions sterling a day and if it can be shown, and it can be shown, that we are increasing debt continuously by normal operation of the banking system and the financial system at the present time, then that is proof that we are not distributing purchasing power sufficient to buy the goods for sale at that time; otherwise we should not be increasing debt, and that is the situation." (C.H. Douglas, "Douglas System of Social Credit", evidence taken by the Agricultural Committee of the Alberta Legislature 1934)

If money disbursed for production makes its way to the bank before its cost can be extinguished in the price of the consumer goods it creates, then there is a corresponding gap between income and prices. If income is reinvested back into the productive system, then each time it is re-invested, it creates a new cost without creating new purchasing power (we have already seen that money does not circulate, but cycles, so money is only capable of cancelling one cost). The income I receive in terms of wages or salaries has been debited to the cost of some good or service. If I invest my income, then I expect to receive my investment back, with a rate of return. The only way the company I invested in can give me my money back with a rate of return is by charging the consumer through prices. Therefore; my income has created two costs: 1) the cost associated with the good or service that I helped provide, and 2) the cost associated with the investment that must be returned to me. However, my income can only cancel one of those costs. There is now a new cost created, without the creation of new purchasing power.

"But we also find that apart from this question of the distribution of purchasing power there is not enough purchasing power distributed to buy the goods which are for sale if the production of these goods has been financed by ordinary methods. There are many contributory causes to this situation, but it is probable that the main cause is due to the reappearance in prices of the same sum of money several times, a state of affairs which is rendered possible by the splitting up of production into a large number of processes." (C.H. Douglas, "Money and the Price System")

The reappearance in prices of the same sum of money several times creates a gap between purchasing power and prices. The re-investment of savings causes the reappearance in prices of the same sum of money, and the more production is split up into a large number of processes, the greater the probability that income disbursed in capital production will be reinvested. Douglas listed five causes of the gap between prices and purchasing power in "The New and The Old Economics":

"Categorically, there are at least the following five causes of a deficiency of purchasing power as compared with collective prices of goods for sale: -
1. Money profits collected from the public (interest is profit on an intangible)
2. Savings, i.e., mere abstentation from buying
3. Investment of savings in new works, which create a new cost without fresh purchasing power
4. Difference in circuit velocity between cost liquidation and price creation which results in charges being carried over into prices from a previous cost accountancy cycle. Practically all plant charges are of this nature, and all payments for material brought in frm a previous wage cycle are of the same nature.
5. Deflation, i.e. sale of securities by banks and recall of loans" (C.H. Douglas, "The New and The Old Economics")

We have already discussed at length reasons 1, 3, and 4. Reasons 2 and 5 are pretty much self-explanatory, both being a reduction in A, and not the creation of B costs. Add to all this the fact that overhead charges are growing in relation to income (i.e. B is increasing relative to A), due to the fact that capital is replacing the need for labour in the productive process, and it is apparent that the gap between income and prices is ever increasing, and this problem is ever worsening.

"At the moment the point to be borne in mind is that B is the financial representation of the lever of capital, and is constantly increasing in comparison with A. So that, in order to keep A and the goods purchase with A at a constant value, A+B must expand with every improvement of process..." (C.H. Douglas, "Credit-Power and Democracy")

What does this mean? If A+B must expand with every improvement of process in order to keep A, and the goods purchased with A ,at a constant value, and if A+B represent prices, then prices must expand with every improvement in process. This is why certain periods of time, when people have enough income to purchase most goods coming onto the market, are met with rising prices (i.e. inflation). Inflation is generally not caused by too much income chasing too few goods, but is caused by the ever increasing expansion of overhead costs via advancing technological processes. This means that inflation is inherent in our economic system, unless credit from an extraneous source is used to decrease, or stabilize, prices.

"Now any attempt, by current financial methods, to reduce prices (or even to stabilize them, as the phrase goes) is a mathematical absurdity unless the cost of this stabilization, or lowering of prices, is met from some extraneous source. Or to put the matter another way, the margin of profit which makes it possible for a producer to go on producing, disappears unless the financial cost, and consequently the price of production, is allowed to rise steadily in relation to direct labour cost." (C.H. Douglas, "Social Credit")