Some Alternative Explanations
of Depression: A Critique
3
Some Alternative Explanations
of Depression: A Critique
Some economists are prepared to admit that the Austrian theory
could "sometimes" account for cyclical booms and depressions, but
add that other instances might be explained by different theories.
Yet, as we have stated above, we believe this to be an error: we
hold that the Austrian analysis is the only one that accounts for
business cycles and their familiar phenomena. Specific crises can,
indeed, be precipitated by other government action or intervention
in the market. Thus, England suffered a crisis in its cotton
textile industry when the American Civil War cut off its supply of
raw cotton. A sharp increase in taxation may depress industry and
the urge to invest and thereby precipitate a crisis. Or people may
suddenly distrust banks and trigger a deflationary run on the
banking system. Generally, however, bank runs only occur after a
depression has already weakened confidence, and this was certainly
true in 1929. These instances, of course, are not cyclical events
but simple crises without preceding booms. They are always
identifiable and create no mysteries about the underlying causes of
the crises. When W.R. Scott investigated the business annals of the
early modern centuries, he found such contemporary explanations of
business crises as the following: famine, plague, seizure of
bullion by Charles I, losses in war, bank runs, etc. It is the fact
that no such obvious disaster can explain modern depressions that
accounts for the search for a deeper causal theory of 1929 and all
other depressions. Among such theories, only Mises's can pass
muster.[1]
General Overproduction
"Overproduction" is one of the favorite explanations of
depressions. It is based on the common-sense observation that the
crisis is marked by unsold stocks of goods, excess capacity of
plant, and unemployment of labor. Doesn't this mean that the
"capitalist system" produces "too much" in the boom, until finally
the giant productive plant outruns itself? Isn't the depression the
period of rest, which permits the swollen industrial apparatus to
wait until reduced business activity clears away the excess
production and works off its excess inventory?
This explanation, popular or no, is arrant nonsense. Short of
the Garden of Eden, there is no such thing as general
"overproduction." As long as any "economic" desires remain
unsatisfied, so long will production be needed and demanded.
Certainly, this impossible point of universal satiation had not
been reached in 1929. But, these theorists may object, "we do not
claim that all desires have ceased. They still exist, but the
people lack the money to exercise their demands." But some money
still exists, even in the steepest deflation. Why can't this money
be used to buy these "overproduced" goods? There is no reason why
prices cannot fall low enough, in a free market, to clear the
market and sell all the goods available.[2] If
businessmen choose to keep prices up, they are simply speculating
on an imminent rise in market prices; they are, in short,
voluntarily investing in inventory. If they wish to sell their
"surplus" stock, they need only cut their prices low enough to sell
all of their product.[3] But won't they then
suffer losses? Of course, but now the discussion has shifted to a
different plane. We find no overproduction, we find now that the
selling prices of products are below their cost of production. But
since costs are determined by expected future selling prices, this
means that costs were previously bid too high by entrepreneurs. The
problem, then, is not one of "aggregate demand" or
"overproduction," but one of cost-price differentials. Why did
entrepreneurs make the mistake of bidding costs higher than the
selling prices turned out to warrant? The Austrian theory explains
this cluster of error and the excessive bidding up of costs; the
"overproduction" theory does not. In fact, there was overproduction
of specific, not general, goods. The malinvestment caused by credit
expansion diverted production into lines that turned out to be
unprofitable (i.e., where selling prices were lower than costs) and
away from lines where it would have been profitable. So there was
overproduction of specific goods relative to consumer desires, and
underproduction of other specific goods.
Underconsumption
The "underconsumption" theory is extremely popular, but it
occupied the "underworld" of economics until rescued, in a sense,
by Lord Keynes. It alleges that something happens during the
boom—in some versions too much investment and too much production,
in others too high a proportion of income going to upper-income
groups—which causes consumer demand to be insufficient to buy up
the goods produced. Hence, the crisis and depression. There are
many fallacies involved in this theory. In the first place, as long
as people exist, some level of consumption will persist. Even if
people suddenly consume less and hoard instead, they must consume
certain minimum amounts. Since hoarding cannot proceed so far as to
eliminate consumption altogether, some level of consumption will be
maintained, and therefore some monetary flow of consumer demand
will persist. There is no reason why, in a free market, the prices
of all the various factors of production, as well as the final
prices of consumer goods, cannot adapt themselves to this desired
level. Any losses, then, will be only temporary in shifting to the
new consumption level. If they are anticipated, there need be no
losses at all.
Second, it is the entrepreneurs' business to anticipate consumer
demand, and there is no reason why they cannot predict the consumer
demand just as they make other predictions, and adjust the
production structure to that prediction. The underconsumption
theory cannot explain the cluster of errors in the crisis. Those
who espouse this theory often maintain that production in the boom
outruns consumer demand; but (1) since we are not in Nirvana, there
will always be demand for further production, and (2) the
unanswered question remains: why were costs bid so high that the
product has become unprofitable at current selling prices? The
productive machine expands because people want it so, because they
desire higher standards of living in the future. It is therefore
absurd to maintain that production could outrun consumer demand in
general.
One common variant of the underconsumption theory traces the
fatal flaw to an alleged shift of relative income to profits and to
the higher-income brackets during a boom. Since the rich presumably
consume less than the poor, the mass does not then have enough
"purchasing-power" to buy back the expanded product. We have
already seen that: (1) marginally, empirical research suggests a
doubt about whether the rich consume less, and (2) there is not
necessarily a shift from the poor to the rich during a boom. But
even granting these assumptions, it must be remembered that: (a)
entrepreneurs and the rich also consume, and (b) that savings
constitute the demand for producers' goods. Savings, which go into
investment, are therefore just as necessary to sustain the
structure of production as consumption. Here we tend to be misled
because national income accounting deals solely in net terms. Even
"gross national product" is not really gross by any means; only
gross durable investment is included, while gross inventory
purchases are excluded. It is not true, as the underconsumptionists
tend to assume, that capital is invested and then pours forth onto
the market in the form of production, its work over and done. On
the contrary, to sustain a higher standard of living, the
production structure—the capital structure—must be permanently
"lengthened." As more and more capital is added and maintained in
civilized economies, more and more funds must be used just to
maintain and replace the larger structure. This means higher gross
savings, savings that must be sustained and invested in each higher
stage of production. Thus, the retailers must continue buying from
the wholesalers, the wholesalers from the jobbers, etc. Increased
savings, then, are not wasted, they are, on the contrary, vital to
the maintenance of civilized living standards.
Underconsumptionists assert that expanding production exerts a
depressing secular effect on the economy because prices will tend
to fall. But falling prices are not depressant; on the contrary,
since falling prices due to increased investment and productivity
are reflected in lower unit costs, profitability is not at all
injured. Falling prices simply distribute the fruits of higher
productivity to all the people. The natural course of economic
development, then, barring inflation, is for prices to fall in
response to increased capital and higher productivity. Money wage
rates will also tend to fall, because of the increased work the
given money supply is called upon to perform over a greater number
of stages of production. But money wage rates will fall less than
consumer goods prices, and as a result economic development brings
about higher real wage rates and higher real incomes throughout the
economy. Contrary to the underconsumption theory, a stable price
level is not the norm, and inflating money and credit in order to
keep the "price level" from falling can only lead to the disasters
of the business cycle.[4]
If underconsumption were a valid explanation of any crisis,
there would be depression in the consumer goods industries, where
surpluses pile up, and at least relative prosperity in the
producers' goods industries. Yet, it is generally admitted that it
is the producers', not the consumers' goods industries that suffer
most during a depression. Underconsumptionism cannot explain this
phenomenon, while Mises's theory explains it precisely.[5], [6] Every crisis is marked by
malinvestment and undersaving, not underconsumption.
The Acceleration Principle
There is only one way that the underconsumptionists can try to
explain the problem of greater fluctuation in the producers' than
the consumer goods' industries: the acceleration principle. The
acceleration principle begins with the undeniable truth that all
production is carried on for eventual consumption. It goes on to
state that, not only does demand for producers' goods depend on
consumption demand, but that this consumers' demand exerts a
multiple leverage effect on investment, which it magnifies and
accelerates. The demonstration of the principle begins inevitably
with a hypothetical single firm or industry: assume, for example,
that a firm is producing 100 units of a good per year, and that 10
machines of a certain type are needed in its production. And assume
further that consumers demand and purchase these 100 units. Suppose
further that the average life of the machine is 10 years. Then, in
equilibrium, the firm buys one new machine each year to replace the
one worn out. Now suppose that there is a 20 percent increase in
consumer demand for the firm's product. Consumers now wish to
purchase 120 units. If we assume a fixed ratio of capital to
output, it is now necessary for the firm to have 12 machines. It
therefore buys two new machines this year, purchasing a total of
three machines instead of one. Thus, a 20 percent increase in
consumer demand has led to a 200 percent increase in demand for the
machine. Hence, say the accelerationists, a general increase in
consumer demand in the economy will cause a greatly magnified
increase in the demand for capital goods, a demand intensified in
proportion to the durability of the capital. Clearly, the
magnification effect is greater the more durable the capital good
and the lower the level of its annual replacement demand.
Now, suppose that consumer demand remains at 120 units in the
succeeding year. What happens now to the firm's demand for
machines? There is no longer any need for firms to purchase any new
machines beyond those necessary for replacement. Only one machine
is still needed for replacement this year; therefore, the firm's
total demand for machines will revert, from three the previous
year, to one this year. Thus, an unchanged consumer demand will
generate a 200 percent decline in the demand for capital goods.
Extending the principle again to the economy as a whole, a simple
increase in consumer demand has generated far more intense
fluctuations in the demand for fixed capital, first increasing it
far more than proportionately, and then precipitating a serious
decline. In this way, say the accelerationists, the increase of
consumer demand in a boom leads to intense demand for capital
goods. Then, as the increase in consumption tapers off, the lower
rate of increase itself triggers a depression in the capital goods
industries. In the depression, when consumer demand declines, the
economy is left with the inevitable "excess capacity" created in
the boom. The acceleration principle is rarely used to provide a
full theory of the cycle; but it is very often used as one of the
main elements in cycle theory, particularly accounting for the
severe fluctuations in the capital-goods industries.
The seemingly plausible acceleration principle is actually a
tissue of fallacies. We might first point out that the seemingly
obvious pattern of one replacement per year assumes that one new
machine has been added in each of the ten previous years; in short,
it makes the highly dubious assumption that the firm has been
expanding rapidly and continuously over the previous decade.[7] This is indeed a curious way of describing an
equilibrium situation; it is also highly dubious to explain a boom
and depression as only occurring after a decade of previous
expansion. Certainly, it is just as likely that the firm bought all
of its ten machines at once—an assumption far more consonant with a
current equilibrium situation for that firm. If that happened, then
replacement demand by the firm would occur only once every decade.
At first, this seems only to strengthen the acceleration principle.
After all, the replacement-denominator is now that much less, and
the intensified demand so much greater. But it is only strengthened
on the surface. For everyone knows that, in real life, in the
"normal" course of affairs, the economy in general does not
experience zero demand for capital, punctuated by decennial bursts
of investment. Overall, on the market, investment demand is more or
less constant during near-stationary states. But if, overall, the
market can iron out such rapid fluctuations, why can't it iron out
the milder ones postulated in the standard version of the
acceleration principle?
There is, moreover, an important fallacy at the very heart of
the accelerationists' own example, a fallacy that has been
uncovered by W.H. Hutt.[8] We have seen that
consumer demand increases by 20 percent—but why must the two extra
machines be purchased in a year? What does the year have to do with
it? If we analyze the matter closely, we find that the year is a
purely arbitrary and irrelevant unit even within the terms of the
example itself. We might just as well take a week as the time
period. Then we would aver that consumer demand (which, after all,
goes on continuously) increases 20 percent over the first week,
thus necessitating a 200 percent increase in demand for machines in
the first week (or even an infinite increase if replacement does
not occur in the first week) followed by a 200 percent (or
infinite) decline in the next week, and stability thereafter. A
week is never used by the accelerationists because the example
would then clearly not apply to real life, which does not see such
enormous fluctuations in the course of a couple of weeks, and the
theory could certainly not then be used to explain the general
business cycle. But a week is no more arbitrary than a year. In
fact, the only non-arbitrary time-period to choose would be the
life of the machine (e.g. ten years).[9] Over a
ten-year period, demand for machines had previously been ten and in
the current and succeeding decades will be ten plus the extra two,
e.g., 12: in short, over the ten-year period, the demand for
machines will increase in precisely the same proportion as the
demand for consumer goods—and there is no ramification effect
whatever. Since businesses buy and produce over planned periods
covering the lives of their equipment, there is no reason to assume
that the market will not plan production accordingly and smoothly,
without the erratic fluctuations manufactured by the
accelerationists' model. There is, in fact, no validity in saying
that increased consumption requires increased production of
machines immediately; on the contrary, it is increased saving and
investment in machines, at points of time chosen by entrepreneurs
strictly on the basis of expected profitability, that permits
future increased production of consumer goods.[10]
There are other erroneous assumptions made by the acceleration
principle. Its postulate of a fixed capital-output ratio, for
example, ignores the ever-present possibility of substitution, more
or less intensive working of different factors, etc. It also
assumes that capital is finely divisible, ignoring the fact that
investments are "lumpy," and made discontinuously, especially those
in a fixed plant.
There is yet a far graver flaw—and a fatal one—in the
acceleration principle, and it is reflected in the rigidity of the
mechanical model. No mention whatever is made of the price system
or of entrepreneurship. Considering the fact that all production on
the market is run by entrepreneurs operating under the price
system, this omission is amazing indeed. It is difficult to see how
any economic theory can be taken seriously that completely omits
the price system from its reckoning. A change in consumer demand
will change the prices of consumer goods, yet such reactions are
forgotten, and monetary and physical terms are hopelessly entwined
by the theory without mentioning price changes. The extent to which
any entrepreneur will invest in added production of a good depends
on its price relations—on the differentials between its selling
price and the prices of its factors of production. These price
differentials are interrelated at each stage of production. If, for
example, monetary consumer demand increases, it will reveal itself
to producers of consumer goods through an increase in the price of
the product. If the price differential between selling and buying
prices is raised, production of this good will be stimulated. If
factor prices rise faster than selling prices, production is
curtailed, however, and there is no effect on production if the
prices change pari passus. Ignoring prices in a discussion of
production, then, renders a theory wholly invalid.
Apart from neglecting the price system, the principle's view of
the entrepreneur is hopelessly mechanistic. The prime function of
the entrepreneur is to speculate, to estimate the uncertain future
by using his judgment. But the acceleration principle looks upon
the entrepreneur as blindly and automatically responding to present
data (i.e., data of the immediate past) rather than estimating
future data. Once this point is stressed, it will be clear that
entrepreneurs, in an unhampered economy, should be able to forecast
the supposed slackening of demand and arrange their investments
accordingly. If entrepreneurs can approximately forecast the
alleged "acceleration principle," then the supposed slackening of
investment demand, while leading to lower activity in those
industries, need not be depressive, because it need not and would
not engender losses among businessmen. Even if the remainder of the
principle were conceded, therefore, it could only explain
fluctuations, not depression—not the cluster of errors made by the
entrepreneurs. If the accelerationists claim that the errors are
precisely caused by entrepreneurial failure to forecast the change,
we must ask, why the failure? In Mises's theory, entrepreneurs are
prevented from forecasting correctly because of the tampering with
market "signals" by government intervention. But here there is no
government interference, the principle allegedly referring to the
unhampered market. Furthermore, the principle is far easier to
grasp than the Mises theory. There is nothing complex about it, and
if it were true, then it would be obvious to all entrepreneurs that
investment demand would fall off greatly in the following year.
Theirs, and other people's, affairs would be arranged accordingly,
and no general depression or heavy losses would ensue. Thus, the
hypothetical investment in seven-year locust equipment may be very
heavy for one or two years, and then fall off drastically in the
next years. Yet this need engender no depression, since these
changes would all be discounted and arranged in advance. This
cannot be done as efficiently in other instances, but certainly
entrepreneurs should be able to foresee the alleged effect. In
fact, everyone should foresee it; and the entrepreneurs have
achieved their present place precisely because of their predictive
ability. The acceleration principle cannot account for
entrepreneurial error.[11]
One of the most important fallacies of the acceleration
principle is its wholly illegitimate leap from the single firm or
industry to the overall economy. Its error is akin to those
committed by the great bulk of Anglo-American economic theories:
the concentration on only two areas—the single firm or industry,
and the economy as a whole. Both these concentrations are fatally
wrong, because they leave out the most important areas: the
interrelations between the various parts of the economy. Only a
general economic theory is valid—never a theoretical system based
on either a partial or isolated case, or on holistic aggregates, or
on a mixture of the two.[12] In the case of the
acceleration principle, how did the 20 percent increase in
consumption of the firm's product come about? Generally, a 20
percent increase in consumption in one field must signify a 20
percent reduction of consumption somewhere else. In that case, of
course, the leap from the individual to the aggregate is peculiarly
wrong, since there is then no overall boom in consumption or
investment. If the 20 percent increase is to obtain over the whole
economy, how is the increase to be financed? We cannot simply
postulate an increase in consumption; the important question is:
how can it be financed? What general changes are needed elsewhere
to permit such an increase? These are questions that the
accelerationists never face. Setting aside changes in the supply or
demand for money for a moment, increased consumption can only come
about through a decrease in saving and investment. But if aggregate
saving and investment must decrease in order to permit an aggregate
increase in consumption, then investment cannot increase in
response to rising consumption; on the contrary, it must decline.
The acceleration principle never faces this problem because it is
profoundly ignorant of economics—the study of the working of the
means—ends principle in human affairs. Short of Nirvana, all
resources are scarce, and these resources must be allocated to the
uses most urgently demanded by all individuals in the society. This
is the unique economic problem, and it means that to gain a good of
greater value, some other good of lesser value to individuals must
be given up. Greater aggregate present consumption can only be
acquired through lowered aggregate savings and investment. In
short, people choose between present and future consumption, and
can only increase present consumption at the expense of future, or
vice versa. But the acceleration principle neglects the economic
problem completely and disastrously.
The only way that investment can rise together with consumption
is through inflationary credit expansion—and the accelerationists
will often briefly allude to this prerequisite. But this admission
destroys the entire theory. It means, first, that the acceleration
principle could not possibly operate on the free market. That, if
it exists at all, it must be attributed to government rather than
to the working of laissez-faire capitalism. But even granting the
necessity of credit expansion cannot save the principle. For the
example offered by the acceleration principle deals in physical,
real terms. It postulates an increased production of units in
response to increased demand. But if the increased demand is purely
monetary, then prices, both of consumer and capital goods, can
simply rise without any change in physical production—and there is
no acceleration effect at all. In short, there might be a 20
percent rise in money supply, leading to a 20 percent rise in
consumption and in investment—indeed in all quantities—but real
quantities and price relations need not change, and there is no
magnification of investment, in real or monetary terms. The same
applies, incidentally, if the monetary increase in investment or
consumption comes from dishoarding rather than monetary
expansion.
It might be objected that inflation does not and cannot increase
all quantities proportionately, and that this is its chief
characteristic. Precisely so. But proceed along these lines, and we
are back squarely and firmly in the Austrian theory of the trade
cycle—and the acceleration principle has been irretrievably lost.
The Austrian theory deals precisely with the distortions of market
adjustment to consumption-investment proportions, brought about by
inflationary credit expansion.[13] Thus, the
accelerationists maintain, in effect, that the entrepreneurs are
lured by increased consumption to overexpand durable investments.
But the Austrian theory demonstrates that, due to the effect of
inflation on prices, even credit expansion can only cause
malinvestment, not "overinvestment." Entrepreneurs will overinvest
in the higher stages, and underinvest in the lower stages, of
production. Total investment is limited by the total supply of
savings available, and a general increase in consumption signifies
a decrease in saving and therefore a decline in total investment
(and not an increase or even magnified increase, as the
acceleration principle claims).[14]
Furthermore, the Austrian theory shows that the cluster of
entrepreneurial error is caused by the inflationary distortion of
market interest rates.[15]
Dearth of "Investment
Opportunities"
A very common tendency among economists is to attribute
depression to a dearth, or "saturation," of "investment
opportunities." Investment opportunities open themselves up during
the boom and are exploited accordingly. After a while, however,
these opportunities disappear, and hence depression succeeds the
boom. The depression continues until opportunities for investment
reappear. What gives rise to these alleged "opportunities"? Typical
are the causal factors listed in a famous article by Professor
Hansen, who attributed the depression of the 1930s to a dearth of
investment opportunities caused by an insufficient rate of
population growth, the lack of new resources, and inadequate
technical innovation.[16] The importance of
this doctrine goes far beyond Hansen's "stagnation" theory—that
these factors would behave in the future so as to cause a permanent
tendency toward depression. For the "refuters" of the stagnation
theory tacitly accepted Hansen's causal theory and simply argued
empirically that these factors would be stronger than Hansen had
believed.[17] Rarely have the causal
connections themselves been challenged. The doctrine has been
widely assumed without being carefully supported.
Whence come these causal categories? A close look will show
their derivation from the equilibrium conditions of the Walrasian
system which assumes a constant and evenly rotating economy, with
tastes, technological knowledge, and resources considered given.
Changes can only occur if one or more of these givens change. If
new net investment is considered the key to depression or
prosperity, then, knowing that new investment is zero in
equilibrium (i.e., there is only enough investment to replace and
maintain capital), it is easy to conclude that only changes in the
ultimate givens can lead to new investment. Population and natural
resources both fall under the Walrasian "resource" category.
Hansen's important omission, of course, is tastes. The omission of
tastes is enough to shatter the entire scheme. For it is time
preferences (the "tastes" of the society for present vis-à-vis
future consumption) that determines the amount that individuals
will save and invest. Omitting time preferences leaves out the
essential determinant of saving and investment.
New natural resources, a relatively unimportant item, is rarely
stressed. We used to hear about the baleful effects on the "closing
of the frontier" of open land, but this frontier closed long before
the 1930s with no ill effects.[18] Actually,
physical space by itself provides no assurance of profitable
investment opportunities. Population growth is often considered an
important factor making for prosperity or depression, but it is
difficult to see why. If population is below the optimum (maximum
real income per capita), its further growth permits investment to
increase productivity by extending the division of labor. But this
can only be done through greater investment. There is no way,
however, that population growth can stimulate investment, and this
is the issue at hand. One thesis holds that increased population
growth stimulates demand for residential construction. But demand
stems from purchasing power, which in turn stems ultimately from
production, and an increase in babies may run up against inability
to produce enough goods to demand the new houses effectively. But
even if more construction is demanded, this will simply reduce
consumption demand in other areas of the economy. If total
consumption increases due to population growth (and there is no
particular reason why it should), it will cause a decline in saved
and invested funds rather than the reverse.
Technology is perhaps the most emphatically stressed of these
alleged causal factors. Schumpeter's cycle theory has led many
economists to stress the importance of technological innovation,
particularly in great new industries; and thus we hear about the
Railroad Boom or the Automobile Boom. Some great technological
innovation is made, a field for investment opens up, and a boom is
at hand. Full exploitation of this field finally exhausts the boom,
and depression sets in. The fallacy involved here is neglect of the
fact that technology, while vitally important, is only indirectly,
and not directly, involved in an investment. At this point, we see
again why the conditions of Misesian rather than Walrasian
equilibrium should have been employed. Austrian theory teaches us
that investment is always less than the maximum amount that could
possibly exploit existing technology. Therefore, the "state of
technical knowledge" is not really a limiting condition to
investment. We can see the truth of this by simply looking about
us; in every field, in every possible line of investment, there are
always some firms which are not using the latest possible
equipment, which are still using older methods. This fact indicates
that there is a narrower limit on investment than technological
knowledge. The backward countries may send engineers aplenty to
absorb "American know-how," but this will not bring to these
countries the great amount of investment needed to raise their
standard of living appreciably. What they need, in short, is
saving: this is the factor limiting investment.[19] And saving, in turn, is limited by time
preference: the preference for present over future consumption.
Investment always takes place by a lengthening of the processes of
production, since the shorter productive processes are the first to
be developed. The longer processes remaining untapped are more
productive, but they are not exploited because of the limitations
of time-preference. There is, for example, no investment in better
and new machines because not enough saving is available.
Even if all existing technology were exploited, there would
still be unlimited opportunities for investment, since there would
still not be satiation of wants. Even if better steel mills and
factories could not be built, more of them could always be built,
to produce more of the presently produced consumer goods. New
technology improves productivity, but is not essential for creating
investment opportunities; these always exist, and are only limited
by time preferences and available saving. The more saving, the more
investment there will be to satisfy those desires not now
fulfilled.
Just as in the case of the acceleration principle, the fallacy
of the "investment opportunity" approach is revealed by its
complete neglect of the price system. Once again, price and cost
have disappeared. Actually, the trouble in a depression comes from
costs being greater than the prices obtained from sale of capital
goods; with costs greater than selling prices, businessmen are
naturally reluctant to invest in losing concerns. The problem,
then, is the rigidity of costs. In a free market, prices determine
costs and not vice versa, so that reduced final prices will also
lower the prices of productive factors—thereby lowering the costs
of production. The failure of "investment opportunity" in the
crisis stems from the overbidding of costs in the boom, now
revealed in the crisis to be too high relative to selling prices.
This erroneous overbidding was generated by the inflationary credit
expansion of the boom period. The way to retrieve investment
opportunities in a depression, then, is to permit costs—factor
prices—to fall rapidly, thus reestablishing profitable
price-differentials, particularly in the capital goods industries.
In short, wage rates, which constitute the great bulk of factor
costs, should fall freely and rapidly to restore investment
opportunities. This is equivalent to the reestablishment of higher
price-differentials—higher natural interest rates—on the market.
Thus, the Austrian approach explains the problem of investment
opportunities, and other theories are fallacious or irrelevant.
Equally irrelevant is all discussion in terms of specific
industries—an approach very similar to the technological
opportunity doctrine. Often it is maintained that a certain
industry—say construction or autos—was particularly prosperous in
the boom, and that the depression occurred because of depressed
conditions in that particular industry. This, however, confuses
simple specific business fluctuations with general business cycles.
Declines in one or several industries are offset by expansion in
others, as demand shifts from one field to another. Therefore,
attention to particular industries can never explain booms or
depressions in general business—especially in a multi-industry
country like the United States.[20] It is, for
example, irrelevant whether or not the construction industry
experiences a "long cycle" of twenty-odd years.
Schumpeter's Business Cycle Theory
Joseph Schumpeter's cycle theory is notable for being the only
doctrine, apart from the Austrian, to be grounded on, and
integrated with, general economic theory.[21]
Unfortunately, it was grounded on Walrasian, rather than Austrian,
general economics, and was thus doomed from the start. The unique
Schumpeterian element in discussing equilibrium is his postulate of
a zero rate of interest. Schumpeter, like Hansen, discards consumer
tastes as an active element and also dispenses with new resources.
With time preference ignored, interest rate becomes zero in
equilibrium, and its positive value in the real world becomes
solely a reflection of positive profits, which in turn are due to
the only possible element of change remaining: technological
innovations. These innovations are financed, Schumpeter maintains,
by bank credit expansion, and thus Schumpeter at least concedes the
vital link of bank credit expansion in generating the boom and
depression, although he pays it little actual attention.
Innovations cluster in some specific industry, and this generates
the boom. The boom ends as the innovatory investments exhaust
themselves, and their resulting increased output pours forth on the
market to disrupt the older firms and industries. The ending of the
cluster, accompanied by the sudden difficulties faced by the old
firms, and a generally increased risk of failure, bring about the
depression, which ends as the old and new firms finally adapt
themselves to the new situation.
There are several fallacies in this approach:
- There is no explanation offered on the lack of accurate
forecasting by both the old and new firms. Why were not the
difficulties expected and discounted?[22]
- In reality, it may take a long time for a cluster of
innovations in a new industry to develop, and yet it may take a
relatively short time for the output of that industry to increase
as a result of the innovations. Yet the theory must assume that
output increases after the cluster has done its work; otherwise,
there is no boom nor bust.
- As we have seen above, time preferences and interest are
ignored, and also ignored is the fact that saving and not
technology is the factor limiting investment.[23] Hence, investment financed by bank credit need not
be directed into innovations, but can also finance greater
investment in already known processes.
- The theory postulates a periodic cluster of innovations in
the boom periods. But there is no reasoning advanced to account for
such an odd cluster. On the contrary, innovations, technological
advance, take place continually, and in most, not just a few,
firms. A cluster of innovations implies, furthermore, a periodic
cluster of entrepreneurial ability, and this assumption is clearly
unwarranted. And insofar as innovation is a regular business
procedure of research and development, rents from innovations will
accrue to the research and development departments of firms, rather
than as entrepreneurial profits.[24]
- Schumpeter's view of entrepreneurship—usually acclaimed as
his greatest contribution—is extremely narrow and one-sided. He
sees entrepreneurship as solely the making of innovations, setting
up new firms to innovate, etc. Actually, entrepreneurs are
continually at work, always adjusting to uncertain future demand
and supply conditions, including the effects of innovations.[25]
In his later version, Schumpeter recognized that different
specific innovations generating cycles would have different
"periods of gestation" for exploiting their opportunities until new
output had increased to its fullest extent. Hence, he modified his
theory by postulating an economy of three separate, and
interacting, cycles: roughly one of about three years, one of nine
years, and one of 55 years. But the postulate of multi-cycles
breaks down any theory of a general business cycle. All economic
processes interact on the market, and all processes mesh together.
A cycle takes place over the entire economy, the boom and
depression each being general. The price system integrates and
interrelates all activities, and there is neither warrant nor
relevance for assuming hermetically-sealed "cycles," each running
concurrently and adding to each other to form some resultant of
business activity. The multi-cycle scheme, then, is a complete
retreat from the original Schumpeterian model, and itself adds
grievous fallacies to the original.[26]
Qualitative Credit Doctrines
Of the theories discussed so far, only the Austrian or Misesian
sees anything wrong in the boom. The other theories hail the boom,
and see the depression as an unpleasant reversal of previous
prosperity. The Austrian and Schumpeterian doctrines see the
depression as the inevitable result of processes launched in the
boom. But while Schumpeter considers "secondary wave" deflation
unfortunate and unsettling, he sees the boom-bust of his pure model
as the necessary price to be paid for capitalist economic
development. Only the Austrian theory, therefore, holds the
inflationary boom to be wholly unfortunate and sees the full
depression as necessary to eliminate distortions introduced by the
boom. Various "qualitative credit" schools, however, also see the
depression as inevitably generated by an inflationary boom. They
agree with the Austrians, therefore, that booms should be prevented
before they begin, and that the liquidation process of depression
should be allowed to proceed unhampered. They differ considerably,
however, on the causal analysis, and the specific ways that the
boom and depression can be prevented.
The most venerable wing of qualitative credit theory is the old
Banking School doctrine, prominent in the nineteenth century and
indeed until the 1930s. This is the old-fashioned "sound banking"
tradition, prominent in older money-and-banking textbooks, and
spearheaded during the 1920s by two eminent economists: Dr.
Benjamin M. Anderson of the Chase National Bank, and Dr. H. Parker
Willis of the Columbia University Department of Banking, and editor
of the Journal of Commerce. This school of thought, now very much
in decline, holds that bank credit expansion only generates
inflation when directed into the wrong lines, i.e., in assets other
than self-liquidating short-term credit matched by "real goods,"
loaned to borrowers of impeccable credit standing. Bank credit
expansion in such assets is held not to be inflationary, since it
is then allegedly responsive solely to the legitimate "needs of
business," the money supply rising with increased production, and
falling again as goods are sold. All other types of loans—whether
in long-term credit, real estate, stock market, or to shaky
borrowers—are considered inflationary, and create a boom-bust
situation, the depression being necessary to liquidate the wasteful
inflation of the boom. Since the bank loans of the 1920s were
extended largely in assets considered unsound by the Banking
School, these theorists joined the "Austrians" in opposing the bank
credit inflation of the 1920s, and in warning of impending
depression.
The emphasis of the Banking School, however, is invalid. The
important aspect of bank credit expansion is the quantity of new
money thrown into business lending, and not at all the type of
business loans that are made. Short-term, "self-liquidating" loans
are just as inflationary as long-term loans. Credit needs of
business, on the other hand, can be financed by borrowing from
voluntary savings; there is no good reason why short-term loans in
particular should be financed by bank inflation. Banks do not
simply passively await business firms demanding loans; these very
demands vary inversely to the rate of interest that the banks
charge. The crucial point is the injection of new money into
business firms; regardless of the type of business loan made, this
money will then seep into the economy, with the effects described
in the Austrian analysis. The irrelevance of the type of loan may
be seen from the fact that business firms, if they wish to finance
long-term investment, can finance it indirectly from the banks just
as effectively as from direct loans. A firm may simply cease using
its own funds for financing short-term inventory, and instead
borrow the funds from the banks. The funds released by this
borrowing can then be used to make long-term investments. It is
impossible for banks to prevent their funds being used indirectly
in this manner. All credit is interrelated on the market, and there
is no way that the various types of credit can be hermetically
sealed from each other.[27] And even if there
were, it would make no economic sense to do so.
In short, the "self-liquidating" loan is just as inflationary as
any other type of loan, and the only merit of this theory is the
indirect one of quantitatively limiting the lending of banks that
cannot find as many such loans as they would like. This loan does
not even have the merit of speedier retirement, since short-term
loans can and are renewed or reloaned elsewhere, thus perpetuating
the loan for as long a time as any "long-term" loan. This emphasis
of the Banking School weakened its salutary effect in the 1920s,
for it served to aggravate the general over-emphasis on types of
loans—in particular the stock market—as against the quantity of
money outstanding.
More dangerous than the Banking School in this qualitative
emphasis are those observers who pick out some type of credit as
being particularly grievous. Whereas the Banking School opposed a
quantitative inflation that went into any but stringently
self-liquidating assets, other observers care not at all about
quantity, but only about some particular type of asset—e.g., real
estate or the stock market. The stock market was a particular
whipping boy in the 1920s and many theorists called for restriction
on stock loans in contrast to "legitimate" business loans. A
popular theory accused the stock market of "absorbing" capital
credit that would otherwise have gone to "legitimate" industrial or
farm needs. "Wall Street" had been a popular scapegoat since the
days of the Populists, and since Thorstein Veblen had legitimated a
fallacious distinction between "finance" and "industry."
The "absorption of capital" argument is now in decline, but
there are still many economists who single out the stock market for
attack. Clearly, the stock market is a channel for investing in
industry. If A buys a new security issue, then the funds are
directly invested; if he buys an old share, then (1) the increased
price of stock will encourage the firm to float further stock
issues, and (2) the funds will then be transferred to the seller B,
who in turn will consume or directly invest the funds. If the money
is directly invested by B, then once again the stock market has
channelled savings into investment. If B consumes the money, then
his consumption or dissaving just offsets A's saving, and no
aggregate net saving has occurred.
Much concern was expressed in the 1920s over brokers' loans, and
the increased quantity of loans to brokers was taken as proof of
credit absorption in the stock market. But a broker only needs a
loan when his client calls on him for cash after selling his stock;
otherwise, the broker will keep an open book account with no need
for cash. But when the client needs cash he sells his stock and
gets out of the market. Hence, the higher the volume of brokers'
loans from banks, the greater the degree that funds are leaving the
stock market rather than entering it. In the 1920s, the high volume
of brokers' loans indicated the great degree to which industry was
using the stock market as a channel to acquire saved funds for
investment.[28]
The often marked fluctuations of the stock market in a boom and
depression should not be surprising. We have seen the Austrian
analysis demonstrate that greater fluctuations will occur in the
capital goods industries. Stocks, however, are units of title to
masses of capital goods. Just as capital goods' prices tend to rise
in a boom, so will the prices of titles of ownership to masses of
capital.[29] The fall in the interest rate due
to credit expansion raises the capital value of stocks, and this
increase is reinforced both by the actual and the prospective rise
in business earnings. The discounting of higher prospective
earnings in the boom will naturally tend to raise stock prices
further than most other prices. The stock market, therefore, is not
really an independent element, separate from or actually
disturbing, the industrial system. On the contrary, the stock
market tends to reflect the "real" developments in the business
world. Those stock market traders who protested during the late
1920s that their boom simply reflected their "investment in
America" did not deserve the bitter comments of later critics;
their error was the universal one of believing that the boom of the
1920s was natural and perpetual, and not an artificially-induced
prelude to disaster. This mistake was hardly unique to the stock
market.
Another favorite whipping-boy during recent booms has been
installment credit to consumers. It has been charged that
installment loans to consumers are somehow uniquely inflationary
and unsound. Yet, the reverse is true. Installment credit is no
more inflationary than any other loan, and it does far less harm
than business loans (including the supposedly "sound" ones) because
it does not lead to the boom-bust cycle. The Mises analysis of the
business cycle traces causation back to inflationary expansion of
credit to business on the loan market. It is the expansion of
credit to business that overstimulates investment in the higher
orders, misleads business about the amount of savings available,
etc. But loans to consumers qua consumers have no ill effects.
Since they stimulate consumption rather than business spending,
they do not set a boom-bust cycle into motion. There is less to
worry about in such loans, strangely enough, than in any other.
Overoptimism and Overpessimism
Another popular theory attributes business cycles to alternating
psychological waves of "overoptimism" and "overpessimism." This
view neglects the fact that the market is geared to reward correct
forecasting and penalize poor forecasting. Entrepreneurs do not
have to rely on their own psychology; they can always refer their
actions to the objective tests of profit and loss. Profits indicate
that their decisions have borne out well; losses indicate that they
have made grave mistakes. These objective market tests check any
psychological errors that may be made. Furthermore, the successful
entrepreneurs on the market will be precisely those, over the
years, who are best equipped to make correct forecasts and use good
judgment in analyzing market conditions. Under these conditions, it
is absurd to suppose that the entire mass of entrepreneurs will
make such errors, unless objective facts of the market are
distorted over a considerable period of time. Such distortion will
hobble the objective "signals" of the market and mislead the great
bulk of entrepreneurs. This is the distortion explained by Mises's
theory of the cycle. The prevailing optimism is not the cause of
the boom; it is the reflection of events that seem to offer
boundless prosperity. There is, furthermore, no reason for general
overoptimism to shift suddenly to overpessimism; in fact, as
Schumpeter has pointed out (and this was certainly true after 1929)
businessmen usually persist in dogged and unwarranted optimism for
quite a while after a depression breaks out.[30] Business psychology is, therefore, derivative
from, rather than causal to, the objective business situation.
Economic expectations are therefore self-correcting, not
self-aggravating. As Professor Bassic has pointed out:
The businessman may expect a decline, and he may cut his
inventories, but he will produce enough to fill the orders he
receives; and as soon as the expectations of a decline prove to be
mistaken, he will again rebuild his inventories . . . the whole
psychological theory of the business cycle appears to be hardly
more than an inversion of the real causal sequence. Expectations
more nearly derive from objective conditions than produce them. The
businessman both expands and expects that his expansion will be
profitable because the conditions he sees justifies the expansion .
. . . It is not the wave of optimism that makes times good. Good
times are almost bound to bring a wave of optimism with them. On
the other hand, when the decline comes, it comes not because anyone
loses confidence, but because the basic economic forces are
changing. Once let the real support for the boom collapse, and all
the optimism bred through years of prosperity will not hold the
line. Typically, confidence tends to hold up after a downturn has
set in.[31]