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Advancing Austrian Economics, Liberty, and Peace

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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.


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:

  1. 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]
  2. 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.
  3. 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.
  4. 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]
  5. 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]

  1. See the discussion by Scott in Wesley C. Mitchell, Business Cycles: The Problem and its Setting (New York: National Bureau of Economic Research, 1927), pp. 75ff.

  2. See C.A. Phillips, T.F. McManus, and R.W. Nelson, Banking and the Business-Cycle (New York: Macmillan, 1937), pp. 59-64.

  3. In the Keynesian theory, "aggregate equilibrium" is reached by two routes: profits and losses, and "unintended" investment or disinvestment in inventory. But there is no unintended investment, since prices could always be cut low enough to sell inventory if so desired.

  4. We often come across the argument that the money supply must be increased "in order to keep up with the increased supply of goods." But goods and money are not at all commensurate, and the entire injunction is therefore meaningless. There is no way that money can be matched with goods.

  5. For a brilliant critique of underconsumptionism by an Austrian, see F.A. Hayek, "The 'Paradox' of Saving," in Profits, Interest, and Investment (London: Routledge and Kegan Paul, 1939), pp. 199-263. Hayek points out the grave and neglected weaknesses in the capital, interest, and production-structure theory of the underconsumptionists Foster and Catchings. Also see Phillips, et al., Banking and the Business Cycle, pp. 69-76.

  6. The Keynesian approach stresses underspending rather than underconsumption alone; on "hoarding," the Keynesian dichotomization of saving and investment, and the Keynesian view of wages and unemployment, see above.

  7. Either that, or such an expansion must have occurred in some previous decade, after which the firm—or whole economy—lapsed into a sluggish stationary state.

  8. See his brilliant critique of the acceleration principle in W.H. Hutt, "Coordination and the Price System" (unpublished, but available from the Foundation for Economic Education, Irvington-on-Hudson, New York, 1955) pp. 73-117.

  9. This is not merely the problem of a time lag necessary to produce the new machines; it is the far broader question of the great range of choice of the time period in which to make the investment. But this reminds us of another fallacy made by the accelerationists: that production of the new machines is virtually instantaneous.

  10. The accelerationists habitually confuse consumption with production of consumer goods, and talk about one when the other is relevant.

  11. The "Cobweb Theorem" is another doctrine built on the assumption that all entrepreneurs are dolts, who blindly react rather than speculate and succeed in predicting the future.

  12. Anglo-American economics suffers badly from this deficiency. The Marshallian system rested on a partial theory of the "industry," while modern economics fragments itself further to discuss the isolated firm. To remedy this defect, Keynesians and later econometric systems discuss the economy in terms of a few holistic aggregates. Only the Misesian and Walrasian systems are truly general, being based themselves on interrelated individual exchanges. The Walrasian scheme is unrealistic, consisting solely of a mathematical analysis of an unrealizable (though important) equilibrium system.

  13. Another defect of the accelerationist explanation of the cycle is its stress on durable capital equipment as the preeminently fluctuating activity. Actually, as we have shown above, the boom is not characterized by an undue stress on durable capital; in fact, such non-durable items as industrial raw materials fluctuate as strongly as fixed capital goods. The fluctuation takes place in producers' goods industries (the Austrian emphasis) and not just durable producers' goods (the accelerationist emphasis).

  14. See Hutt, "Coordination and the Price System," p. 109.

  15. The acceleration principle also claims to explain the alleged tendency of the downturn in capital goods to lead downturns in consumer goods activity. However, it could only do so, even on its own terms, under the very special—and almost never realized—assumption that the sale of consumer goods describes a sine-shaped curve over the business cycle. Other possible curves give rise to no leads at all.

    On the acceleration principle, also see L. Albert Hahn, Common Sense Economics (New York: Abelard-Schuman, 1956), pp. 139-43; Ludwig von Mises, Human Action (New Haven, Conn.: Yale University Press, 1949), pp. 581-83; and Simon S. Kuznets, "Relation Between Capital Goods and Finished Products in the Business Cycle," in Economic Essays in Honor of Wesley C. Mitchell (New York: Columbia University Press, 1935), pp. 209-67.

  16. Alvin H. Hansen, "Economic Progress and Declining Population Growth," in Readings in Business Cycle Theory (Philadelphia: Blakiston, 1944), pp. 366-84.

  17. For an example, see George Terborgh, The Bogey of Economic Maturity (Chicago: Machinery and Allied Products Institute, 1945).

  18. Curiously, these same worriers did not call upon the federal government to abandon its conservation policies, which led it to close millions of acres of public domain permanently. Nowadays, outer space will presumably provide "frontier" enough.

  19. Saving, not monetary expansion. A backward country, for example, could not industrialize itself by issuing unlimited quantities of paper money or bank deposits. That could only bring on runaway inflation.

  20. The economic fortunes of a small country producing one product for the market will of course be dominated by the course of events in that industry.

  21. Schumpeter's pure theory was presented in his famous Theory of Economic Development (Cambridge, Mass.: Harvard University Press, 1934), first published in 1911. It later appeared as the "first approximation" in an elaborated approach that really amounted to a confession of failure, and which introduced an abundance of new fallacies into the argument. The later version constituted his Business Cycles, 2 vols. (New York: McGraw-Hill, 1939).

  22. To be sure, the Schumpeterian "Pure Model" explicitly postulates perfect knowledge and therefore absence of error by entrepreneurs. But this is a flagrantly self-contradictory assumption within Schumpeter's own model, since the very reason for depression in the Pure Model is the fact that risks increase, old firms are suddenly driven to the wall, etc., and no one innovates again until the situation clears.

  23. Schumpeter wisely saw that voluntary savings could only cause simple economic growth and could not give rise to business cycles.

  24. See Carolyn Shaw Solo, "Innovation in the Capitalist Process: A Critique of the Schumpeterian Theory," Quarterly Journal of Economics (August, 1951): 417-28.

  25. This refutes Clemence and Doody's defense of Schumpeter against Kuznets's criticism that the cluster of innovations assumes a cluster of entrepreneurial ability. Clemence and Doody identified such ability solely with the making of innovations and the setting up of new firms. See Richard V. Clemence and Francis S. Doody, The Schumpeterian System (Cambridge, Mass.: Addison Wesley Press, 1950), pp. 52ff; Simon S. Kuznets, "Schumpeter's Business Cycles," American Economic Review (June, 1940): 262-63.

  26. Schumpeter also discusses a "secondary wave" superimposed on his pure model. This wave takes into account general inflation, price speculation, etc., but there is nothing particularly Schumpeterian about this discussion, and if we discard both the pure model and the multicycle approach, the Schumpeterian theory is finished.

  27. Thus, during the late 1920s, when banks, influenced by qualitative credit doctrines, tried to shut off the flow of credit to the stock market specifically, the market was able to borrow from the swollen funds of non-bankers, funds swollen by years of bank credit inflation.

    On the fallacies of the qualitative credit theorists, and of their views on the stock market, see the excellent study by Fritz Machlup, who at that time was a leading Austrian School theorist, The Stock Market, Credit and Capital Formation (New York: Macmillan, 1940).

  28. On all this, see Machlup, The Stock Market, Credit, and Capital Formation. An individual broker might borrow in order to pay another broker, but in the aggregate, inter-broker transactions cancel out and total brokers' loans reflect only broker-customer relations.

  29. Real estate values will often behave similarly, real estate conveying units of title of capital in land.

  30. See Schumpeter, Business Cycles, vol. 1, chap. 4.

  31. V. Lewis Bassic, "Recent Developments in Short-Term Forecasting," in Short-Term Forecasting, Studies in Income and Wealth (Princeton, N.J.: National Bureau of Economic Research, 1955), vol. 17, pp. 11-12. Also see pp. 20-21.