Preface by F.A. Hayek Lecture I: The Problem of the Trade Cycle Lecture II: Non-Monetary Theories of the Trade Cycle Lecture III: Monetary Theories of the Trade Cycle Lecture IV: The Fundamental Cause of Cyclical Fluctuations Lecture V: Unsettled Problems of Trade Cycle Theory Notes

Preface by F.A. Hayek

The German essay,[1] of which the following is a translation, represents an expanded version of a paper[2] prepared for the meeting of the Verein für Sozialpolitik,[3] held in Zurich in September 1928, and of some remarks contributed to the discussion at that meeting. Although, in revising the translation, I have made numerous minor alterations and additions (mainly confined to the footnotes), the general course of the argument has been left unchanged. The book, therefore, still shows signs of the particular aim with which it was written. In submitting it to a public different from that for which it was originally intended, a few words of explanation are, perhaps, required.

In Germany, somewhat in contrast to the situation in English-speaking countries, monetary explanations of the trade cycle were always, or at least until quite recently, regarded with some mistrust. One of the aims of this study — one on which an English reader may feel that I have wasted unnecessary energy — was to justify the monetary approach to these problems. But I hope that this more explicit statement of the role of the monetary factor will not be found quite useless, for it is not only a justification of the monetary approach but also a refutation of some oversimplified monetary explanations that are widely accepted. In order to save the sound elements in the monetary theories of the trade cycle, I had to attempt, in particular, to refute certain theories that have led to the belief that, by stabilizing the general price level, all the disturbing monetary causes would be eliminated. Although, since this book was written, this belief has been somewhat rudely shaken by the crisis of 1929, I hope that a systematic examination of its foundations will still be found useful. The critique of the program of the "stabilizers," which is in many ways the central theme of this book, has now occupied me for many years, and since I deal here only with some special problems that have grown mainly out of these studies, I may perhaps be permitted to refer below to other publications, in which I have partly dealt with certain further theoretical problems and partly attempted to use these considerations for the elucidation of contemporary phenomena.[4] In particular, my Prices and Production, originally published in England, should be considered as an essential complement to the present publication. While I have here emphasized the monetary causes that start the cyclical fluctuations, I have, in that later publication, concentrated on the successive changes in the real structure of production, which constitute those fluctuations. This essential complement of my theory seems to me to be the more important since, in consequence of actual economic developments, the over-simplified monetary explanations have gained undeserved prominence in recent times. And since, in all my English publications, I have purposely refrained from combining purely theoretical considerations with discussions of current events, it may be useful to add here one or two remarks on the bearing of those considerations on the problems of today.

It is a curious fact that the general disinclination to explain the past boom by monetary factors has been quickly replaced by an even greater readiness to hold the present working of our monetary organization exclusively responsible for our present plight. And the same stabilizers who believed that nothing was wrong with the boom and that it might last indefinitely because prices did not rise, now believe that everything could be set right again if only we would use the weapons of monetary policy to prevent prices from falling. The same superficial view, which sees no other harmful effect of a credit expansion but the rise of the price level, now believes that our only difficulty is a fall in the price level, caused by credit contraction.

There can, of course, be little doubt that, at the present time, a deflationary process is going on and that an indefinite continuation of that deflation would do inestimable harm. But this does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, central banks, particularly in the United States, have been making earlier and more far-reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion — with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices that existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion.

It is very probable that the much discussed rigidities, which had already grown up in many parts of the modern economic system before 1929, would, in any case, have made the process of readjustment much slower and more painful. It is also probable that these very resistances to readjustment would have set up a severe deflationary process that would finally have overcome those rigidities. To what extent, under the given situation of a relatively rigid price and wage system, this deflationary process is perhaps not only inevitable but is even the quickest way of bringing about the required result, is a very difficult question, about which, on the basis of our present knowledge, I should be afraid to make any definite pronouncement.

It seems certain, however, that we shall merely make matters worse if we aim at curing the deflationary symptoms and, at the same time (by the erection of trade barriers and other forms of state intervention) do our best to increase rather than to decrease the fundamental maladjustments. More than that: while the advantages of such a course are, to say the least, uncertain, the new dangers it creates are great. To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end. It would not be the first experiment of this kind that has been made. We should merely be repeating, on a much larger scale, the course followed by the Federal Reserve system in 1927, an experiment that Mr. A.C. Miller, the only economist on the Federal Reserve Board and at the same time its oldest member, has rightly characterized as "the greatest and boldest operation ever undertaken by the Federal reserve system," an operation that "resulted in one of the most costly errors committed by it or any other banking system in the last 75 years." It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown.

We cannot hope for the overthrow of this alluringly simple theory until its theoretical basis is definitely refuted and something better substituted for it. The opponents of the stabilization program still labor — and probably always will labor — under the disadvantage that they have no equally simple and clear-cut rule to propose; perhaps no rule at all that will satisfy the eagerness of those who hope to cure all evils by authoritative action. But whatever may be our hope for the future, the one thing of which we must be painfully aware at the present time — a fact that no writer on these problems should fail to impress upon his readers — is how little we really know of the forces that we are trying to influence by deliberate management; so little indeed that it must remain an open question whether we would try if we knew more.

Friedrich A. Hayek

The London School of Economics June 1932

Lecture I: The Problem of the Trade Cycle

i

Any attempt either to forecast the trend of economic development, or to influence it by measures based on an examination of existing conditions, must presuppose certain quite definite conceptions as to the necessary course of economic phenomena. Empirical studies, whether they are undertaken with such practical aims in view, or whether they are confined merely to the amplification with the aid of special statistical devices of our knowledge of the course of particular phases of trade fluctuations, can at best afford merely a verification of existing theories; they cannot in themselves provide new insight into the causes or the necessity of the trade cycle.

This view has been stated very forcibly by Professor A. Lowe.[5]

"Our insight into the theoretical interconnections of economic cycles, and into the structural laws of circulation," he says, "has not been enriched at all by descriptive work or calculations of correlations." We can entirely agree with him, moreover, when he goes on to say that "to expect an immediate furtherance of theory from an increase in empirical insight is to misunderstand the logical relationship between theory and empirical research."

The reason for this is clear. The means of perception employed in statistics are not the same as those employed in economic theory; and it is therefore impossible to fit regularities established by the former into the structure of economic laws prescribed by the latter. We cannot superimpose upon the system of fundamental propositions comprised in the theory of equilibrium, a trade cycle theory resting on unrelated logical foundations. All the phenomena observed in cyclical fluctuations, particularly price formation and its influence on the direction and the volume of production, have already been explained by the theory of equilibrium; they can only be integrated as an explanation of the totality of economic events by means of fundamentally similar constructions. Trade cycle theory itself is only expected to explain how certain prices are determined, and to state their influence on production and consumption; and the determining conditions of these phenomena are already given by elementary theory. Its special task arises from the fact that these phenomena show empirically observed movements for the explanation of which the methods of equilibrium theory are as yet inadequate. One need not go so far as to say that a successful solution could be reached only in conjunction with a positive explanation of elementary phenomena; but no further proof is needed that such a solution can only be achieved in association with, or by means of, a theory that explains how certain prices or certain uses of given goods are determined at all. It is not only that we lack theories that fulfill this condition and that fall outside the category best described as "equilibrium theories"[6] — theories that are characterized by taking the logic of economic action as their starting point; the point is rather that statistical method is fundamentally unsuited to this purpose. Just as no statistical investigation can prove that a given change in demand must necessarily be followed by a certain change in price, so no statistical method can explain why all economic phenomena present that regular wave-like appearance we observe in cyclical fluctuations. This can be explained only by widening the assumptions on which our deductions are based, so that cyclical fluctuations would follow from these as a necessary consequence, just as the general propositions of the theory of price followed from the narrower assumptions of equilibrium theory.

But even these new assumptions cannot be established by statistical investigation. The statistical approach, unlike deductive inference, leaves the conditions under which established economic relations hold good fundamentally undetermined; and similarly, the objects to which they relate cannot be determined as unequivocally as by theory. Empirically established relations between various economic phenomena continue to present a problem to theory until the necessity for their interconnections can be demonstrated independently of any statistical evidence.[7] The concepts on which such an explanation is based will be quite different from those by which statistical interconnections are demonstrated; they can be reached independently. Moreover, the corroboration of statistical evidence provides, in itself, no proof of correctness. A priori we cannot expect from statistics anything more than the stimulus provided by the indication of new problems.

In thus emphasizing the fact that trade cycle theory, while it may serve as a basis for statistical research, can never itself be established by the latter, it is by no means desired to deprecate the value of the empirical method. On the contrary, there can be no doubt that trade cycle theory can only gain full practical importance through exact measurement of the actual course of the phenomena it describes. But before we can examine the question of the true importance of statistics to theory, it must be clearly recognized that the use of statistics can never consist in a deepening of our theoretical insight.

ii

Even as a means of verification, the statistical examination of the cycles has only a very limited value for trade cycle theory. For the latter — as for any other economic theory — there are only two criteria of correctness. Firstly, it must be deduced with unexceptionable logic from the fundamental notions of the theoretical system; and secondly, it must explain by a purely deductive method those phenomena with all their peculiarities that we observe in the actual cycles.[8] Such a theory could only be "false" either through an inadequacy in its logic or because the phenomena it explains do not correspond with the observed facts. If, however, the theory is logically sound, and if it leads to an explanation of the given phenomena as a necessary consequence of these general conditions of economic activity, then the best that statistical investigation can do is to show that there still remains an unexplained residue of processes. It could never prove that the determining relationships are of a different character from those maintained by the theory.[9]

It might be shown, for instance, by statistical investigation that a general rise in prices is followed by an expansion of production, and a general fall in prices by a diminution of production; but this would not necessarily mean that theory should regard the movement of price as an independent cause of movements of production. So long as a theory could explain the regular occurrence of this parallelism in any other way, it could not be disproved by statistics, even if it maintained that the connection between the two phenomena was of a precisely opposite nature.[10] It is therefore only in a negative sense that it is possible to verify theory by statistics. Either statistics can demonstrate that there are phenomena the theory does not sufficiently explain, or it is unable to discover such phenomena. It cannot be expected to confirm the theory in a positive sense. The possibility is completely ruled out by what has been said above, since it would presuppose an assertion of necessary interconnections, such as statistics cannot make. There is no reason to be surprised, therefore, that although nearly all modern trade cycle theories use statistical material as corroboration, it is only where a given theory fails to explain all the observed phenomena that this statistical evidence can be used to judge its merits.

iii

Thus it is not by enriching or by checking theoretical analysis that economic statistics gain their real importance. This lies elsewhere. The proper task of statistics is to give us accurate information about the events that fall within the province of theory, and so to enable us not only to connect two consecutive events as cause and effect, a posteriori, but to grasp existing conditions completely enough for forecasts of the future and, eventually, appropriate action, to become possible. It is only through this possibility of forecasts of systematic action that theory gains practical importance.[11] A theory might, for instance, enable us to infer from the comparative movements of certain prices and quantities an imminent change in the direction of those movements: but we should have little use for such a theory if we were unable to ascertain the actual movements of the phenomena in question. With regard to certain phenomena having an important bearing on the trade cycle, our position is a peculiar one. We can deduce from general insight how the majority of people will behave under certain conditions; but the actual behavior of these masses at a given moment, and therefore the conditions to which our theoretical conclusions must be applied, can only be ascertained by the use of complicated statistical methods. This is especially true when a phenomenon is influenced by a number of partly known circumstances, such as, e.g., seasonal changes. Here very complicated statistical investigations are needed to ascertain whether these circumstances whose presence indicates the applicability of theoretical conclusions were in fact operative. Often statistical analysis may detect phenomena that have, as yet, no theoretical explanation, and which therefore necessitate either an extension of theoretical speculation or a search for new determining conditions. But the explanation of the phenomena thus detected, if it is to serve as a basis for forecasts of the future, must in every case utilize other methods than statistically observed regularities; and the observed phenomena will have to be deduced from the theoretical system, independently of empirical detection.

The dependence of statistical research on preexisting theoretical explanation hardly needs further emphasis. This holds good not only as regards the practical utilization of its results, but also in the course of its working, in which it must look to theory for guidance in selecting and delimiting the phenomena to be investigated. The oft-repeated assertion that statistical examination of the trade cycle should be undertaken without any theoretical prejudice is therefore always based on self-deception.[12]

On the whole, one can say without exaggeration that the practical value of statistical research depends primarily upon the soundness of the theoretical conceptions on which it is based. To decide upon the most important problems of the trade cycle remains the task of theory; and whether the money and labor so freely expended on statistical research in late years will be repaid by the expected success depends primarily on whether the development of theoretical understanding keeps pace with the exploration of the facts. For we must not deceive ourselves: not only do we now lack a theory that is generally accepted by economists, but we do not even possess one that could be formulated in such an unexceptionable way, and worked out in such detail, as eventually to command such acceptance. A series of important interconnections have been established and some principles of the greatest significance expounded; but no one has yet undertaken the decisive step that creates a complete theory by using one of these principles to incorporate all the known phenomena into the existing system in a satisfactory way. To realize this, of course, does not hinder us from pursuing either economic research or economic policy; but then we must always remember that we are acting on certain theoretical assumptions whose correctness has not yet been satisfactorily established. The "practical man" habitually acts on theories that he does not consciously realize; and in most cases this means that his theories are fallacious. Using a theory consciously, on the other hand, always results in some new attempt to clear up the interrelations that it assumes, and to bring it into harmony with which theoretical assumptions; that is, it results in the pursuit of theory for its own sake.

iv

The value of business forecasting depends upon correct theoretical concepts; hence there can, at the present time, be no more important task in this field than the bridging of the gulf that divides monetary from non-monetary theories.[13] This gulf leads to differences of opinion in the front rank of economists; and is also the characteristic line of division between trade cycle theory in Germany and in America — where business forecasting originated. Such an analysis of the relation between these two main trends seems to me especially important because of the peculiar position of the monetary theories. Largely through the fault of some of their best-known advocates in Germany, monetary explanations became discredited, and their essentials have, moreover, been much misunderstood; while, on the other hand, the reaction against them forms the main reason for the prevailing skepticism as to the possibility of any economic theory of the trade cycle — a skepticism that may seriously retard the development of theoretical research.[14]

There is a fundamental difficulty inherent in all trade cycle theories that take as their starting point an empirically ascertained disturbance of the equilibrium of the various branches of production. This difficulty arises because, in stating the effects of that disturbance, they have to make use of the logic of equilibrium theory.[15] Yet this logic, properly followed through, can do no more than demonstrate that such disturbances of equilibrium can come only from outside — i.e., that they represent a change in the economic data — and that the economic system always reacts to such changes by its well-known methods of adaptation, i.e., by the formation of a new equilibrium. No tendency towards the special expansion of certain branches of production, however plausibly adduced, no chance shift in demand, in distribution or in productivity, could adequately explain, within the framework of this theoretical system, why a general "disproportionality" between supply and demand should arise. For the essential means of explanation in static theory — which is, at the same time, the indispensable assumption for the explanation of particular price variations — is the assumption that prices supply an automatic mechanism for equilibrating supply and demand. The next section will deal with these difficulties in more detail: a mere hint should therefore be sufficient at this point. At the moment we have only to draw attention to the fact that the problem before us cannot be solved by examining the effect of a certain cause within the framework, and by the methods, of equilibrium theory. Any theory that limits itself to the explanation of empirically observed interconnections by the methods of elementary theory necessarily contains a self-contradiction. For trade cycle theory cannot aim at the adaptation of the adjusting mechanism of static theory to a special case; this scheme of explanation must itself be extended so as to explain how such discrepancies between supply and demand can ever arise. The obvious, and (to my mind) the only possible way out of this dilemma, is to explain the difference between the course of events described by static theory (which only permits movements towards an equilibrium, and which is deduced by directly contrasting the supply of and the demand for goods) and the actual course of events, by the fact that, with the introduction of money (or strictly speaking with the introduction of indirect exchange), a new determining cause is introduced. Money being a commodity that, unlike all others, is incapable of finally satisfying demand, its introduction does away with the rigid interdependence and self-sufficiency of the "closed" system of equilibrium, and makes possible movements that would be excluded from the latter. Here we have a starting point that fulfils the essential conditions for any satisfactory theory of the trade cycle. It shows, in a purely deductive way, the possibility and the necessity of movements that do not at any given moment tend towards a situation that, in the absence of changes in the economic "data," could continue indefinitely. It shows that, on the contrary, these movements lead to such a "disproportionality" between certain parts of the system that the given situation cannot continue.

But while it seems that it was a sound instinct that led economists to begin by looking on the monetary side for an explanation of cyclical fluctuations, it also seems probable that the one-sided development of the theory of money has, as yet, prevented any satisfactory solution to the problem being found. Monetary theories of the trade cycle succeeded in giving prominence to the right questions and, in many cases, made important contributions towards their solution; but the reason why an unassailable solution has not yet been put forward seems to reside in the fact that all the adherents of the monetary theory of the trade cycle have sought an explanation either exclusively or predominantly in the superficial phenomena of changes in the value of money, while failing to pursue the far more profound and fundamental effects of the process by which money is introduced into the economic system, as distinct from its effect on prices in general. Nor did they follow up the consequences of the fundamental diversity between a money economy and the pure barter economy that is assumed in static theory.[16]

v

Naturally it cannot be the business of this essay to remove all defects and deficiencies from the monetary theories of the trade cycle, or to develop a complete and unassailable theory. In these pages I shall only attempt to show the general significance for this theory of the monetary starting point, and to refute the most important objections raised against the monetary explanation by proving that certain rightly exposed deficiencies of some monetary theories do not necessarily follow from the monetary approach. All that is wanted, therefore, is, first, a proof, using as our examples some of the best-known non-monetary theories, that the "real" explanations adduced by them do not, in themselves, suffice to build up a complete and consistent theory; secondly, a demonstration that the existing monetary theories contain the germ of a true explanation, although all suffer, more or less, from that oversimplification of the problem which results from reducing all cyclical fluctuations to fluctuations in the value of money; finally that the monetary starting point makes it possible, in fact, to show deductively the inevitability of fluctuation under the existing monetary system and, indeed, under almost any other that can be imagined. It will be shown, in particular, that the Wicksell-Mises theory of the effects of a divergence between the "natural" and the money rate of interest already contains the most important elements of an explanation, and has only to be freed from any direct reference to a purely imaginary "general money value" (as has already been partly done by Prof. Mises) in order to form the basis of a trade cycle theory sufficing for a deductive explanation of all the elements in the trade cycle.

Lecture II: Non-Monetary Theories of the Trade Cycle

i

Any attempt at a general proof, within the compass of a short essay, of the assertion that non-monetary theories of the trade cycle inevitably suffer from a fundamental deficiency, appears to be confronted with an insuperable obstacle by reason of the very multiplicity of such theories. If it were necessary for our purpose to show that every one of the numerous disequilibrating forces which have been made starting points for trade cycle theories was, in fact, non-existent, then the conditions of our success would, indeed, be impossible of fulfillment; for not only would it be almost impossible to deal with all extant theories but no conclusive answer could result, seeing that we should still have to reckon with a new and hitherto unrefuted crop of such theories in the future. Moreover the existence of most of the interconnections elaborated by the various trade cycle theories can hardly be denied, and our task is rather their coordination in a unified logical structure than the development of entirely new and different trains of thought. In fact, it is by no means necessary to question the material correctness of the individual interconnections emphasized in the various non-monetary theories in order to show that they do not afford a sufficient explanation. As has already been indicated in the first chapter, none of them is able to overcome the contradiction between the course of economic events as described by them and the fundamental ideas of the theoretical system which they have to utilize in order to explain that course. It will, therefore, be sufficient to show, by examination of some of the best-known theories, that they do not answer this fundamental question; nor can they ever do so by their present methods and by reference to the circumstances they now regard as relevant to trade cycle theory. When, however, the question is answered on different lines, viz., by reference to monetary circumstances, it can be shown that the elements of explanation adduced by different theories lose their independent importance and fall into a subordinate position as necessary consequences of the monetary cause.

It is rather difficult to select the main types of trade cycle theory for this purpose, since we have no theoretically satisfactory classification. The latest attempts at such classifications, by Mr. W.M. Persons,[17] Professor W.C. Mitchell,[18] and Mr. A.H. Hansen,[19] show that the usual division, which relies on external features and hardly touches the solution of fundamental problems, gives far too wide a scope for arbitrary decisions. As Professor Löwe[20] has correctly emphasized (and as should be obvious from what has been said above) the only classification that could be really unobjectionable would be one that proceeded according to the manner in which such theories explain the absence of the "normal course" of economic events, as presented by static theory. In fact, the various theories — as we shall hope to show later — make no attempt whatever to do this. As there is, therefore, no classification that would serve our purpose, our choice must be more or less arbitrary; but by choosing some of the best-known theories and exemplifying the train of thought to which our objection particularly applies, we should be able to make the general validity of the latter sufficiently clear. The task is made rather easier by the fact that there does exist today, on at least one point, a far-reaching agreement among the different theories. They all regard the emergence of a disproportionality among the various productive groups, and in particular the excessive production of capital goods, as the first and main thing to be explained. The development of theory owes a real debt to statistical research in that, today, there is at least no substantial disagreement as to the thing to be explained.

There is, however, a point to be emphasized here. The modern habit of going beyond the actual crisis and seeking to explain the entire cycle, suffers inherently from the danger of paying less and less attention to the crucial problem. In particular, the attempt to give the object of the theory as neutral a name as possible (such as "industrial fluctuations" or "cyclical movements of industry") threatens to drive the real theoretical problem more into the background than was the case in the old theory of crisis. The simple fact that economic development does not go on quite uniformly, but that periods of relatively rapid change alternate with periods of relative stagnation, does not in itself constitute a problem. It is sufficiently explained by the adjustment of the economic system to irregular changes in the data — changes whose occurrence we always have to assume and which cannot be further explained by economic science. The real problem presented to economic theory is: Why doesn't this adjustment come about smoothly and continuously, just as a new equilibrium is formed after every change in the data? Why is there this temporary possibility of developments leading away from equilibrium and finally, without any changes in data, necessitating a change in the economic trend? The phenomena of the upward trend of the cycle and of the culminating boom constitute a problem only because they inevitably bring about a slump in sales — i.e., a falling-off of economic activity — which is not occasioned by any corresponding change in the original economic data.

ii

The prevailing disproportionality theories are in agreement in one respect. They all see the cause of the slump in the fact that, during the boom, for various reasons, the productive apparatus is expanded more than is warranted by the corresponding flow of consumption; there finally appears a scarcity of finished consumption goods, thus causing a rise in the price of such goods relatively to the price of production goods (which amounts to the same thing as a rise in the rate of interest) so that it becomes unprofitable to employ the enlarged productive apparatus or, in many cases, even to complete it. At present there is hardly a recognized theory that does not give this idea, which we only sketch for the moment,[21] a decisive place in its argument, and we should therefore be well advised to begin by seeing how the various theories try to deal with the phenomenon in question. Apart from the monetary theories, which, as will be shown later, can only be considered satisfactory if they explain that phenomenon, there are two groups of explanations that can be entirely disregarded. In the first place there is nothing to be gained from an examination of those theories that seek to explain cyclical fluctuations by corresponding cyclical changes in certain external circumstances, while merely using the unquestionable methods of equilibrium theory to explain the economic phenomena that follow from these changes. To decide on the correctness of these theories is beyond the competence of economics. In the second place, it is best, for the moment, to exclude from consideration those theories whose argument depends so entirely on the assumption of monetary changes that when the latter are excluded no systematic explanation is left. This category includes Professor J. Schumpeter,[22] Professor E. Lederer,[23] and Professor G. Cassel,[24] and to a certain extent Professor W.C. Mitchell and Professor J. Lescure.[25] We shall have to consider later, with regard to this category, how far it is theoretically permissible to treat these monetary interconnections as determining conditions on the same footing as the other phenomena used in explanation.

It is, of course, impossible at this point to go into the peculiarities of all types of theory, as worked out by their respective authors. We must leave out of account the forms in which the various explanations are presented, and confine ourselves to certain underlying types of theory that recur in a number of different guises. Inevitably, this treatment of contemporary theories must fail to do full justice to the intellectual merits exemplified in each; but for the purposes of this chapter — that is, to show the fundamental objections to which all non-monetary theories of the trade cycle are open — this somewhat cursory and imperfect treatment may be enough. We may begin our demonstration by pointing out that all those forms of disproportionality theory with which we have to deal here rest on the existence of quite irregular fluctuations of "economic data" (that is, the external determining circumstances of the economic system, including human needs and abilities). From this assumption, they try to explain in one way or another that the fluctuations in consumption or some other element in the economic system occasioned by these changes are followed by relatively greater changes in the production of production goods.[26] These wide fluctuations in the industries making production goods bring about a disproportionality between them and the consumption industries to such an extent that a reversal of the movement becomes necessary. It is not, therefore, the simple fact of fluctuation in the production of capital goods (which is certainly inevitable in the course of economic growth) which has to be explained. The real problem is the growth of excessive fluctuations in the capital goods industries out of the inevitable and irregular fluctuations of the rest of the economic system, and the disproportional development, arising from these, of the two main branches of production. We can distinguish three main types of non-monetary theories explaining the exaggerated effect of given fluctuations on capital goods industries. The most common, at the moment, are those explanations that try to show that, on account of the technique of production, an increase in the demand for consumption goods, whether expected or actual, tends to bring about a relatively larger increase in the production of goods of a higher order, either generally or in a certain group of these goods. Hardly less common, and differing only in appearance, are explanations that seek to derive these augmented fluctuations from special circumstances (non-monetary in character) arising in the field of savings and investment. Finally, as a third group, we must mention certain psychological theories, which, for the most part, have however no pretension to rank as independent explanations and which merely reinforce other arguments, and are open to the same objections as the two other main types.

iii

We shall mention only the most important of our objections to the first type, which is the easiest to discuss from this point of view. It is common to so many economists that it is hardly necessary to mention particular representatives. The simplest way of deductively explaining excessive fluctuations in the production of capital goods is by reference to the long period of time that is necessary, under modern conditions, for preparing the fixed capital goods that enable the expansion of the productive process to take place.[27] According to a widely held view, this circumstance alone is enough to make every increase in the sales of consumption goods, whether brought about by an intensification of demand or by a fall in the costs of production, capable of bringing about a more-than-proportional increase in the production of intermediary goods. This is explained either by the individual producer's ignorance of what his competitors are doing, or — as is common in American writings — by the "cumulative effect" of each change in the sale of consumption goods on the higher stages of production. Owing to circumstances that will be explained later, the leading idea in all these types of explanation is that the long period that, with the present technique of production, elapses between the beginning of a productive process and the arrival of its final product at the market, prevents the gradual adjustment of production to changes in demand through the agency of prices and makes it possible, from time to time, for an excessively large supply to be thrown on the market. This idea is supported by another, which however, can be independently and more widely applied; that is, that every change in demand, from the moment of its appearance, propagates itself cumulatively through all the grades of production, from the lowest to the highest. This cumulative effect arises because at each stage, besides the change that would be appropriate to the actual shift in demand, another change arises from the adjustment of stocks and of productive apparatus to the alteration in market conditions.[28] An increase in the demand for consumption goods will not merely call forth a proportional increase in the demand for goods of a higher order: the latter will also be increased by the amount needed to raise current stocks to a proportional level, and, finally, by the further amount by which the requirements for producing new means of production exceed those for keeping the existing means of production intact. (For instance, an extension of 10 percent, in one particular year, in the machinery of a factory that normally renews 10 percent of its machinery annually, causes an increase of 100 percent in the production of machinery — i.e., a given increase in the demand for consumption goods occasions a tenfold increase in the production of production goods.) This idea is offered as an adequate reason not only for the relatively greater fluctuations in production goods industries but also for their excessive expansion in periods of boom. Similarly, the extensive use of durable capital equipment in the modern economy is often singled out for responsibility.[29] Industries using heavy equipment are prone to excessive expansion in boom periods because small increments in this equipment are impossible; expansion must necessarily take place by sudden jerks. Once the new equipment is available, on the other hand, the volume of production has little influence on total costs, which go on even if no production takes place at all. New inventions and new needs, however, although they are often adduced as explaining the accelerated and excessive growth of capital goods industries, cannot be dealt with on the same footing. They only represent a special group of the many possible causes from which the cumulative processes described above may originate.

iv

There is virtually no doubt that all these interconnections, and many others that are given prominence in various trade cycle theories and which similarly tend to disturb economic equilibrium, do actually exist; and any trade cycle theory that claims to be comprehensively worked out must take them into consideration. But none of them get over the real difficulty — namely: why do the forces tending to restore equilibrium become temporarily ineffective and why do they only come into action again when it is too late? They all try to explain this phenomenon by a further, usually tacit, assumption, which one of the advocates of these theories, Mr. C.O. Hardy,[30] has himself put forward as their common idea, by which, in my opinion, he brings out with the utmost clarity their fundamental weakness. He states that all those theories that are based on the length of the production period under modern technical conditions agree in regarding these conditions as a source of difficulty to producers in adjusting production to the state of the market; producing, as they must, for a future period, the market possibilities of which are necessarily unknown to them. He then emphasizes that in general it is the task of the price mechanism to adjust supply to demand; he thinks, however, that this mechanism is imperfect, if a long period has to lapse between production and the arrival of the product at the market, because "prices and orders give information concerning the prospective state of demand compared with the known facts of the present and future supply, but they give no clue to the changes in supply which they themselves are likely to cause."[31] He tries to show how periodic over- and underproduction may result from an increase in demand acting as an incentive to increased production. He here states explicitly what others assume tacitly, and thus his exposition completely gives away the question-begging nature of all such arguments. For he holds that under free competition, in the case considered, more and more people try to profit by the favorable situation, all ignoring one another's preparations, and "no force intervenes to check the continual increase in production until it reflects itself in declining orders and falling prices."[32] In this statement (according to which the price mechanism comes into action only when the products come on to the market, while, until then, producers can regulate the extent of their production solely according to the estimated total volume of demand) the fundamental error that can be shown to recur in all these theories is plainly revealed. It arises from a misconception of the deliberations that regulate the entrepreneur's actions and of the significance of the price mechanism.

If the entrepreneur really had to guide his decisions exclusively by his knowledge of the quantitative increase in the total demand for his product, and if the success of economic activity were really always dependent on that knowledge, no very complicated circumstances would be needed to produce constant disturbances in the relation between supply and demand. But the entrepreneur in a capitalist economy is not — as many economists seem to assume — in the same situation as the dictator of a socialist economy. The protagonists of this view seem to overlook the fact that production is generally guided not by any knowledge of the actual size of the total demand, but by the price to be obtained in the market. In the modern exchange economy, the entrepreneur does not produce with a view to satisfying a certain demand — even if that phrase is sometimes used — but on the basis of a calculation of profitability; and it is just that calculation that will equilibrate supply and demand. He is not in the least concerned with the amount by which, in a given case, the total amount demanded will alter; he only looks at the price he can expect to get after the change in question has taken place. None of the theories under discussion explains why these expectations should generally prove incorrect. (To deduce their incorrectness from the fact that overproduction, arising from false expectations, causes prices to fall, would be mere argument in a circle.) Nor can this generalization be theoretically established by any other method. For so long, at least, as disturbing monetary influences are not operating, we have to assume that the price that entrepreneurs expect to result from a change in demand or from a change in the conditions of production will more or less coincide with the equilibrium price. For the entrepreneur, from his knowledge of the conditions of production and the market, will generally be in a position to estimate the price that will rule after the changes have taken place, as distinct from the quantitative changes in the total volume of demand. One can only say, as to this prospective price of the product concerned, that it is just as likely to be lower than the equilibrium price as to be higher and that, on the average, it should more or less coincide, since there is no reason to assume that deviations will take place only in one direction. But this prospective price only represents one factor determining the extent of production. The other factor, no less important but all too often overlooked, is the price the producer has to pay for raw materials, labor power, tools and borrowed capital — i.e., his costs. These prices, taken together, determine the extent of production for all producers operating under conditions of competition; and the producer's decisions as to his production must be guided not only by changes in expectations as to the price of his product, but also by changes in his costs. To show how the interplay of these prices keeps supply and demand, production and consumption, in equilibrium, is the main object of pure economics, and the analysis cannot be repeated here in detail. It is, however, the task of trade cycle theory to show under what conditions a break may occur in that tendency towards equilibrium which is described in pure analysis — i.e., why prices, in contradiction to the conclusions of static theory, do not bring about such changes in the quantities produced as would correspond to an equilibrium situation. In order to show that the theories under discussion do not solve this problem, and only as far as is necessary for this purpose, we shall now study the most important of the interconnections which bring about equilibrium under the assumptions of static theory.

v

We may attempt this task by asking what kind of reactions will be brought about by the original change in the economic data that is supposed to cause the excessive extension of the production of capital goods, and how, in such cases, a new equilibrium can result. Whether the original impetus comes from the demand side or the supply side, the assumption from which we have to start is always a price — or rather an expected price — that renders it profitable under the new conditions to extend production. As stated above, we can assume — since none of the theories in question give any reason to the contrary — that this expected price will approximate to the new equilibrium price. We can assume, that is, that if the impetus is a fall in unit costs, the producer will consider the effects of an increased supply; if the impetus is an increase in demand, he will consider the increase in the cost per unit following the increase in the quantity produced. The existence of a general misconception in this respect would require a special explanation, and unless this is to rest on a circular argument, it can only be accounted for by a monetary explanation, which we cannot consider at this point.

Now the length of time required to produce modern means of production cannot induce a tendency to an excessive extension of the productive apparatus; or, more accurately, any such tendency is bound to be effectively eliminated by the increase in price of the factors of production. Thus we cannot give a sufficient explanation for the occurrence of the disproportionality in these terms. This becomes obvious as soon as we drop the assumption that the price mechanism begins to function only from the moment at which the increased supply comes on the market, and consider that whenever the price obtainable for the finished product is correctly estimated, the adjustment of the prices of factors of production must ensure that the amount produced is limited to what can be sold at remunerative prices. The mere existence of a lengthy production period cannot be held to impair the working of the price mechanism, so long, at any rate, as no additional reason can be given for the occurrence of a general miscalculation in the same direction concerning the effect of the original change in data on the prices of the products.

We must next inquire what truth there is in the alleged tendency towards a cumulative propagation of the effect of every increase (or decrease) of demand from the lower to the higher stages of production. The arguments given below against this frequently adduced theory must serve at the same time to refute all other theories based on similar technical considerations, for space will not permit us to go into every one of these, and the reader can be trusted to apply the same reasoning as is employed in this demonstration to all similar explanations — such as those based on the necessary discontinuity of the extension of productive apparatus. Does the cumulative effect of every increase in demand represent a new price-determining factor, as a result of which prices, and therefore quantities produced, will be different from those needed to achieve equilibrium? Is the regulating effect of prices on the extent of production really suspended by the fact that when turnover increases merchants try to increase stocks, and manufacturers to extend production? If the increase in the prices of production goods were the only counterbalancing factor to set against the increase in the demand for these goods, it would still be possible for more investments to be undertaken than would prove permanently profitable. According to the view we are considering, there will be an increase in the quantity of factors of production demanded at any price, as compared with the equilibrium situation, and therefore it would appear possible that at every price at which producers still think they can profitably make use of this quantity, investments will be undertaken to an unwarrantable extent.

This way of stating the position, however, entirely overlooks the fact that every attempt to extend the productive apparatus must necessarily bring about, besides the rise in factor prices, a further checking force: viz., a rise in the rate of interest. This greatly strengthens the effect of the rise in factor prices. It makes a greater margin between factor prices and product prices necessary just when this margin threatens to diminish. The maintenance of equilibrium is thus further secured.

For we must not forget that not only the volume of current production, but also the size at any given moment of the productive apparatus (including stocks, which cannot be omitted) is regulated through prices, and especially — apart from the above-mentioned prices for goods and services — by the price paid for the use of capital, that is, interest. Whatever particular explanation of interest we may accept, all contemporary theories agree in regarding the function of interest as one of equalizing the supply of capital and the demand arising in various branches of production. Until some special reason can be adduced why it should not fulfill this function in any given case, we have to assume, in accordance with the fundamental thesis of static theory, that it always keeps the supply of capital goods in equilibrium with that of consumption goods. This assumption is just as indispensable, and just as inevitable, as a starting point, as the main assumption that the supply of and demand for any kind of goods will be equilibrated by movements in the prices of those goods. In our case, when we are considering a tendency to enlarge the productive apparatus and the size of stocks, this function must be performed in such a way as to increase the rate of interest, and hence the necessary margin of profit between the price of the products and that of the means of production. This, however, automatically excludes that part of the increase in the demand for productive goods, which would have been satisfied despite the increase in their prices if the rise in the rate of interest had not taken place. None of the various trade cycle theories based on some alleged peculiarity of the technique of production can even begin to explain why the equilibrium position, determined by the various above-mentioned processes of price formation, should be reached at a different point from where it would be without these peculiarities.

Now as regards the prices of goods and services used for productive purposes, there seems to be no reason why they should not fulfill their function of equilibrating supply and demand. For supply and demand are here in direct relation with one another, so that any discrepancy which may arise between them, at a given price must, directly and immediately, lead to a change in that price. Only when we come to consider the second group of prices (those paid for borrowed capital or, in other words, interest) is it conceivable that disturbances might creep in, since, in this case, price formation does not act directly, by equalizing the marginal demand for and supply of capital goods, but indirectly, through its effect on money capital, whose supply need not correspond to that of real capital. But the process by which divergences can arise between these two is left unexplained by all the theories with which we have hitherto dealt. Yet before going on to see how far interest may present such a breach in the strict system of equilibrium as may serve to explain cyclical disturbances, we must briefly examine the explanation offered by the second important group of non-monetary theories, which attempt to explain the origin of periodical disturbances of equilibrium purely through the phenomena arising out of the accumulation and investment of saving.[33]

vi

The earlier versions of these theories start from the groundless and inadmissible assumption that unused savings are accumulated for a time and then suddenly invested, thus causing the productive apparatus to be extended in jerks. Such versions can be passed over without further analysis. For one thing, it is impossible to give any plausible explanation why unused savings should accumulate for a time;[34] for another thing, even if such an explanation were forthcoming, it would provide no clue to the disproportional development in the production of capital goods. The fact that the mere existence of fluctuations in saving activity does not in itself explain this problem is realized (in contrast to many other economists) by the most distinguished exponent of these theories, Prof. A. Spiethoff. This is plain from his negative answer to the analogous question, whether in a barter economy an increase in saving can create the necessary conditions for depression.[35] Indeed, it is difficult to see how spontaneous variations in the volume of saving (which are not themselves open to further economic explanation, and must therefore be regarded as changes of data) within the limits in which they are actually observed can possibly create the typical disturbances with which trade cycle theory is concerned.[36]

Where, then, according to these theories, may we find the reason for this genesis of disequilibrating disturbances in the processes of saving and investment? We will keep to the basis of Spiethoff's theory, which is certainly the most complete of its kind. We may disregard his simple reference to the "complexity of capital relations," for it does not in itself provide an explanation. The main basis of his explanation is to be found in the following sentence: "If capitalists and producers of immediate consumption goods want to keep their production in step with the supply of acquisitive loan capital, these processes should be consciously adjusted to one another."[37] But the creation of acquisitive loan capital ensues independently of the production of intermediate goods and durable capital goods; and conversely, the latter can be produced without the entrepreneur knowing the extent to which acquisitive capital (i.e., savings) exists and is available for investment; and thus there is always a danger that one of these processes may lag behind while the other hastens forward. This reference to the entrepreneur's ignorance of the situation belongs, however, to that category of explanation that we had to reject earlier. Instead of showing why prices — and in this case, particularly, the price of capital, which is interest — do not fulfill, or fail to fulfill adequately, their normal function of regulating the volume of production, it unexpectedly overlooks the fact that the extent of production is regulated on the basis not of a knowledge of demand but through price determination. Assuming that the rate of interest always determines the point to which the available volume of savings enables productive plant to be extended — and it is only by this assumption that we can explain what determines the rate of interest at all — any allegations of a discrepancy between savings and investments must be backed up by a demonstration why, in the given case, interest does not fulfill this function.[38] Professor Spiethoff, like most of the theorists of this group, evades this necessary issue — as we shall see later — by introducing another assumption of crucial importance. It is only by means of this assumption that the causes that he particularly enumerates in his analysis gain significance as an explanation; and therefore it should not have been treated as a self-evident condition, to be casually mentioned, but as the starting point of the whole theoretical analysis.

vii

Before going into this question, however, we must turn our attention to the importance in trade cycle theory of errors of forecast, and, in connection with these, to a third group of theories that have not been considered up to now: the psychological theories. Here, as elsewhere in our investigations, we shall only be concerned with those theories that are endogenous — i.e., which explain the origin of general under- and overestimation from the economic situation itself, and not from some external circumstance such as weather changes, etc. As we said earlier, fluctuations of economic activity that merely represent an adjustment to corresponding changes in external circumstances present no problem to economic theory. The various psychological factors cited are only relevant to our analysis in so far as they can cast light on its central problem: that is, how an overestimate of future demand can occasion a development of the productive apparatus so excessive as automatically to lead to a reaction, unprecipitated by other psychological changes. Those who are familiar with the most distinguished of these theories, that of Professor A.C. Pigou (which, owing to lack of space, cannot be reproduced here)[39] will see at once that the endogenous psychological theories are open to the same objections as the two groups of theories we have already examined. Professor Pigou does not explain why errors should arise in estimating the effect, on the price of the final product, of an increase in demand or a fall in cost — or, if the estimate is correct, why the readjustment of the prices of means of production should not check the expansion of production at the right point. No one would deny, of course, that errors can arise as regards the future movements of particular prices. But it is not permissible to assume without further proof that the equilibrating mechanism of the economic system will begin its work only when the excessively increased product due to these mistaken forecasts actually comes on the market, the disproportional development continuing undisturbed up to that time. At one point or another, all theories that start to explain cyclical fluctuations by miscalculations or ignorance as regards the economic situation fall into the same error as those naive explanations that base themselves on the "planlessness" of the economic system. They overlook the fact that, in the exchange economy, production is governed by prices, independently of any knowledge of the whole process on the part of individual producers, so that it is only when the pricing process is itself disturbed that a misdirection of production can occur. The "wrong" prices, on the other hand, which lead to "wrong" dispositions, cannot in turn be explained by a mistake. Within the framework of a system of explanations in which, as in all modern economic theory, prices are merely expressions of a necessary tendency towards a state of equilibrium, it is not permissible to reintroduce the old Sismondian idea of the misleading effect of prices on production without first bringing it into line with the fundamental system of explanation.

viii

It is perhaps scarcely necessary to point out that all the objections raised against the non-monetary theories, already cited in our investigations, are justified by one particular assumption that we had to make in order to examine the independent validity of the so-called "real" explanations. In order to see whether the "real" causes (whose effect is always emphasized as a proof that monetary changes are not the cause of cyclical fluctuations) can provide a sufficient explanation of the cycle, it has been necessary to study their operation under conditions of pure barter. And even if it were impossible to prove fully that, under these conditions, no non-monetary explanation is sufficient, enough has been said, I think, to indicate the general trend of thought which would refute all theories based exclusively on productive, market, financial, or psychological phenomena. None of these phenomena can help us to dissolve the fundamental equilibrium relationships that form the basis of all economic explanation. And this dissolution is indispensable if we are to protect ourselves against objections such as those outlined above.

If the various theories comprised in these groups are still able to offer a plausible explanation of cyclical fluctuations, and if their authors do not realize the contradictions involved, this is due to the unconscious importation of an assumption incompatible with a purely 'real' explanation. This assumption is adequate to dissolve the rigid reaction-mechanisms of barter-economy, and thus makes possible the processes described; but for this very reason it should not be treated as a self-evident condition, but as the basis of the explanation itself. The condition thus tacitly assumed — and one can easily prove that it is in fact assumed in all the theories examined above — is the existence of credit which, within reasonable limits, is always at the entrepreneur's disposal at an unchanged price. This, however, assumes the absence of the most important controls that, in the barter economy, keep the extension of the productive apparatus within economically permissible limits. Once we assume that, even at a single point, the pricing process fails to equilibrate supply and demand, so that over a more or less long period demand may be satisfied at prices at which the available supply is inadequate to meet total demand, then the march of economic events loses its determinateness and a range of indeterminateness appears, within which movements can originate leading away from equilibrium. And it is rightly assumed, as we shall see later on, that it is precisely the behavior of interest, the price of credit, which makes possible these disturbances in price formation. We must not, however, overlook the fact that the range of indeterminateness thus created is 'indeterminate' only in relation to the absolute determinateness of barter economy. The new price formation, together with the new structure of production determined by it, must in turn conform to certain laws, and the apparent indeterminateness does not imply unfettered mobility of prices and production. On the contrary, every departure from the original equilibrium position is definitely determined by the new conditioning factor. But if it is the existence of credit that makes these various disturbances possible, and if the volume and direction of new credit determines the extent of deviations from the equilibrium position, it is clearly not permissible to regard credit as a kind of passive element, and its presence as a self-evident condition. One must regard it rather as the new determining factor whose appearance causes these deviations and whose effects must form our starting point when deducing all those phenomena that can be observed in cyclical fluctuations. Only when we have succeeded in doing this can we claim to have explained the phenomena described.

The neglect to derive the appearance of disproportionality from this condition, which must be assumed in order to keep the argument within the framework of equilibrium theory, leads to certain consequences that are best exemplified in the work of Professor Spiethoff. For, in his theory, all-important interconnections are worked out in the fullest detail and none of the observed phenomena remains unaccounted for. But he is not able to deduce the various phenomena described from the single factor that, by virtue of its role in disturbing the interrelationships of general equilibrium, should form the basis of his explanation. At each stage of his exposition he calls in experience to back him up and to show what deviations from the equilibrium position actually occur within the given range of indeterminateness. Consequently it never becomes clear why these phenomena must always occur as they are described; and there always remains a possibility that, on some other occasion, they may occur in a different way, or in a different order, without his being able to account for this difference on the basis of his exposition. In other words the latter, however accurately and pertinently it describes the observed phenomena, does not qualify as a theory in the rigid sense of the word, for it does not set out those conditions in whose presence events must follow a scientifically determined course.

ix

Although there is no doubt that all non-monetary trade cycle theories tacitly assume that the production of capital goods has been made possible by the creation of new credit, and although this condition is often emphasized in the course of the exposition,[40] no one has yet proved that this circumstance should form the exclusive basis of the explanation. As far as strict logic is concerned, it would not be impossible for such theories to make use of some other assumption that is capable of dissolving the rigid interrelationships of equilibrium and, therefore, of forming the basis of an exact theoretical analysis. But once we assume the existence of credit in our explanation, we can attack the problem by seeing how far the objections raised earlier against the validity of the various theories under a barter economy are invalidated when the new assumption is made. Then we shall also be able to determine whether this assumption has necessarily to be made in the usual form, or whether it only represents a special instance of a far more widely significant extension of the assumptions of elementary theory.

The question we have to ask ourselves is: what new price-determining factor is introduced by the assumption of a credit supply that can be enlarged while other conditions remain unchanged — a factor capable of deflecting the tendency towards the establishment of equilibrium between supply and demand? Whether we necessarily accept the answer that, to my mind, is the only possible one depends on whether we agree with a certain basic proposition, which could only be briefly outlined here and whose full proof could only be given within the framework of a complete system of pure economics: namely, the proposition that, in a barter economy, interest forms a sufficient regulator for the proportional development of the production of capital goods and consumption goods, respectively. If it is admitted that, in the absence of money, interest would effectively prevent any excessive extension of the production of production goods, by keeping it within the limits of the available supply of savings, and that an extension of the stock of capital goods that is based on a voluntary postponement of consumers' demand into the future can never lead to disproportionate extensions, then it must also necessarily be admitted that disproportional developments in the production of capital goods can arise only through the independence of the supply of free money capital from the accumulation of savings, which in turn arises from the elasticity of the volume of money.[41] Every change in the volume of means of circulation is, in fact, an event to be distinguished from all other real causes, for the purpose of theoretical reasoning; for, unlike all others, it implies a loosening of the interrelationships of equilibrium. No change in "real" factors, whether in the amount of available means of production, in consumers' preferences, or elsewhere, can do away with that final identity of total demand and total supply on which every conception of economic equilibrium is based. A change in the volume of money, on the other hand, represents as it were a one-sided change in demand, which is not counterbalanced by an equivalent change in supply. Money, being a pure means of exchange, not being wanted by anyone for purposes of consumption, must by its nature always be re-exchanged without ever having entirely fulfilled its purpose; thus when it is present it loosens that finality and "closedness" of the system which is the fundamental assumption of static theory, and leads to phenomena that the closed system of static equilibrium renders inconceivable.[42]

Together with the "closedness" of the system there necessarily disappears the interdependence of all its parts, and thus prices become possible which do not operate according to the self-regulating principles of the economic system described by static theory. On the contrary, these prices may elicit movements that not only do not lead to a new equilibrium position but actually create new disturbances of equilibrium. In this way, through the inclusion of money among the basic assumptions of exposition, it becomes possible to deduce a priori phenomena such as those observed in cyclical fluctuations. One instance of these disturbances in the price mechanism, brought about by monetary influences — and the one which is most important from the point of view of trade cycle theory — is that putting out of action of the "interest brake" which is taken for granted by the trade cycle theories examined above. How far this circumstance forms a sufficient basis for a theory of the trade cycle is a problem of the concrete elaboration of monetary explanation, and will therefore be dealt with in the next chapter, where we shall examine how far existing monetary theories have already tackled those problems that are relevant to a theory of the trade cycle.

x

The purpose of the foregoing chapter was to show that only the assumption of primary monetary changes can fulfill the fundamentally necessary condition of any theoretical explanation of cyclical fluctuations — a condition not fulfilled by any theory based exclusively on "real" processes. If this is true then at the outset of theoretical exposition, those monetary processes must be recognized as decisive causes. For we can gain a theoretically unexceptionable explanation of complex phenomena only by first assuming the full activity of the elementary economic interconnections as shown by the equilibrium theory, and then introducing, consciously and successively, just those elements that are capable of relaxing these rigid interrelationships. All the phenomena that become possible only as a result of this relaxation must then be explained — as consequences of the particular elements, through whose inclusion among the elementary assumptions they become explicable within the framework of general theory. In place of such a theoretical deduction, we often find an assertion, unfounded on any system, of a far-reaching indeterminacy in the economy. Paradoxically stated as it is, this thesis is bound to have a devastating effect on theory; for it involves the sacrifice of any exact theoretical deduction, and the very possibility of a theoretical explanation of economic phenomena is rendered problematic.

Similar objections of a general nature must be leveled against another large group of theories that we have not yet mentioned. This group pays close attention to the monetary interconnections and expressly emphasizes them as a necessary condition for the occurrence of the processes described. But they fail to pass from this realization to the necessary conclusion — to make it a starting point for their theoretical elaboration, from which all other particular phenomena have to be deduced. To this group belongs the theory of Professor J. Schumpeter, and certain "underconsumption theories"[43] notably that of Professor E. Lederer — and, similarly, the various "realistic" theories: that is, those that renounce any unified theoretical deduction, such as those of Professors G. Cassel, J. Lescure and Wesley Mitchell. With regard to all these semi-monetary explanations, we must ask whether — once we have been compelled to introduce new assumptions foreign to the static system — it is not the first task of a theoretical investigation to examine all the consequences that must necessarily ensue from this new assumption, and, in so far as any phenomena are thus proved to be logically derivable from the latter, to regard them in the course of the exposition as effects of the new condition introduced. Only in this way is it possible to incorporate trade cycle theory into the static system that is the basis of all theoretical economics; and, for this very reason, the monetary elements must be regarded as decisive factors in the explanation of cyclical fluctuations. The contrast therefore can be reduced to a question of theoretical presentation, and it may even seem, when comparing these theories, that the matter of the express recognition of the monetary starting point is one of purely methodological or even terminological importance, having no bearing on the essential solution of the problem. But the same procedure that in one case may only lead to a lapse from theoretical elegance, breaking the unity of the theoretical structure, may in another case lead to the introduction of thoroughly faulty reasoning, against which only a rigid systematical procedure provides an effective security.

Lecture III: Monetary Theories of the Trade Cycle

i

The argument of the foregoing chapters has demonstrated the main reason for the necessity of the monetary approach to trade cycle theory. It arises from the circumstance that the automatic adjustment of supply and demand can only be disturbed when money is introduced into the economic system. This adjustment must be considered, according to the reasoning that it most clearly expressed in Say's Théorie des Débouchés, as being always present in a state of natural economy. Every explanation of the trade cycle that uses the methods of economic theory — which of course is only possible through systematic coordination of the former with the fundamental propositions of the latter — must, therefore, start by considering the influences that emanate from the use of money. By following up their results it should be possible to demonstrate the total effect on the economic system, and formulate the result into a coordinated whole. This must be the aim of all theories that set out to explain disturbances in equilibrium, which by their very nature cannot be regarded as immediate consequences of changes in data, but only as arising out of the development of the economic system itself. For that typical form of disturbance that experience shows to be regularly recurrent, and that can properly be called the trade cycle, the influence of money should be sought in the fact that when the volume of money is elastic, there may exist a lack of rigidity in the relationship between saving and the creation of real capital. This is a fact that nearly all the theories of the disproportional production of capital goods are agreed in emphasizing. It is, therefore, the first task of monetary trade cycle theory to show why and how monetary influences directly bring about regular disturbances in just this part of the economic system.

ii

Naturally no attempt will be made at this stage to present such a theory systematically. This chapter is concerned with one particular task: it attempts to show how far existing monetary theories have already gone towards a satisfactory solution of the problem of the trade cycle, and what corrections are needed in order to invalidate certain objections that, up to the present, have appeared well founded.

It should already be clear that what we expect from a monetary trade cycle theory differs considerably from what most of the monetary trade cycle theories regard as the essential aim of their explanation. We are in no way concerned to explain the effect of the monetary factor on trade fluctuations through changes in the value of money and variations in the price level — subjects that form the main basis of current monetary theories. We expect such an explanation to emerge rather from a study of all the changes originating in the monetary field — more especially variations in its quantity — changes that are bound to disturb the equilibrium interrelationships existing in the natural economy, whether the disturbance shows itself in a change in the so-called "general value of money" or not. Our plea for a monetary approach to all trade cycle theory does not, therefore, imply that henceforward such theories should be exclusively, or even principally, based on those arguments that usually predominate in writings on money, and that set out to explain the general level of prices and alterations in the "value of money." On the contrary, monetary theory should not merely be concerned with money for its own sake, but should also study those phenomena that distinguish the money economy from the equilibrium interrelationships of barter economy that must always be assumed by "pure economies."

It must of course be admitted that many trade cycle theorists regard the importance of monetary theory as residing precisely in its ability to explain the cause of fluctuations by reference to changes in the general price level. Hence, it is not difficult to understand why certain economists believe that, once they have rejected this view, they have settled once and for all with the monetary explanations of the trade cycle. It is not surprising that monetary theories of the trade cycle should be rejected by those who, like Professor A. Spiethoff in his well-known work on the quantity theory as "Haussetheorie,"[44] identify them with the naive quantity theory explanations that derive fluctuations from changes in the price level.[45] Against such a conception it can rightly be urged that there are a number of phenomena tending to bring about fluctuations, which certainly do not depend on changes in the value of money, and which can, in fact, exert a disturbing effect on the economic equilibrium without these changes occurring at all. Again, in spite of many assertions to the contrary, fluctuations in the general price level need not always be ascribed to monetary causes.[46]

iii

But theories that explain the trade cycle in terms of fluctuations in the general price level must be rejected not only because they fail to show why the monetary factor disturbs the general equilibrium, but also because their fundamental hypothesis is, from a theoretical standpoint, every bit as naive as that of those theories which entirely neglect the influence of money. They start off with a "normal position" which, however, has nothing to do with the normal position obtaining in the static state; and they are based on a postulate, the postulate of a constant price level, which, if fulfilled, suffices in itself to break down the interrelationships of equilibrium. All these theories, indeed, are based on the idea — quite groundless but hitherto virtually unchallenged — that if only the value of money does not change it ceases to exert a direct and independent influence on the economic system. But this assumption (which is present, more or less, in the work of all monetary theorists), so far from being the necessary starting point for all trade cycle theory, is perhaps the greatest existing hindrance to a successful examination of the course of cyclical fluctuations. It forces us to assume variations in the effective quantity of money as given. Such variations, however, always dissolve the equilibrium interrelationships described by static theory; but they must necessarily be assumed if the value of money is to remain constant despite changes in data; and therefore they cannot be used to explain deviations from the course of events which static theory lays down. The only proper starting point for any explanation based on equilibrium theory must be the effect of a change in the volume of money; for this, in itself, constitutes a new state of affairs, entirely different from that generally treated within the framework of static theory.

In complete contrast to those economic changes conditioned by "real" forces, influencing simultaneously total supply and total demand, changes in the volume of money have, so to speak, a one-sided influence that elicits no reciprocal adjustment in the economic activity of different individuals. By deflecting a single factor, without simultaneously eliciting corresponding changes in other parts of the system, it dissolves its "closedness," makes a breach in the rigid reaction mechanism of the system (which rests on the ultimate identity of supply and demand) and opens a way for tendencies leading away from the equilibrium position. As a theory of these one-sided influences, the theory of monetary economy should, therefore, be able to explain the occurrence of phenomena that would be inconceivable in the barter economy, and notably the disproportional developments that give rise to crises.[47] A starting point for such explanations should be found in the possibility of alterations in the quantity of money occurring automatically and in the normal course of events, under the present organization of money and credit, without the need for violent or artificial action by any external agency.

iv

Even if a systematic treatment of the trade cycle problem has not yet been forthcoming, it should be noted that, throughout the different attempts at monetary explanation, there runs a secondary idea that is closely allied to that of the direct dependence of fluctuations on changes in the value of money. It is true that this idea is used merely as a subordinate device of technique to assist in the explanation of fluctuations in the value of money. But its development included the analysis of the most important elements in the monetary factors chiefly connected with the trade cycle. This was done in the teaching that began with H. Thornton[48] and D. Ricardo[49] and was taken up again by H.D. Macleod,[50] H. Sidgwick, R. Giffen and J.S. Nicholson,[51] and finally developed by A. Marshall,[52] K. Wicksell,[53] and L. v. Mises,[54] whose works trace the development of the effects on the structure of production of a rate of interest that alters relatively to the equilibrium rate, as a result of monetary influences. For the purpose of this review it is unnecessary to go back to the earlier representatives of this group; it is enough to consider the conceptions of Wicksell and Mises, since both the recent improvements that have been effected and the errors that still subsist can be best examined on the basis of these studies.[55]

It must be taken for granted that the reader is acquainted with the works of both Wicksell and Mises. Wicksell, from the outset,[56] regards the problem as concerning explicitly the average change in the price of goods, which from the theoretical standpoint is quite irrelevant. He starts from the hypothesis that, in the absence of disturbing monetary influences, the average price level must remain unchanged. This assumption is based on another, only incidentally expressed,[57] which is not worked out and which, from the point of view of most of the problems dealt with, is not even permissible: i.e., the assumption of a stationary state of the economy. His fundamental thesis is that when the money rate of interest coincides with the natural rate (i.e., that rate which exactly balances the demand for loan capital and the supply of savings)[58] then money bears a completely neutral relationship to the price of goods, and tends neither to raise nor to lower it. But, owing to the nature of his basic assumptions, this thesis enables him to show deductively only that every lag of the money rate behind the natural rate must lead to a rise in the general price level, and every increase of the money rate above the natural rate to a fall in general price level. It is only incidentally, in the course of his analysis of the effects on the price level of a money rate of interest differing from the natural rate that Wicksell touches on the consequences of such a distortion of the natural price formation (made possible by elasticity in the volume of currency) on the development of particular branches of production; and it is this question that is of the most decisive importance to trade cycle theory. If one were to make a systematic attempt to coordinate these ideas into an explanation of the trade cycle (dropping, as is essential, the assumption of the stationary state) a curious contradiction would arise. On the one hand, we are told that the price level remains unaltered when the money rate of interest is the same as the natural rate; and, on the other, that the production of capital goods is, at the same time, kept within the limits imposed by the supply of real savings. One need say no more in order to show that there are cases — certainly all cases of an expanding economy, which are those most relevant to trade cycle theory — in which the rate of interest that equilibrates the supply of real savings and the demand for capital cannot be the rate of interest that also prevents changes in the price level.[59] In this case, stability of the price level presupposes changes in the volume of money: but these changes must always lead to a discrepancy between the amount of real savings and the volume of investment. The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price level stable, is always lower than the rate that would keep the amount of available loan capital equal to the amount simultaneously saved by the public: and thus, despite the stability of the price level, it makes possible a development leading away from the equilibrium position. But Wicksell does not recognize here a monetary influence tending, independently of changes in the price level, to break down the equilibrium system of barter economics: so long as the stability of the price level is undisturbed, everything appears to him to be in order.[60] Obsessed by the notion that the only aim of monetary theory is to explain those phenomena that cause the value of money to alter, he thinks himself justified in neglecting all deviations of the processes of money economy from those of barter economy, so long as they throw no direct light on the determination of the value of money: and thus he shuts the door on the possibility of a general theory covering all the consequences of the phenomena he indicates.[61] But although his thesis of a direct relationship between movements in the price level and deviations of the money rate of interest from its natural level, holds good only in a stationary state, and is therefore inadequate for an explanation of cyclical fluctuations, his account of the effects of this deviation on the price structure and the development of the various branches of production constitutes the most important basis for any future monetary trade cycle theory. But this future theory, unlike that of Wicksell, will have to examine not movements in the general price level but rather those deviations of particular prices from their equilibrium position that were caused by the monetary factor.

v

The investigations of Professor Mises represent a big step forward in this direction, although he still regards the fluctuations in the value of money as the main object of his explanation, and deals with the phenomena of disproportionality only in so far as they can be regarded as consequences — in the widest sense of the term — of these fluctuations. But Professor Mises's conception of the intrinsic value of money extends the notion of "fluctuations in money value" far beyond the limits of what this term is commonly understood to mean; and so he is in a position to describe within the framework, or rather under the name, of a theory of fluctuations in the value of money, all monetary influences on price formation.[62] His exposition already contains an account of practically all those effects of a rate of interest altered through monetary influences, which are important for an explanation of the course of the trade cycle. Thus he describes the disproportionate development of various branches of production and the resulting changes in the income structure. And yet this presentation of his theory under the guise of a theory of fluctuation in the value of money remains dangerous, partly because it always gives rise to misunderstandings, but mainly because it seems to bring into the foreground a secondary effect of cyclical fluctuations, an effect that generally accompanies the latter but need not necessarily do so.

This is no place to examine the extent to which Professor Mises escapes from this difficulty by using the concept of the inner objective value of money. For us, the only point of importance is that the effects of an artificially lowered rate of interest, pointed out by Wicksell and Mises, exist whether this same circumstance does or does not eventually react on the general value of money, in the sense of its purchasing power. Therefore they must be dealt with independently if they are to be properly understood.[63] Increases in the volume of circulation, which in an expanding economy serve to prevent a drop in the price level, present a typical instance of a change in the monetary factor calculated to cause a discrepancy between the money and natural rate of interest without affecting the price level. These changes are consequently neglected, as a rule, in dealing with phenomena of disproportionality; but they are bound to lead to a distribution of productive resources between capital goods and consumption goods that differs from the equilibrium distribution, just as those changes in the monetary factor that do manifest themselves in changes in the price level. This case is particularly important, because under contemporary currency systems, the automatic adjustment of the value of money in the form of a flow of precious metals will regularly make available new supplies of purchasing power that will depress the money rate of interest below its natural level.[64]

Since a stable price level has been regarded as normal hitherto, far too little investigation has been made into the effects of these changes in the volume of money, which necessarily cause a development different from that which would be expected on the basis of static theory and which lead to the establishment of a structure of production incapable of perpetuating itself once the change in the monetary factor has ceased to operate. Economists have overlooked the fact that the changes in the volume of money, which, in an expanding economy, are necessary to maintain price stability, lead to a new state of affairs foreign to static analysis, so that the development that occurs under a stable price level cannot be regarded as consonant with static laws. Thus the disturbances described as resulting from changes in the value of money form only a small part of the much wider category of deviations from the static course of events brought about by changes in the volume of money — which may often exist without changes in the value of money, while they may also fail to accompany changes in value of money when the latter occur.

vi

As has been briefly indicated above, most of the objections raised against monetary theories of cyclical fluctuations rest on the mistaken idea that their significant contribution consists in deducing changes in the volume of production from the movement of prices en bloc. In particular, the very extensive criticism recently leveled by Dr. Burchardt and Professor Lowe against monetary trade cycle theory is based throughout on the idea that this theory must start from the wave-like fluctuations of the price level, which are conditioned mainly by monetary causes; the rise, as well as the fall, of the price level being brought about by particular new forces originating on the side of money. It is only through this special assumption, which is also stated explicitly, that Professor Lowe's systematic presentation of his objections in his latest work[65] becomes comprehensible; he is completely misleading when he asserts that, if it is to raise the monetary factor to the rank of a conditio sine qua non of the trade cycle, monetary theory ought to prove that the effectiveness of all non-monetary factors depends on a previous price boom.[66] We have already shown that it is not even necessary, in order to ascribe the cause of cyclical fluctuations to monetary changes, to assume that these monetary causes act through changes in the general price level. It is therefore impossible to maintain that the importance of monetary theories lies solely in an explanation of price cycles.[67]

But even the essential point in the criticism of Lowe and Burchardt — the assertion that all monetary theories explain the transition from boom to depression not in terms of monetary causes but in terms of other causes super-added to the monetary explanation — rests exclusively on the idea that only general price changes can be recognized as monetary effects. But general price changes are no essential feature of a monetary theory of the trade cycle; they are not only unessential, but they would be completely irrelevant if only they were completely "general" — that is, if they affected all prices at the same time and in the same proportion. The point of real interest to trade cycle theory is the existence of certain deviations in individual price relations occurring because changes in the volume of money appear at certain individual points; deviations, that is, away from the position that is necessary to maintain the whole system in equilibrium. Every disturbance of the equilibrium of prices leads necessarily to shifts in the structure of production, which must therefore be regarded as consequences of monetary change, never as additional separate assumptions. The nature of the changes in the composition of the existing stock of goods, which are effected through such monetary changes, depends of course on the point at which the money is injected into the economic system.

There is no doubt that the emphasis placed on this phenomenon marks the most important advance made by monetary science beyond the elementary truths of the quantity theory. Monetary theory no longer rests content with determining the final reaction of a given monetary cause on the purchasing power of money, but attempts instead to trace the successive alterations in particular prices, which eventually bring about a change in the whole price system.[68] The assumption of a "time lag" between the successive changes in various prices has not been spun out of thin air solely for the purposes of trade cycle theory; it is a correction, based on systematic reasoning, of the mistaken conceptions of older monetary theories.[69] Of course, the expression "time lag," borrowed from Anglo-American writers and denoting a temporary lagging behind of the changes in the price of some goods relatively to the changes in the price of other goods, is a very unsuitable expression when the shifts in relative prices are due to changes in demand that are themselves conditioned by monetary changes. For such shifts are bound to continue so long as the change in demand persists. They disappear only with the disappearance of the disturbing monetary factor. They cease when money ceases to increase or diminish further — not, however, when the increase or diminution has itself been wiped out. But, whatever expression we may use to denote these changes in relative prices and the changes in the structure of production conditioned by them, there can be no doubt that they are, in turn, conditioned by monetary causes, which alone make them possible.

The only plausible objection to this argument would be that the shifts in price relationships occurring at any point in the economic system could not possibly cause those typical, regularly recurring, shifts in the structure of production that we observe in cyclical fluctuations. In opposition to this view, as we shall show in more detail later, it can be urged that those changes that are constantly taking place in our money and credit organization cause a certain price — the rate of interest — to deviate from the equilibrium position, and that deviations of this kind necessarily lead to such changes in the relative position of the various branches of production as are bound later to precipitate the crisis.[70] There is one important point, however, that must be emphasized against the above-named critics: namely, that it is not only when the crisis is directly occasioned by a new monetary factor, separate from that which originally brought about the boom, that it is to be regarded as conditioned by monetary causes. Once the monetary causes have brought about that development in the whole economic system which is known as a boom, sufficient forces have already been set in motion to ensure that, sooner or later, when the monetary influence has ceased to operate, a crisis must occur. The "cause" of the crisis is, then, the disequilibrium of the whole economy occasioned by monetary changes and maintained through a longer period, possibly, by a succession of further monetary changes — a disequilibrium the origin of which can only be explained by monetary disturbances.

Professor Lowe's most important argument against the monetary theory of the trade cycle — an argument that so far as most existing monetary theories are concerned is unquestionably valid — will be discussed in more detail later. The sole purpose of the next chapter of this book is to show that the cycle is not only due to "mistaken measures by monopolistic bodies" (as Professor Lowe assumes),[71] but that the reason for its continuous recurrence lies in an "immanent necessity of the monetary and credit mechanism."

vii

Among the phenomena that are fundamentally independent of changes in the value of money, we must include, first of all, the effects of a rate of interest lowered by monetary influences, which must necessarily lead to the excessive production of capital goods. Wicksell and Mises both rightly emphasize the decisive importance of this factor in the explanation of cyclical phenomena, as its effect will occur even when the increase in circulation is only just sufficient to prevent a fall in the price level. Besides this, there exist a number of other phenomena, by virtue of which a money economy (in the sense of an economy with a variable money supply) differs from a static economy, which for this reason are important for a true understanding of the course of the trade cycle. They have been partly described already by Mises, but they can only be clearly observed by taking as the central subject of investigation not changes in general prices but the divergences of the relation of particular prices as compared with the price system of static equilibrium. Phenomena of this sort include the changes in the relation of costs and selling prices and the consequent fluctuations in profits, which Professors Mitchell and Lescure in particular have made the starting point of their exposition; and the shifts in the distribution of incomes that Professor Lederer investigates — both of these phenomena depending for their explanation on monetary factors,[72] while neither of them can be immediately connected with changes in the general value of money. It is, perhaps, for this very reason that their authors, although perfectly realizing the monetary origin of the phenomena they described, did not present their views as monetary theories. While we cannot attempt here to show the position these phenomena would occupy in a systematically developed trade cycle theory (a task that really involves the development of a new theory, and is unnecessary for the purposes of our present argument) it is not difficult to see that all of them can be logically deduced from an initiating monetary disturbance,[73] which, in any case, we are compelled to assume in studying them. The special advantages of the monetary approach consist precisely in the fact that, by starting from a monetary disturbance, we are able to explain deductively all the different peculiarities observed in the course of the trade cycle, and so to protect ourselves against objections such as were raised in an earlier chapter against non-monetary theories. It makes it possible to look upon empirically recognized interconnections, which would otherwise rival one another as independent clues to an explanation, as necessary consequences of one common cause.

Much theoretical work will have to be done before such a theoretical system can be worked out in such detail that all the empirically observed characteristics of the trade cycle can find their explanation within its framework. Up to now, the monetary theories have unduly narrowed the field of phenomena to be explained, by limiting research to those monetary changes that find their expression in changes in the general value of money. Thus they are prevented from showing the deviations of a money economy from a static economy in all their multiplicity. The problem of cyclical fluctuations can only be solved satisfactorily when a theory of the money economy itself — still almost entirely lacking at present — has been evolved, comprising a detailed discussion of all those points in which it differs from the equilibrium analysis worked out on the assumption of a pure barter economy. The full elaboration of this intermediate step of theoretical exposition is indispensable before we can achieve a trade cycle theory, which — as Böhm-Bawerk has expressed it in a phrase, often quoted but hardly ever taken to heart — must constitute the last chapter of the complete theory of social economy.[74] In my opinion, the most important step towards such a theory, which would embrace all new phenomena arising from the addition of money to the conditions assumed in elementary equilibrium theory, would be the emancipation of the theory of money from the restrictions that limit its scope to a discussion of the value of money.

viii

Once, however, we have accomplished this urgently necessary displacement of the problem of monetary value from its present central position in monetary theory, we find ourselves in a position to come to an understanding with the most important non-monetary theorists of the trade cycle; for the effect of money on the "real" economic processes will automatically be brought more to the surface, while monetary theory will no longer appear to be insisting on the immediate dependence of trade cycle phenomena on changes in the value of money — a claim which is certainly unjustified. On the other hand, a number of non-monetary theories do not question in the least the dependence of the processes they describe on certain monetary assumptions; and in their case the only conflict now arising concerns the systematic presentation of these. It should be the task of our analysis to show that the placing of the monetary factor in the center of the exposition is necessary in the interest of the unity of the system, and that the various "real" interconnections, which, in certain theories, form the main basis of the explanation, can only find place in a closed system as consequences of the original monetary influences. There can hardly be any question, in the present state of research, as to what should be the basic idea of a completely developed theory of money. One can abandon those parts of the Wicksell-Mises theory that aim at explaining the movements in the general value of money, and develop to the full the effects of all discrepancies between the natural and money rates of interest on the relative development of the production of capital goods and consumption goods — a theory that has already been largely elaborated by Professor Mises. In this way, one can achieve, by purely deductive methods, the same picture of the process of cyclical fluctuations that the more realistic theories of Spiethoff and Cassel have already deduced from experience. Wicksell himself[75] drew attention to the way in which the processes deduced from his own theory harmonize with the exposition of Spiethoff; and conversely, Spiethoff, in a statement already quoted, has emphasized the fact that the phenomena he describes are all conditioned by a change in monetary factors. But it is only by placing monetary factors first that such expositions as those of Spiethoff and Cassel can be incorporated into the general system of theoretical economics. A final point of decisive importance is that the choice of the monetary starting point enables us to deduce simultaneously all the other phenomena — such as shifts in relative prices and incomes — that are more empirically determined and utilized as independent factors, and thus the relations existing between them can be classified and their relative position and importance determined within the framework of the theory.

Even when these phenomena are, as yet, much further from a satisfactory explanation than are the disproportionalities in the development of production, which are cleared up in a greater degree, there can be no doubt that it will become possible to incorporate them also into a self-sufficient theory of the effects of monetary disturbances. These effects, however, although ultimately caused by monetary factors, do not fall within the narrower field of monetary theory. A well-developed theory of the trade cycle ought to deal thoroughly with them; but as this book is exclusively concerned with the monetary theories themselves, we shall, in the following chapters, only study the reasons why these monetary causes of the trade cycle inevitably recur under the existing system of money and credit organization, and what are the main problems with which future research is faced by reason of the realization of the determining role played by money.

Lecture IV: The Fundamental Cause of Cyclical Fluctuations

i

So far we have not answered, or have only hinted at an answer to the question why, under the existing organization of the economic system, we constantly find those deviations of the money rate of interest from the equilibrium rate[76] which, as we have seen, must be regarded as the cause of the periodically recurring disproportionalities in the structure of production. The problem is, then, to discover the gap in the reaction mechanism of the modern economic system that is responsible for the fact that certain changes of data, so far from being followed by a prompt readjustment (i.e., the formation of a new equilibrium) are, actually, the cause of recurrent shifts in economic activity that subsequently have to be reversed before a new equilibrium can be established.

The analysis of the foregoing chapters has shown that when it is possible to detect, in the organization of our economy, a dislocation in the reaction mechanism described by equilibrium theory, it should be possible (and should, indeed, be the object of a fully developed trade cycle theory) to describe deductively, as a necessary effect of the disturbance — quite apart from their observed occurrence — all the deviations in the course of economic events conditioned by this dislocation. It has been shown, in addition, that the primary cause of cyclical fluctuations must be sought in changes in the volume of money, which are undoubtedly always recurring and which, by their occurrence, always bring about a falsification of the pricing process, and thus a misdirection of production. The new element we are seeking is, therefore, to be found in the "elasticity" of the volume of money at the disposal of the economic system. It is this element whose presence forms the "necessary and sufficient" condition for the emergence of the trade cycle.[77] The question we now have to examine is whether this elasticity in the volume of money is an immanent characteristic of our present money and credit system; whether, given certain conditions, changes in the volume of money and the resulting differences between the natural and the monetary rate of interest must necessarily occur, or whether they represent, so to speak, casual phenomena arising from arbitrary interferences by the authorities responsible for the regulation of the volume of currency media. Is it an inherent necessity of the existing monetary and credit system that its reaction to certain changes in data is different from what we should expect on the basis of economic equilibrium theory; or are these discrepancies to be explained by special assumptions regarding the nature of the monetary administration, i.e., by a series of what might be called "political" assumptions? The question whether the recurrence of credit cycles is, or is not, due to an unavoidable characteristic of the existing economic organization, depends on whether the existing monetary and credit organization in itself necessitates changes in the currency media, or whether these are brought about only by the special interference of external agencies. The answer to this question will also decide into which of the most commonly accepted categories a given trade cycle theory is to be placed. We must deal briefly with this point because a false classification, which is largely the fault of the exponents of the monetary theories, has contributed much to make them misunderstood.

ii

If we are to understand the present status of monetary theories of the trade cycle, we must pay special attention to the assumptions upon which they are based. At the present day, monetary theories are generally regarded as falling within the class of so-called "exogenous" theories, i.e., theories that look for the cause of the cycle not in the interconnections of economic phenomena themselves but in external interferences. Now it is, no doubt, often a waste of time to discuss the merits of classifying a theory in a given category. But the question of classification becomes important when the inclusion of a theory in one class or another implies, at the same time, a judgment as to the sphere of validity of the theory in question. This is undoubtedly the case with the distinction, very general today, between endogenous and exogenous theories — a distinction introduced into economic literature some twenty years ago by Bouniatian.[78] Endogenous theories, in the course of their proof, avoid making use of assumptions that cannot either be decided by purely economic considerations, or regarded as general characteristics of our economic system — and hence capable of general proof. Exogenous theories, on the other hand, are based on concrete assertions whose correctness has to be proved separately in each individual case. As compared with an endogenous theory, which, if logically sound, can in a sense lay claim to general validity, an exogenous theory is at some disadvantage, inasmuch as it has, in each case, to justify the assumptions on which its conclusions are based.

Now as far as most contemporary monetary theories of the cycle are concerned, their opponents are undoubtedly right in classifying them, as does Professor Lowe[79] in his discussion of the theories of Professors Mises and Hahn, among the exogenous theories; for they begin with arbitrary interferences on the part of the banks. This is, perhaps, one of the main reasons for the prevailing skepticism concerning the value of such theories. A theory that has to call upon the deus ex machina[80] of a false step by bankers, in order to reach its conclusions is, perhaps, inevitably suspect. Yet Professor Mises himself — who is certainly to be regarded as the most respected and consistent exponent of the monetary theory of the trade cycle in Germany — has, in his latest work, afforded ample justification for this view of his theory by attributing the periodic recurrence of the trade cycle to the general tendency of central banks to depress the money rate of interest below the natural rate.[81] Both the protagonists and the opponents of the monetary theory of the trade cycle thus agree in regarding these explanations as falling ultimately within the exogenous and not the endogenous group. The fact that this is not an inherent necessity of the monetary starting point is however shown by the undoubtedly endogenous nature of the various older trade cycle theories, such as that of Wicksell. But since this suffers from other deficiencies, which have already been indicated, the question of whether the exogenous character of modern theories is or is not an inherent necessity of their nature remains an open one.[82] It seems to me that this classification of monetary trade cycle theory depends exclusively on the fact that a single especially striking case is treated as the normal, while in fact it is quite unnecessary to adduce interference on the part of the banks in order to bring about a situation of alternating boom and crisis. By disregarding those divergencies between the natural and money rate of interest that arise automatically in the course of economic development, and by emphasizing those caused by an artificial lowering of the money rate, the monetary theory of the trade cycle deprives itself of one of its strongest arguments; namely, the fact that the process it describes must always recur under the existing credit organization, and that it thus represents a tendency inherent in the economic system, and is in the fullest sense of the word an endogenous theory.

It is an apparently unimportant difference in exposition that leads one to this view that the monetary theory can lay claim to an endogenous position. The situation in which the money rate of interest is below the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the "natural rate" (at which the demand for and the supply of savings are equal) above its previous level; while the banks refrain from raising their rate of interest to a proportionate extent, but continue to lend at the previous rate, and thus enable a greater demand for loans to be satisfied than would be possible by the exclusive use of the available supply of savings. The decisive significance of the case quoted is not, in my view, due to the fact that it is probably the commonest in practice, but to the fact that it must inevitably recur under the existing credit organization.

iii

The notion that the increase in circulation is due to arbitrary interference by the banks owes its origin to the widespread view that banks of issue are the exclusive or predominant agencies that can change the volume of the circulation; and that they do so of their own free will. But the central banks are by no means the only factor capable of bringing about a change in the volume of circulating media;[83] they are, in their turn, largely dependent upon other factors, although they can influence or compensate for these to a great extent. Altogether, there are three elements that regulate the volume of circulating media within a country — changes in the volume of cash, caused by inflows and outflows of gold; changes in the note circulation of the central banks: and last, and in many ways most important, the often-disputed "creation" of deposits by other banks. The interrelations of these are, naturally, complicated.

As regards original changes in the first two factors — that is, changes that are not set in motion by changes in one of the other factors — there is comparatively little to say. It has already been pointed out that, in principle, an increase in the volume of cash, occasioned by an increase in the volume of trade, also implies a lowering of the money rate of interest — which gives rise to shifts in the structure of production that seem, though only temporarily, to be advantageous. It must certainly appear very problematical whether the deviations in the money rate of interest thus occasioned would, as a rule, be large enough to cause fluctuations of an empirically ascertainable magnitude. Central banks, on the other hand, are by law or custom bound to preserve such a close connection between note issues and cash holdings that we have no reason to assume that they, and they alone, provide the original impetus. Of course, it is possible to assume, with Professor Mises, that the central banks, under the pressure of an inflationist ideology, are always trying to expand credit and thus provide the impetus for a new upward swing of the trade cycle; and this assumption may be correct in many cases. The credit expansion is then conditioned by special circumstances, which need not always be present; and the cyclical fluctuations caused by it are, therefore, not the necessary consequence of an inherent tendency of our credit system, for the removal of the special circumstances would eliminate them. But before deciding in favor of this special assumption — which requires a proof of its own, to be given separately in the case of each cycle — we have to ask whether, in some other part of our credit system, such extensions may not take place automatically under certain conditions — without the necessity for any special assumption of the inadequate functioning of any part of the system. To me this certainly appears to be true as regards the third factor of money expansion — the "credit creation" of the commercial banks. There are few questions upon which scientific literature, especially in Germany, is so lacking in clarity as on the possibility and importance of an increase in circulating media due to the granting of additional credit by the banks of deposit. To give an answer to the question of whether credit creation is a regular consequence of the existing organization of banking, we shall have to attempt to clear up our conception of the methods and extent of such credit creation by deposit banks. Besides dealing with the fundamental question of the possibility of credit creation and the limits to which it can extend, we shall have to discuss two special questions that are important for our further investigations: namely, whether the practical importance of credit creation depends upon certain practices of banking technique, as is often assumed; and secondly, whether it is, in fact, possible to determine whether a given issue of credit represents credit freshly created or not.

If in the course of our investigation, it is possible to prove that the rate of interest charged by the banks to their borrowers is not promptly adjusted to all changes in the economic data (as it would be if the volume of money in circulation were constant) — either because the supply of bank credit is, within certain limits, fundamentally independent of changes in the supply of savings, or because the banks have no particular interest in keeping the supply of bank credit in equilibrium with the supply of savings and because it is, in any case, impossible for them to do so — then we shall have proved that, under the existing credit organization, monetary fluctuations must inevitably occur and must represent an immanent feature of our economic system — a feature deserving of the closest examination.

iv

The main reason for the existing confusion with regard to the creation of deposits is to be found in the lack of any distinction between the possibilities open to a single bank and those open to the banking system as a whole.[84] This is connected with the fact that, in Germany, the whole theory has been taken over bodily from England, where, owing to differences in banking technique, the limits imposed on any individual bank are, perhaps, somewhat less narrow, so that the general possibilities open to the banking system as a whole have not been indicated with the degree of emphasis that their importance deserves. In Germany, following the popular exposition of Mr. Hartley Withers, the most generally accepted view starts from English banking practice, which (except in the case of "overdrafts") credits the account of the customer with the amount borrowed before the latter is actually utilized. Granted this assumption, the process leading to an increase of circulating media is comparatively easy to survey and therefore hardly ever disputed. So long and in so far as the credit a bank is able to grant, considering its cash position, remains on current account — and in the United States, for example, it is a regular condition for the granting of a loan that the current account of the borrower shall never fall below a certain relatively high percentage of the sum borrowed[85] — every new grant of credit must, of course, bring about an equivalent increase of deposits and a proportionately smaller diminution of cash reserves. Against these "deduced deposits" (Phillips) which regularly occur in the normal course of business, the banks naturally have to keep only a certain percentage of cash reserve; an