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C. Secondary Developments of the Business Cycle
In the previous section we have presented the basic process of the business cycle. This process is often accentuated by other or “secondary” developments induced by the cycle. Thus, the expanding money supply and rising prices are likely to lower the demand for money. Many people begin to anticipate higher prices and will therefore dishoard. The lowered demand for money raises prices further. Since the impetus to expansion comes first in expenditure on capital goods and later in consumption, this “secondary effect” of a lower demand for money may take hold first in producers’-goods industries. This lowers the price-and-profit differentials further and hence widens the distance that the rate of interest will fall below the free-market rate during the boom. The effect is to aggravate the need for readjustment during the depression. The adjustment would cause some fall in the prices of producers’ goods anyway, since the essence of the adjustment is to raise price differentials. The extra distortion requires a steeper fall in the prices of producers’ goods before recovery is completed.
As a matter of fact, the demand for money generally rises at the beginning of an inflation. People are accustomed to thinking of the value of the monetary unit as inviolate and of prices as remaining at some “customary” level. Hence, when prices first begin to rise, most people believe this to be a purely temporary development, with prices soon due to recede. This belief mitigates the extent of the price rise for a time. Eventually, however, people realize that credit expansion has continued and undoubtedly will continue, and their demand for money dwindles, becoming lower than the original level.
After the crisis arrives and the depression begins, various secondary developments often occur. In particular, for reasons that will be discussed further below, the crisis is often marked not only by a halt to credit expansion, but by an actual deflation—a contraction in the supply of money. The deflation causes a further decline in prices. Any increase in the demand for money will speed up adjustment to the lower prices. Furthermore, when deflation takes place first on the loan market, i.e., as credit contraction by the banks—and this is almost always the case—this will have the beneficial effect of speeding up the depression-adjustment process. For credit contraction creates higher price differentials. And the essence of the required adjustment is to return to higher price differentials, i.e., a higher “natural” rate of interest. Furthermore, deflation will hasten adjustment in yet another way: for the accounting error of inflation is here reversed, and businessmen will think their losses are more, and profits less, than they really are. Hence, they will save more than they would have with correct accounting, and the increased saving will speed adjustment by supplying some of the needed deficiency of savings.
It may well be true that the deflationary process will overshoot the free-market equilibrium point and raise price differentials and the interest rate above it. But if so, no harm will be done, since a credit contraction can create no malinvestments and therefore does not generate another boom-bust cycle.113 And the market will correct the error rapidly. When there is such excessive contraction, and consumption is too high in relation to savings, the money income of businessmen is reduced, and their spending on factors declines—especially in the higher orders. Owners of original factors, receiving lower incomes, will spend less on consumption, price differentials and the interest rate will again be lowered, and the free-market consumption/ investment ratios will be speedily restored.
Just as inflation is generally popular for its narcotic effect, deflation is always highly unpopular for the opposite reason. The contraction of money is visible; the benefits to those whose buying prices fall first and who lose money last remain hidden. And the illusory accounting losses of deflation make businesses believe that their losses are greater, or profits smaller, than they actually are, and this will aggravate business pessimism.
It is true that deflation takes from one group and gives to another, as does inflation. Yet not only does credit contraction speed recovery and counteract the distortions of the boom, but it also, in a broad sense, takes away from the original coercive gainers and benefits the original coerced losers. While this will certainly not be true in every case, in the broad sense much the same groups will benefit and lose, but in reverse order from that of the redistributive effects of credit expansion. Fixed-income groups, widows and orphans, will gain, and businesses and owners of original factors previously reaping gains from inflation will lose. The longer the inflation has continued, of course, the less the same individuals will be compensated.114
Some may object that deflation “causes” unemployment. However, as we have seen above, deflation can lead to continuing unemployment only if the government or the unions keep wage rates above the discounted marginal value products of labor. If wage rates are allowed to fall freely, no continuing unemployment will occur.
Finally, deflationary credit contraction is, necessarily, severely limited. Whereas credit can expand (barring various economic limits to be discussed below) virtually to infinity, circulating credit can contract only as far down as the total amount of specie in circulation. In short, its maximum possible limit is the eradication of all previous credit expansion.
The business-cycle analysis set forth here has essentially been that of the “Austrian” School, originated and developed by Ludwig von Mises and some of his students.115 A prominent criticism of this theory is that it “assumes the existence of full employment” or that its analysis holds only after “full employment” has been attained. Before that point, say the critics, credit expansion will beneficently put these factors to work and not generate further malinvestments or cycles. But, in the first place, inflation will put no unemployed factors to work unless their owners, though holding out for a money price higher than their marginal value product, are blindly content to accept the necessarily lower real price when it is camouflaged as a rise in the “cost of living.” And credit expansion generates further cycles whether or not there are unemployed factors. It creates more distortions and malinvestments, delays indefinitely the process of recovery from the previous boom, and makes necessary an eventually far more grueling recovery to adjust to the new malinvestments as well as to the old. If idle capital goods are now set to work, this “idle capacity” is the hangover effect of previous wasteful malinvestments, and hence is really sub-marginal and not worth bringing into production. Putting the capital to work again will only redouble the distortions.116
- 113. If some readers are tempted to ask why credit contraction will not lead to the opposite type of malinvestment to that of the boom—overinvestment in lower-order capital goods and underinvestment in higher-order goods—the answer is that there is no arbitrary choice open of investing in higher-order or lower-order goods. Increased investment must be made in the higher-order goods—in lengthening the structure of production. A decreased amount of investment simply cuts down on higher-order investment. There will thus be no excess of investment in the lower orders, but simply a shorter structure than would otherwise be the case. Contraction, unlike expansion, does not create positive malinvestments.
- 114. If the economy is on a gold or silver standard, then many advocates of a free market will argue for credit contraction for the following additional reasons: (a) to preserve the principle of paying one's contractual obligations and (b) to punish the banks for their expansion and force them back toward a 100-percent-specie reserve policy.
- 115. Mises first presented the “Austrian theory” in a notable section of his Theory of Money and Credit, pp. 346–66. For a more developed statement, see his Human Action, pp. 547–83. For F.A. Hayek's important contributions, see especially his Prices and Production, and also his Monetary Theory and the Trade Cycle (London: Jonathan Cape, 1933), and Profits, Interest, and Investment. Other works in the Misesian tradition include Robbins, The Great Depression, and Fritz Machlup, The Stock Market, Credit, and Capital Formation (New York: Macmillan & Co., 1940).
- 116. See Mises, Human Action, pp. 577–78; and Hayek, Prices and Production, pp. 96–99.