Mises Daily Articles
On the Problem of Business Cycles
There are as many causes for fluctuations in economic life as there are external conditions of economizing. Each of these conditions can change and thereby effect a change in the course of the economic process. If the economy is affected to a greater extent, if farther reaching changes prove necessary and, in particular, if a lasting change in an external determinant of the economy causes disruptions in the economy for a longer period of time, then one can speak of an economic crisis. In all of these cases, the process occurring in the economy is one of an adjustment to changed data; as compared with the smallest fluctuations which arise daily in the course of an economy, we are simply faced with a change in the dimension of the effects. However, since experience has shown that there is a certain regularity in the fluctuations of an economy — a regularity which in no way receives a satisfactory explanation from the coincidental external disturbances — one has attempted to find a specific cause for these regular cycles. Of the various crisis theories or cycle theories (since one is not only concerned with explaining a more or less "acute" crisis, but rather with a regular recurrence of upswings and downswings), today probably only those theories which can already be found in the original literary debate on the crisis problem and which look for the causes of cyclic movements of an economy in the conditions of the money market demand a right to general recognition. The following explanations, too, acknowledge the correctness of the "circulation credit theory of economic crisis," usually called monetary theory of the trade cycle.
Two circumstances speak for the fact that this theory is on the right track in the search for the cause of economic cycles. Let me first present something from experience: The process of a cyclic upswing and the development to a crisis corresponds precisely to what theory can deduce as the effect of expanding credit. Yet, there is another thing that has to do with the starting point of the theorem: When one of the magnitudes of the economic system is changed, a movement will be released that causes an adjustment of the economic system to this change. However, if the change begins with the interest rate, there is one peculiarity in this adjustment. Lowering the interest rate initiates a movement which cannot be an adaptation to data in the sense that this data will in the end be incorporated in a stationary economic course. Credit expansion occurring hand in hand with a drop in the interest rate leads to a continual movement away from equilibrium. We first presented the effects of credit expansion without regard to the crisis problem. There we saw that if they reach their final effects without inhibition, the effects of credit expansion lead to an immobilization of all capital investments. Apparently, this is a movement which does not incorporate a tendency towards equilibrium, i.e., to a stationary economic course. We have also seen that the effect of credit expansion ultimately leads to tensions so that a discontinuation of the policy of credit expansion can be expected.
We will begin with this situation in our analysis of the business cycle. Only later will we have to prove that the upswing of the cycle actually leads to a situation which is structured so as to provide the justification for our choice of a starting point.
Let it be said in advance that the method of analyzing the business cycle will be other than that which we used previously in our explanations. We can roughly describe it by saying that here we will not use the same "exact" method we applied up to now when examining the temporal structuring of production. Later we will have the opportunity to justify this change in method. Then we will see that it is necessary for the treatment of the following topic.
The Two Turning Points of the Business Cycle
Upon ceasing to expand credit, the state of the economy that arose in consequence of credit expansion entails the possibility that a further economic process will bring about an adjustment to the existing data. When credit is no longer expanded, the monetary element of disruption is eliminated. The only capital now available to the economy is that portion of previously saved capital that can be freed from a production process — disregarding here entirely the formation of capital through new saving. We will have to show shortly that in this situation circumstances will also arise which will prevent an undisturbed adjustment to the actual data, i.e., that will lead the economy away from the tendency towards equilibrium. Before we consider this in detail, let us first explain how such a process of adjustment to the data resulting from ceasing credit expansion would develop.
Since the supply of capital is too scarce to make possible the continuation of the already begun "too lengthy" roundabout methods of production, a discontinuation of production must result. The relatively (and probably also absolute) high interest rate will function as the selection principle for the possibility of continuing production processes. By raising the interest rate, the competition among entrepreneurs for free capital prevents those entrepreneurs who can no longer pay the going rate from continuing production. The consequence of stopping production will be the freeing up of factors of production — capital goods as well as laborers — whose prices thus must sink. After what has previously been explained, it is no longer necessary to point out that this pressure on the prices of factors of production must not necessarily lead to these prices reaching a low point at which the supply of the factors under consideration can be absorbed entirely. If in particular — and this is generally also the case when there are no price controls — a lowering of the labor wage only occurs slowly, and if it is not possible, or only possible with great difficulty, to go below a certain minimum, then greater unemployment will occur. With regard to the subsistence fund, it shall only be pointed out that the small supply of capital is identical to a reduced provision of subsistence means for the purpose of supporting roundabout methods of production. The smaller wage fund must correspond to a smaller number of laborers unless the full effect of wage pressure has correspondingly lowered the price of labor. The restrictions in production and the drop in the prices of many intermediate products will frequently result in losses. The losses of invested capital can hit not only entrepreneurs and private owners of capital but also banks that created and distributed credit. It is not necessary to present the generally known phenomenon of an economic crisis in greater detail here.
Discontinuing production processes will not occur in a systematic way. For ultimately, the course of events is determined by the actions of individual entrepreneurs who adjust to actual market conditions. In particular, the fact that the investments consist to a large extent of fixed capital equipment representing a large cost value will cause it not to come to a complete halt of already initiated production processes exclusively. Instead, the process will frequently be determined by attempts to free invested capital. Thus, factors of production will be used to finish a production process even if its lasting continuation does not appear possible. In addition to a need for free capital to continue productions, a need will also arise for capital acquired for the purpose of liquidating existing investments. If on the one hand there is now an increased demand for capital, then on the other hand a successful liquidation can mean the availability of new free capital for production. Here, too, one must note that this freeing up of capital can only occur by producing finished consumer goods; only then has an "economic" liquidation of a capital investment occurred. Wherever the liquidation only means that capital goods are being sold, we simply have the case we have repeatedly mentioned before of an interpersonal change in the position of liquidity. The prerequisite for this case is that free money capital is already available somewhere else. With regard to freeing up capital, however, let us point out yet another circumstance that arises in the course of the adjustment. A disruption of the economy might often result in production processes being continued in which new cost expenditures are justified by a corresponding revenue but in which at the same time continued production of the necessary renewal fund is not possible (or not possible to a sufficient extent).1 Because of this, there will be a significant shortage in the supply of capital. What is significant in this respect is: The freeing up of capital does not take place to the extent necessary for the lasting continuation of production, including all necessary reinvestments. As long as a production process is continued which does not make reinvestments, the result must be disemployment in preceding production stages.
Thus, the process of adjustment which follows once the expansion of credit is halted is not at all a simple one. The demand for capital will vary according to the given situation (besides the demand expressed in order to continue production there is initially also greater demand for the purpose of liquidating production processes) as will the supply. There will be an increase in the supply through liquidation of previously invested capital, and a lack in the supply for those cases in which the production of a renewal fund is not possible and probably can only occur in the process of a readjustment of the economy. In effect, one can assume that the relatively small amount of free capital available at the outbreak of the crisis will increase in the course of this adjustment. One can assume that under these circumstances the adaptation will not occur in one uninterrupted sweep, but that there will be a longer period of continuing fluctuations. However, we have no reason to assume that a complete adjustment to the point of equilibrium — a gliding of the economy into a static economic course — would not be possible here. Regarding the interest rate, it can probably be assumed that at the beginning of the recovery from the crisis situation it will be higher and only later will slowly go down; and one can probably also assume that the degree of employment of laborers will increase with an increase in the supply of capital. The details of this movement towards a mutual adjustment of the individual elements of the economy shall not be explained further here.
However, attaining an equilibrium is dependent on one essential prerequisite, and we must now investigate whether its existence can be assumed. If we run into a new disruptive circumstance while analyzing the liquidation of the crisis, we will have to draw the consequence that the movement cannot lead to an equilibrium. Here again we are at the question of the supply of monetary capital and the height of the interest rate. The tendency towards adapting to an equilibrium can only arise under the condition of the "neutrality" of money. The prerequisite here is that the supply of monetary capital is the same as the supply of actually saved capital.2 Ignoring the case of new savings, such real savings can only have grown out of the returns from consumer-goods production, i.e., from the freeing up of previously saved capital, with respect to which saving will now be "maintained." Wherever else monetary capital appears, it can only have reached an economic subject through the transfer of capital that is ultimately freed up in the production of consumer goods. The identity of monetary capital with saved capital here means a neutrality of money. In this sense, neutrality of money is a natural prerequisite for the crisis leading to an equilibrium. Whereas earlier we deduced the course of that process which leads to a crisis from the injection of additional credit, we will now attempt to show that in the process of liquidating the crisis a distraction from the movement towards equilibrium must be expected because money which could assume the function of capital is withdrawn from the sequence of turnovers. Whereas we saw that in the course of the upswing a credit expansion brought about a lead in the supply of money capital over the size of the supply of saved capital, we now wish to show that during a depression the supply of money capital lags behind — as compared to the extent of it which would be possible according to the output of production. Here we will first present individual circumstances in isolation that work in this direction, and only later attempt to find the link uniting them.
A first reason for the non-neutral behavior of money is already clear from the conditions that lead to a halt in the expansion of credit. The "over-straining of the credit system" will not only cause the banks to discontinue the further expansion of credit, but to restrict the amount of credit they grant. In addition to this, the symptoms of the crisis — collapses and connected losses, "freezing" of credit — make it likely that the banks will make the relationship between their cash reserves and their granted credit more favorable. Hence, the volume of credit will be restricted and banks will recall cash. Something very similar can also be expected outside the area of banks: Considering the insecurity of conditions and the danger of not maintaining liquid assets — the lack of expected payments, the impossibility of withdrawing from deposits, the difficulty of obtaining credit — many firms will increase their cash reserves. As compared to the adjustment process that we have studied, all of this means a disruption in the course of an economy by withdrawing money from the circulatory system of payments.3
There would have been two possible ways of using this money in the economy. It could have served in the purchase of consumer goods whereby the owner of the money would have consumed it.4 This would simply be a case of capital consumption: Previous savings were not maintained. The effects of such a procedure are not taken into consideration here. Let us notice that this situation can also occur in the course of a liquidation of the crisis; the effects of capital consumption will not be different in this special case than in any other. The other possibility open to the owner of money would have been to invest this money. This would have corresponded to the procedure in a static economy. The money would thus have been used for the payment of originary factors of production (directly from its owner or via an intermediate hand or an intermediate stage). The latter would have brought about a productive contribution and, moreover, would have purchased the consumer goods represented by this money with their monetary income. If investment does not occur here and the money is kept in the entrepreneurs' or banks' reserves, and a previously repeatedly granted circulation credit is no longer granted, then the demand for originary factors of production will be decreased and hence also the demand for a means of subsistence. The situation is then as follows: The means of subsistence which are waiting to be purchased by the consumers are available, but the money which should go to consumers and help them finance a purchase disappears in the course of withdrawing credit. The result will be a drop in the price of consumer goods. Here something could occur which is completely analogous to the case of the unemployed laborers in the crisis. If the prices of consumer goods do not drop to an appropriate degree — perhaps as a result of more or less narrow ties on the market — then to a large extent they will be "unsellable."5 However, the drop in the prices of consumer goods will initiate the tendency towards restricting their production.6
Now the economy is in a peculiar situation. A specific amount of consumer goods has been produced and is confronted with a monetary demand which at the current prices only allows a portion of them to be taken up. The rest of the consumer goods could be available for the support of roundabout production processes, but it cannot assume this function because the money is lacking which should lead it to such use. The economy's supply of consumer goods could be an expanded supply of free capital, but the economy does not use these available consumer goods as free capital. Finished available consumer goods form, so to speak, a potential supply of capital. The money necessary for their purchase is there at first, but it disappears in the reserves or is "destroyed" (recall of credit), so that these finished subsistence means are neither directly supplied to consumption, nor are they drawn on to support originary factors of production used in roundabout production methods by investing this money. The result is a progressive drop in prices and a progressive shrinking of production. And a peculiar kind of situation regarding the interest rate results: The interest rate is higher than it would have to be. If for instance the lack of credit we have seen here were balanced by "a compensatory creation of credit" — as we will still see this is a very problematic thing — then the interest rate could be below that height which actually results from the supply of monetary capital. In any case, the effects of the crisis must be sharpened by this decline in monetary capital.
Let us recall here what we said earlier about the general function of capital. If in its real-goods form as a subsistence fund free capital should make the support of roundabout production methods possible, then on the one hand, it must be suitable to serve as the support for originary factors of production. But on the other hand, it must also be made available by its owner for the time period during which it is to be tied up. In a money economy, monetary capital assumes the latter function — the function of "bridging time." What we have seen here is simply that money which could assume the function of monetary capital is eliminated from economic circulation. Thus, something entirely new is brought into the process of liquidating the crisis. Whereas in our first examination the crisis had simply meant an adjustment of the production structure to a supply of capital that was too small for the present structure, now we are faced with yet another development which leads to a narrowing of the supply of capital. In our first examination we generally saw an adjustment in the area of production processes prior to the production of consumer goods. Now the effect of the crisis will also be felt in the production of consumer goods. The range of the effect of the crisis will thus be expanded considerably. The situation is probably that all of those external symptoms of the course of the economic crisis presented in detail in descriptive economics do not take effect with all their consequences through the simple process of an adjustment to a too limited supply of capital, but instead only through the effects of the reduction in the volume of credit.
It must now be shown that this situation of the economy, in particular the state of the capital market, will lead to even further-reaching disruptive moments. Something is first to be expected that is closely linked to the appearance of a reduced volume of credit which previously was the basis for our analysis. There we said that banks which are paid back credit in many cases do not redistribute this credit. However, what about those cases in the economy in which economic subjects receive a sum of money that can be invested as capital? Recalling credit by the banks is first justified essentially by the desire for an improvement in the relationship between their liabilities and their cash reserves. The increase of cash reserves by many firms can be explained in a similar way. Beyond this we will also see a desire for increased liquidity arise in another sense. Owners of capital who have invested capital in some way and are faced with many losses they themselves have suffered or that they see occurring repeatedly in the economy will generally strive to withdraw their capital from investments. This will not apply to all owners of capital, but it will occur frequently — even if not at the beginning of the crisis then in the course of the crisis — partly because capital can often only be withdrawn from an investment slowly. Insofar as owners of capital hoard money, the effects will be the same as in the earlier described case. Frequently, however, money that is withdrawn from investments is reinvested in another way: The owner of capital will no longer be prepared to make an investment of capital that can only be freed up slowly or with difficulty; "liquid" investments in the sense that the capital can be easily and surely withdrawn at any time will be preferred. The common rule is: Money will flow from the capital market to the money market. The result of a progression of this transformation will be the situation characteristic of the advanced depression known from experience: that an increased supply of short-term money credit keeps the interest rate low for this kind of capital investment, whereas capital wanted for a more lengthy investment is very expensive (or practically unavailable).7
With this development, however, the economic cycle has entered a new stage. In the economic crisis, we first saw a severe lack of capital. A high interest rate reflects the imbalance between a large demand for capital arising from the continuation of too lengthy roundabout production processes and a small supply of capital. Then we saw that the lack of capital (so to speak "natural" for a crisis situation) will even grow through monetary changes. Because a withdrawal of credit occurs and higher cash reserves are maintained, a lack of money capital results. The situation is such that the general economic conditions cause the economic subjects to change their behavior regarding the allocation of money to the function of capital. The banks do not take advantage of the possibilities of granting credit to the same degree as heretofore. Entrepreneurs (and also the banks) seek to maintain increased cash reserves and refrain from bringing the money they have received onto the capital market to the previous extent. The result of this movement is a reduction in the amount of money employed as monetary capital for investment and a relatively larger (that is, as compared to the "economic volume") supply of cash reserves. The process of withdrawing money from the function of capital finally changes such that a transformation occurs in the way money is invested. It can probably be assumed that this change will have been preceded by an existent saturation of the economy with cash reserves and a plentiful supply of cash reserves covering credit still granted by the banks. When it no longer seems appropriate to further increase one's own liquid assets, when liquidity in the sense of a supply of cash money is already so advanced that its expansion is no longer regarded as necessary, and when the question arises of what should happen with the money capital that has become free, then in many cases a depression will bring about a specific attitude: Primarily short-term ("liquid") investments will be sought for liquid assets. In an advanced depression, a rich supply of liquid monies will be found next to a small supply of capital for long-term investments.
Here we must characterize the motivations that will become decisive in this situation in even greater detail. It must be pointed out once again that the investment of free capital is never something that results with economic necessity from the material supplies of the economy. The situation is such that an economic subject owns money (in the barter economy: the means of subsistence), which he can either consume or invest. The choice remains with the individual economic subject and the motives which spur the individual determine the extent to which money will be offered as capital. Now it is clear that the phenomena of the economic crisis will influence the motives of the economic subjects, also in the sense that wherever capital investments are made, they will be made with greater care. Every investment means assuming a risk, and the desire to assume such a risk will probably be lower after the disruptions of the economic crisis. This applies to loaning capital by individual owners of capital as well as to the banks which, even with large cash reserves and full liquidity, will largely shy away from assuming risks. Thus, even insofar as the general conditions for the possibility of providing a supply of capital are concerned if the conditions for the appearance of a larger supply of capital are very unfavorable, then in addition the situation is one in which the objective data of the economy will not stimulate increased investment. As long as prices fall — we have already pointed out the reasons for this movement — investments are only too easily tied to losses. Putting off an investment can mean that it will be carried out at a lower cost. Anticipating the possibility of falling product prices provides yet another reason for holding back. If the uncertainty of further developments increases the danger of a loss, the owner of capital will not be very inclined to make money available to an entrepreneur; and the entrepreneur in turn will not be inclined to invest his own money or by taking on credit assume a responsibility that may become oppressive with a further decline in prices.8
This situation must lead to a surplus on the money market (the market for short-term investments). Particularly for the banks, a flood of money will appear whose investment will be considered as completely liquid and recallable at any time; for logically this will frequently be viewed as the safest and most convenient form of a short-term investment. However, upon investing these short-term monies, the banks will run into difficulties, and this situation will depress the interest rate paid for these investments and under certain circumstances make it disappear entirely. This situation will lead to a further withdrawal of money from circulation if the banks see their cash reserves grow beyond their intended level.
How, then, can short-term loans of monetary capital be used in production? The expanded supply of capital will only be able to have an effect here if those production processes which permit an imminent freeing up of capital with a short production length are continuously expanded. For an economy in which there are significant investments of fixed capital, this will mean in practice that the existing investments will be used to a greater extent for current production; they will be provided with a richer supply of "operating capital"; but on the other hand, money will not be available to a corresponding degree for the purpose of investment. Even the renewal fund obtained from the revenues of production will frequently not be used for reinvestment, but instead will seek a short-term investment on the money market.
Now we have developed the theoretical analysis of the course of a depression to a point at which the disturbances gradually cease. The effect of monetary movements comes to a halt. Additional recalls of credit and additional hoarding of money no longer take place. The economy's supply of capital becomes richer, but short-term investments are preferred. With a rich supply of liquid capital, production continues, but investments, and in particular reinvestments, are greatly curtailed. With the elimination of monetary disturbances the drop in prices will come to a halt. A certain degree of stability in the economy is reached.9
Thus, the conditions for a new upswing exist. It is clear which movement becomes the initiating force here: The wall which holds back capital on the "money market" and prevents its flow onto the capital market must be torn down. We have mentioned two circumstances that determine the situation characteristic of a depression on the capital market: the owners of capital refrain from long-term investments and the profitability of these investments with falling prices is reduced. When the absence of monetary disruptions brings the fall in prices to a halt, then it is only necessary that the psychological prerequisites for the transition to increased long-term investments, to new investments, exist; the conviction that the economy is no longer regressing must again raise the willingness for long-term investments. This willingness must exist among the owners of capital who no longer demand complete liquidity for their investments, but it must also exist among the entrepreneurs who assume credit in order to tie it up in long-term investments. As soon as a larger supply appears on the market for long-term capital investments and as soon as the investments in which an entrepreneur wants to invest appear attractive, there is a possibility for expanding production.
It is important for us here to examine in detail what will reach the market as a supply of money capital. The question again revolves around the problem of the neutrality of money. The situation here is apparently a reflection of one which appeared before the beginning of the crisis. If during the upswing an excessive supply of monetary capital surpasses the supply of real saved capital, then after the turning point, the supply of monetary capital which does not reach the potential real capital is that disruptive monetary element which prevents the adjustment towards an equilibrium. If whatever initiated the unusual movement of the depression now disappears, then we are again faced with the question of whether the ensuing adjustment will lead to an equilibrium.
This would be the case if only those sums of money would appear as monetary capital which represented available means of subsistence and which were thus derived from a (newly carried out or maintained) act of saving. To the extent that only money which previously had been placed in short-term investments reaches the market for long-term capital investments, this prerequisite indeed exists. However, the conditions of the economy's supply of money will lead to a situation in which sums of money, which have not in the same sense been saved, also reach the capital market. In the course of the depression, cash reserves have been increased and credit has been withdrawn whereby the banks have achieved a significantly more favorable position with respect to their cash liquidity. Furthermore, in the course of the short-term capital investments, capital has remained temporarily unemployed, and far beyond the intentions of the economy they have perhaps led to an even greater increase in the cash reserves. Significant reserves of money are available in the economy which can be offered as monetary capital. A supply of capital can come from this which doubtless must function as additional credit. Of course, all of the money of which we have spoken here was at one time actually saved capital. Only effectively freed up capital investments have assumed the form of freely available money, and the choice of employing it as capital has remained open. Refraining from using this money for investment (or for consumption) once caused this money to be withdrawn from economic circulation: the portion of the consumer goods output corresponding to this money was not purchased with it. This loss of demand has caused a change in production. If these sums of money that once arose from saving but were then "decapitalized" now appear as a supply of money capital, they will function to increase credit. The same thing naturally applies in the other case, namely, in the case that new credits are granted in the form of bank deposits.
The result is that in the first movement of the upswing following the depression, a disruptive element of monetary expansion takes over — an expansion of monetary capital as compared to the supply of real saved capital arising from the current production process. The movement does not lead to an equilibrium but instead contains a disequilibrating element.
To be sure, the effect of additional amounts of money is not the only stimulating force in the course of an upswing. If production is expanded, if in particular favorable prices are thereby achieved, then not only will corresponding renewal funds be formed which are available as capital, but profits will also be attained which — insofar as they are saved — increase capital. This, so to speak, natural growth of capital can in itself cause an upward movement of the economy. Insofar as no more than this occurs, the movement cannot lead to a crisis; rather it can only be a movement which indicates an adjustment to a richer supply of capital. However, if in addition to this saved capital, other money appears on the market which increases the supply of capital beyond this extent, then the interest rate will thereby be held below the rate corresponding to the supply of real saved capital. An excessive expansion of the roundabout methods of production must be the consequence.
We previously presented the effect of this movement by beginning with an expansion of credit undertaken by the banks. Insofar as this formulation describes the source of additional credit, it surely is too narrow. It can probably be assumed that the banks will grant additional credit. This is because they are able to reduce their cash reserves at a time when the economy appears to be on the upswing. But in any case, "new" money will appear on the capital market from the economy. This will be that money which was previously hoarded and served to increase cash reserves. If there is great liquidity everywhere so that credit can be obtained easily, then there is no longer a reason to keep a liquid reserve in the form of enlarged cash holdings. All of this money will not reach the capital market directly; it will not all be used by the owners themselves for the purchase of originary factors of production and capital goods. In many cases it will be passed on via the banks whereby it can serve as the basis for granting more bank credit. However, for the problem at issue here it is irrelevant where the additional supply on the capital market comes from and what the ultimate sources for the non-neutral money are. What is essential is that the supply of monetary capital is not derived exclusively from savings, and hence that the interest rate will be depressed below that rate at which the length of the roundabout production processes is adjusted to the economy's supply of real saved capital.
Hence, the upswing does not lead to an equilibrium, but rather to a regular change between upswing and downswing.
Is the Recurrence of Crises Necessary?
The Problem of Trade Cycle Policy
If we review the path we took in analyzing the moments between the two turning points in the business cycle, we find the cause of these movements in a deficient operation of those forces which adjust the structure of production — the length of the roundabout production methods — to the supply of real capital. In an upswing, an increased supply of monetary capital leads to an excessive expansion of roundabout production. If this movement can no longer be maintained and a rise in the interest rate forces the roundabout production to be shortened, a situation is thereby created which in turn leads to the withdrawal of money from economic circulation, and production arrives at a state which is the counterpart of an upswing. Saved capital is available that is not used in production, and the result is a shrinking of production which is not justified by the supply of real goods. Only the new appearance of money that had previously been withdrawn from the function of capital on the capital market leads again to an upswing, but simultaneously prevents a movement towards an equilibrium. Thus the movement leads to a new crisis.
Is this movement necessary, or is it possible to stabilize the wave-like movements of economic life? This question, which perhaps some see today as one of the most important questions of the existing economic order, leads us to examine in detail the characteristics of those elements which have an effect on the recurrence of economic cycles. Whereas we have repeatedly presented the conditions of the supply of capital as decisive for the cyclical movements, we must now point out that in these situations it is not exclusively economic necessities that are effective, but also changes in the behavior of economic subjects. This has to do with the fact that what enters the market as capital is always determined solely by people who either offer something they own to others as capital or use it themselves as capital. In the barter economy only real goods can be used as capital. There can be no more capital than there are goods actually available. If real goods are not used as capital, then they will be used up in "pure consumption," they will be available for later use or they spoil. The situation is different in the monetary economy. Capital appears in the form of monetary capital. Money received in the course of an economic transaction by an economic subject can be consumed by him or used as capital. In this case, a "monetary" disruption cannot occur. However, money can also be withdrawn from circulation. Insofar as this is the case — and it seems to us that in the course of the economic crisis this is to be expected — this withdrawal of money operates as an element pulling away from equilibrium and leading to a depression. If this money later returns to the economy, then again the movement must pass by the equilibrium and lead to a new crisis.
In this situation, the question now arises whether the intervention of economic policy could remove the deviations from the path towards equilibrium and prevent the economy from repeatedly fluctuating between upswings and downswings. The answer to this question might vary according to whether one has in mind the theoretical possibility or the chance of carrying it out in practice. From a purely theoretical viewpoint, the question can be answered in the affirmative to the extent that the theory is permitted to exclude the possibilities of changes in human behavior regarding the employment of money as capital. Wherever the expansion or restricion of the volume of credit operates as a disruptive element, a corresponding countereffect by the central bank — ignoring here again other banks10 — can be initiated at any time. We recall here a previously used formula. If the central bank were an organization equipped with perfect knowledge regarding economic phenomena, then at any time it could secure the complete neutrality of money via a corresponding restriction or expansion of the circulation of money. Hence, it could paralyze every disequilibrating tendency resulting from monetary causes. This can occur in every stage of an upswing or a downswing. We have already mentioned that this perfect knowledge of the central bank can never be assumed, and that the central bank cannot find a reliable index anywhere in the economy on which it could base its policy. However, a certain crude interference has always been a characteristic practice of central banks: During a boom the interest rate is raised; thereby the continuation of the upswing with all of the results that must ensue when the excessive lengthening of roundabout production is allowed to run full course is halted. In turn, in a depression the central bank often tries to stimulate an upswing by granting more credit. We will have more to say about this shortly. In both cases, however, it can only be a matter of leading the economy past the two turning points more quickly — to lead it onto a path which, given the circumstances, has become a necessary one. At best, a true stabilization policy would probably begin either at the start of a downswing such that the contraction of credit will be compensated by credit from the central bank, or at an early point in the upswing so that the expansion of credit will be balanced by a restriction in the volume of money issued by the central bank.11 This is the theoretical rule.
In practice, however, one would first have to ask how the economy would react to such a policy of the central bank. This is not solely a matter of necessary economic relationships. That the effect of an "automatic" expansion or contraction of credit in the economy could be counteracted by opposite measures taken by the central bank must initially be beyond dispute. It is only questionable whether the economy would not react in another way; namely that with such a policy of the central bank, men would change their behavior so that the policy of the central bank would be rendered futile.
Let us begin with the start of a downswing in the cycle. The here given shortage of credit has a specific socioeconomic function: It should force the entrepreneurs to liquidate the excessive lengthening of roundabout production methods. It is a healing force, to use a metaphorical expression. If the central bank would eliminate this result of a credit shortage by granting additional credit, then this apparently would lead to lengthening the crisis. This policy of the central bank would only mean that roundabout production methods are continued which in the long run cannot be maintained. It would perhaps be able to weaken the monetary effects of the crisis, but in the long run it would have to sharpen the crisis. For it leads from the given stage, in which production is excessively roundabout and from which an equilibrating path should be followed, on a path of continuing excessive roundaboutness of production; on a path which — unless beforehand an even more painful turnaround occurs — ultimately leads to a complete liquidation of productive investments and a complete lack of free capital. However, we said that during the development of the crisis a withdrawal of money capital from the circulatory flow of the turnover of capital also takes place within the economy because it is striving for increased liquidity and a more favorable balance of cash reserves. A compensation without damage would seem conceivable here. However, it must be clear that this compensation will not be possible because the economy will not be prepared to use the additional credit for the purpose of investment. The economy will first secure an increase in its liquidity with this credit. But there is still another thing: During the downturning segment of the cycle, the situation is such that credit for investment will be refused. With its supply of credit, the central bank will encounter a rejection of credit-taking by the economy. We have already given two reasons for this. On the one hand, the psychological conditions necessary for the investment of money into durable investments will not be present. There will be general unrest in the economy. On the other hand, the relationship of prices and the general tendency of price development will stand in the way of investment activity. The repudiation of credit will, however, not be general. Even in this stage of the cycle there is a very significant demand for credit, namely the demand by those who are forced to liquidate, to make emergency sales or to cease production due to a lack of capital — a demand for which any credit means at least the momentary avoidance of losses and perhaps even the potential for later improvements. However, satisfying this demand implies delaying the liquidation of the crisis, lengthening and strengthening it. For it is essential to this situation that a significant demand for credit by those who would like to work towards continuing the boom, that is, an "unhealthy" demand for credit, exists along with a significantly reduced demand for new sound investments.
To be sure, these explanations are highly schematic. However, they can show that the chance of a compensating expansion of credit in the recessive phase of the cycle is in practice very small; that there is hardly any chance of financing production processes which can be lastingly continued; and that the danger, instead, that additional credit prolongs and makes the crisis more severe is very large. However, if the depression is already more advanced when in the second stage of the depression there is greater liquidity on the money market, then the liquidation process is essentially completed. Hence, the danger of the damaging effect of additional credit in the just mentioned sense no longer exists. Experience shows, however that a repudiation of credit makes itself felt strongly, particularly in this stage.
Now, a cycle policy is also conceivable which, by enlarging consumption would try to avoid those effects of "decapitalization" which consist of the loss of demand for consumer goods. Here, additional money would function such that it would replace the money withdrawn from circulation and would demand consumer goods for pure consumption in its place. The movement of goods would thus be the same as if the money withdrawn from circulation had served consumption. We have already pointed out that withdrawing money from investment and using it for consumption is the same as consuming capital. Such a thing could be financed without difficulty by additional money, and the path along which this money is directed to consumption would be irrelevant.12 In addition, some effect on the relationships between prices must also surface in the form of support for the cost prices, since the pressure that the restriction of demand must ultimately exert will be weakened by this policy. Thus, the policy of financing consumption must in the end cause the emergence of price relationships that make an improvement in the potential for new investments more difficult. Regarding all this, it must finally be said that financing consumption cannot interfere at that point in the economy which (besides unfavorable price relationships) represents the decisive obstacle to carrying out new investment: namely at the psychological inhibitions which discourage undertaking new investments. The "artificially" created demand for consumer goods will ultimately also create an increased need for "operating capital" (short-term investments) and will thereby make these investments increasingly profitable. This, too, must serve to weaken the forces that work in the direction of removing the obstacles which stand between short-term investments and the long-term capital market. In conclusion let it be said that a guideline for determining the extent of credit that should operate in this way does not exist.
How is it then with an intervention by the central bank in an upswing? Could not the central bank compensate for the effect of an additional supply of capital stemming from the economy's reserves? In practice, the situation is such that a restriction of credit for the purpose of preventing or weakening an upswing would be an extremely unpopular step, in particular at the beginning of the upswing. It would probably be difficult for the administration of the central bank to justify such a step. But one must first consider the effect of this kind of policy. Let one thing be said here. The policy of a compensating credit restriction will already be a problem at the beginning of the upswing. In the economy there are significant cash reserves which gradually appear as a supply of capital. The economy's credit system is capable of expanding entirely independent of the central bank. And finally, the very first favorable production successes appearing during the upswing create new renewal capital and perhaps also new real saved capital. Where would there be a guideline for orientation for the central bank? And even if credit restrictions began, the economy would be hungry for credit, and there would be possibilities independent of the central bank. Could not a restriction by the central bank cause the speed at which additional credit is created to be increased in other ways? Once the economy's movement has been determined by the effect of a supply of capital surpassing the degree of real saved capital, once the initiation of "too lengthy" roundabout production methods has led the economy towards an economic crisis, then the only path remaining is via an economic crisis. And the only thing that remains a certain possibility for crisis policy seems to be that the central bank — insofar as it is able to restrict credit and raise the interest rate — can also force a turnaround from an upswing to an economic crisis at any time. This turning point can thus only be reached earlier than otherwise would be the case; earlier than that point at which the circumstances we mentioned elsewhere cause the central bank to halt the expansion of credit. An earlier forced turnaround would occur at the expense of the length and success of the upswing; perhaps one could hope that the severity of the crisis would thereby be ameliorated.
Whether this should be the goal of crisis policy is certainly as problematic as the question of whether cycle-stabilizing is even desirable. The call for a crisis policy is usually a call for the stimulation of production during a downswing. However, here crisis policy can lead to more general questions regarding economic policy. Whether or not it might earn a justification from any other standpoint, from the point of view of ameliorating the results of the crisis and preparing for a new upswing, everything which hampers the adjustments of economic magnitudes or impairs economic success can only be judged negatively.
How to Explain the Business Cycle
Economic laws can only be conceived of by assuming constant data. Once the data are given, what occurs in the economy is also precisely determined. This principle must be the basis for all economic theorizing. We applied it when we analyzed the effects that an expansion of credit must have on the structure of production. We thereby came to the conclusion that the final consequence of the constellation of data described by the formula of expanding credit must be a complete immobilization of free capital. We then tried to explain that the development will not lead to this situation, but that more often a halt to the expansion of credit will occur beforehand. We thereby introduced a new datum into our argument — in fact two further data changes: the decapitalization of money and the repudiation of credit. Finally, we also believed we could assume that decapitalization turns into a tendency to avoid or reduce long-term investments. We studied the effects of this constellation of data on the structure of the economy and thereby saw the economy advance to a lower turning point in the business cycle. Once we reached this point, we introduced a new datum — the newly appearing initiative for expanded investment which created an increase in the supply of monetary capital from the economy's reserves and additional credit.
Our argument has always had as its goal the analysis of the structure of production. The effects of the previously mentioned data constellations on the capital market were the starting point for further argumentation.
This analysis of the method we employed should show clearly how the business cycle can be explained. The people who bring the supply of capital onto the market change their behavior. This holds for the final credit source of an economy — the central bank — as well as for other banks and private owners of capital. Likewise, the entrepreneurs who make investments change their behavior. With this basis for our argumentation, we have moved outside the framework of analyzing a movement which can be explained as originating from an economic situation. In this regard there are two things to be said: First, the justification for this procedure must be given; and second, it must be shown that this procedure will not lead to incorporating any arbitrary elements.
On the first point, it is a fact that in an upswing the volume of credit grows and in a depression it falls. The monetary theory of the trade cycle is without a doubt correct in including these circumstances in its explanation. However, expanding or restricting the volume of credit can never spring from an economic law, but rather only from a change in human behavior. Thus, an explanation of the business cycle must go beyond the boundaries of an analysis applying means of economic theory exclusively.
On the second point, one could attempt to explain changes in human behavior by considering external circumstances. For example, just as the influence of regular changes in weather on harvests can be an explanation for a cyclic movement (the "sunspot theory" is methodologically possible, although it may be factually incorrect), so could there also be distant causes for regular changes in human behavior. However in our presentation we have searched for a closer link between the changes in human behavior and the occurrences in the course of a cycle. The connecting link is easy to see. A specific economic situation leads humans to change their behavior in a specific way. Thus, the economic crisis leads to decapitalization and credit repudiation. We are confronted with an adjustment of human behavior to a specific situation; an adjustment which certainly is no economic necessity in the sense that with the means of economic theory it could be recognized as precisely determined. Whether or not people are prepared to save, this is in any case a datum for an economic process; it is something that economic theory must assume as a starting point for its explanation. Such a fact can never be the goal for an explanation. In particular leaving money in the function of capital or newly introducing money to be used as capital — both of which we encountered in considering the business cycle — are determined by human will. But it is extremely likely that in this respect humans change their behavior in the course of a cycle.13 If the explanation of business cycles wished to ignore this fact, it would neglect something that doubtlessly influences the course of events to the highest degree. We also do not believe that there is another way to solve the problem facing a cycle theory wishing to do justice to the facts: namely that the upswing creates conditions that lead to a downswing, just as these conditions in turn lead to a new upswing.
- 1. One often hears: It is only possible to cover operating costs, but not general (fixed) expenses. Achieving a return that corresponds to a previously made long-term investment is identical to the successive freeing up of this investment, i.e., with the formation of a renewal fund necessary for a static course.
- 2. Here we are ignoring another case of the non-neutral interference of money — for example, the creation of new money which will be fed directly into consumption uses — because this case is not part of the problem area treated here.
- 3. For the problem analyzed here it is irrelevant which type of money is withdrawn from circulation. In practice the reduction in the circulation of means of payment primarily affects check-money. On the other hand, bank notes will probably to a large extent cover payments which had previously been handled by check-money.
- 4. The same would hold in the case of a consumer loan.
- 5. The unsellability of a good is essentially identical to the absence of the willingness on the part of the good's owner to go below the going price. The cost-oriented thinking of vulgar economics is unable to comprehend this obvious fact.
- 6. Here we have the opposite of that case which we analyzed more closely in considering the expansion of credits, namely that credit expansion leads to an increase in demand on the consumer goods market and hence spurs a tendency towards expanding this production.
- 7. It is basically senseless to distinguish between the expressions money market and capital market. In both cases, money is offered as capital; that is, money is offered against its later return. If a short-term credit is invested in a long-term investment and if this money is then demanded back, the debtor becomes insolvent, unless another source of credit is available to him. The short-term investment in an antecedent production stage is "economically" (it would be better to say: in the global economic picture) a long-term investment since this money will only become "free" once the consumer good is complete. In a private economy, however, this money can be completely liquid if in this antecedent production stage it is possible to obtain money capital from somewhere else in the economy in exchange for one's product — from the purchaser of an intermediate product or a durable capital good.
- 8. The risk is not only that of possible losses with falling prices. In addition, something else must be considered. Every investment generates a certain need for liquidity. This means that the investor wants to have the possibility of obtaining cash in case the fluctuations in the economy cause any changes in the assumptions on which he based his calculations. The availability of cash means in many cases the possibility of avoiding losses, often solely by virtue of the fact that one can thus wait for better times. Of course, the need for liquidity in the sense described here will vary from case to case; under certain circumstances the daring entrepreneur will also proceed without any liquid reserves. In the connection that interests us here, however, one thing must be noted: In a depression the demand for liquid reserves will be larger, but the general abstention from investing will limit the possibilities available to every individual entrepreneur for obtaining money. This is another factor which strengthens the holding back of investments.
- 9. Naturally, one cannot speak of a static economic course here. The economy could not be lastingly maintained in this way because it does not reinvest to the necessary degree. Insofar as they produce capital goods for fixed investments antecedent production processes will thus be underemployed.
- 10. Ignoring the behavior of other banks here is, of course, a questionable assumption for the conditions of the economy could cause the policies of the central bank to be frustrated, at least temporarily, by the behavior of other sources of credit in the economy.
- 11. That a stabilization policy should best take effect directly after the turning points is explained by the following: After the turning point, a departure from the previous development in the direction of an equilibrium is necessary. The economy takes this path. However, right from the beginning a disequilibrating element is operative, too. In any case, at the beginning of this movement, the general tendency of the economy towards equilibrium is strongest, and hence eliminating the disruptive element is most likely possible here.
- 12. Financing consumption through consuming capital also occurs in what is generally recommended under the title of emergency measures in times of crises. Even though production is directly financed here, this is only done for the purpose of creating values which do not free up the invested capital. If a production integrated in the normal course of the economy is financed, then it creates a product — as we have already explained — from whose sale the further financing of this production becomes possible. If, in contrast, a street is built, then means are employed which produce a street that can naturally be valued in economic terms, too, but not a product whose sale will finance further production processes. No more shall be said here on the question of when such an expenditure can be justified solely from an economic point of view. There is only one thing to be said: If the neighbors (and other interested parties) attain a greater return after the street is built and save this return; that is, use it for new investments, then in this case the capital invested in the street is set free via a detour. If, however, this increased return is consumed, then from an economic point of view this is a case of freezing free capital. In both cases there occurs, of course, an enrichment of such interested parties at the expense of those who have provided the means for the street (or respectively in the case of inflationary money creation: at the expense of all owners of money). A purely economic calculation of profitability of the street could take place via the formula of comparing the costs with the possible surplus return for the interested parties, whereby naturally in this formula an interest rate would have to be incorporated.
- 13. In order to distinguish them from data changes which can be caused by factors entirely outside the economy I have spoken of "economically determined data changes." On this, see my article mentioned in number 8, p. 167.