Banking and the Business Cycle

BANKING AND THE BUSINESS CYCLE CHAPTER I INTRODUCTION

In 1921, following the upheaval of prices which accompanied the primary post-War deflation, Professor T. E. Gregory, in writing on the situation then prevailing in the foreign exchanges, was moved to lament that:1

Ours is a weary and disillusioned generation, dealing with a world which is nearer collapse than it has been at any time since the downfall of the Roman Empire. The problem which is discussed in this little book is an integral part of the general problem of reconstruction after the ravages of war. It will be shown in detail in the course of the subsequent chapters that the main cause of the dislocation of the exchanges has been the almost universal disregard of the rules of common sense in the treatment of the money supply of the world, or, as it is usually put, the dislocation of the exchanges is an inevitable effect of inflation.

Thirteen years later, near the nadir of the Great Depression, Professor J. M. Clark wrote in like vein:2

The peculiarly grave and threatening character of the present emergency needs no proof. As to how close it has brought us to a complete collapse of our economic system economists, like others, can only conjecture.

Certainly ours is a weary and disillusioned generation. The tragedies of the War and the sufferings and disappointments of subsequent years have left the occidental world cynical and despairing. Old ideals, old values, old institutions, old faiths—all have crumbled, leaving stretches of barren waste all too receptive to the seeds scattered so freely by economic charlatans and political medicine-men. Partial economic disintegration has been accompanied by the collapse of democratic governments. With the remaining ruins as foundations, with a frantic energy born of despair, no inconsiderable fraction of mankind has set about attempting to construct new shelters in the form of totalitarian states, to be entrusted to the custodianship of authoritarian dictators. Certainly the forces of economic liberalism have suffered severe reverses; whether or not those reverses terminate in a complete rout appears to depend upon the course of events during the remainder of the present decade.

During recent years a number of pseudo-economists have indulged in much glibness about the passing of the “economy of scarcity” and the arrival of the “economy of abundance.” Sophistry of this sort has claimed the public ear far too long; it is high time that the speciousness of such fantastic views be clearly and definitely exposed. Attention needs to be focused on the hard elementary fact that man’s darkest curse has ever been his poverty, and that it yet is and promises to continue so for numberless generations. No economist worthy of the name, moreover, should need to be reminded that in the absence of “scarcity” there would be no system of “economy” and no “science of economics.”

Professor Gustav Cassel has said that3 “Our attention must now for a long time onwards be devoted towards a complete analysis of the upheaval now in progress.” The present study is directed to an inquiry into certain of the more fundamental aspects of major industrial fluctuations, and to the relationship of banking operations thereto, special reference being had throughout to the causes and relevant phases of the cycle beginning in the United States in 1922 and ending with the Great Depression. It is at the same time devoted to the formulation of a theory of business cycles—for “the present crisis is, in fact, a crisis also for the entire theory of business cycles.”4 The theory of business cycles here set forth, it is believed, is not only one which is applicable as a general explanation of depressions, but also one whose validity is particularly well illustrated by setting it against the background of the experience of the recent crisis. Accordingly, this theory of the cycle is correlated with the banking and financial situation in the United States during the post-War years into an explanation of the causes of the Great Depression.

“Causes” is used advisedly, it being “at once evident that no general or single theory is valid for so varying and varied a phenomenon as crisis.”5 And, as Professor Clark states, 6 most “theoretical studies give us causes that are too few and too simple, such as over-production, under-consumption, over-saving, or failure to distribute to laborers their whole product or enough of the whole product of industry to enable them to buy the things they have produced.” The present apparent need is not for the propagating of novel theories, but rather for the orienting and synthesizing of extant knowledge.

The special objective of this volume is an integration of views of the business cycle frequently considered as conflicting—the monetary, the structural, and the equilibrium theories. Hence the theoretical portion may be denoted an eclectic theory of the business cycle. The views of those who argue that the cycle is a “purely monetary phenomenon,” of those who hold that those “real” phenomena connected with the alterations in the structure of production are the root causes, and of those who are devotees of the equilibrium theory of business cycles, have been drawn upon to effect a synthesis or combination of these three main theories. The monetary or bank credit theory occupies first rank in the chain of causation and explains the origin of the boom; the structural view, with its emphasis upon the changes in the structure of production and the disequilibrium between saving and investment, explains the underlying character of the boom; and the equilibrium theory is necessary to describe the depression proper and to explain its severity and persistence. All three theories in combination give a more nearly complete understanding of the whole cycle than can any single or more particularistic view.

The central thesis of the volume is that the Great Depression and the feverish activity of the immediately preceding years were notably bank credit phenomena. The markedly oscillatory movements of the economic pendulum in the United States during the ’twenties and early ’thirties are attributable to forces resident in central banking. But for the superimposition of the Federal Reserve Banks upon our commercial banking structure, the amplitude of the cycle in question would have been greatly restricted.

However, if it be regarded from a point of observation that focuses attention on the continuity of historical processes, the recent depression will be seen to have been directly connected with the efforts at reconstruction that followed after the dislocations caused by war. The ultimate causes of the depression are traceable to the War; just as the late war was the Great War, the recent depression was the Great Depression. But the more immediate causes of the depression grew out of the post-War inflation of bank credit in this country. It is sought to show that the main cause of the dislocation in trade and industry was, in Gregory’s language, the “disregard of the rules of common sense in the treatment of the money supply” of the United States; the depression is proximately an effect of inflation. The post-war inflation in the United States was an investment credit inflation, however, as distinguished from the commodity credit inflation of War-time. An explanation of the nature of this investment inflation and its relation to the subsequent depression will be essayed in the ensuing chapters.

It therefore becomes necessary to inquire rather fully into the character and nature of post-War developments within the banking system of the United States prior to 1929, particularly from 1922 onwards. The striking and far-reaching changes which were developing in the structure and operation of the American banking system were intimately connected in a causal fashion with the development of the investment boom and with the origins of the depression itself. The historical complex of factors and circumstances that leads up to any crisis usually ferments long before the actual occurrence of the crisis; therefore the causes of a particular crisis must be traced farther back than is commonly supposed. An understanding of what was taking place in American banking during the post-War years is therefore essential to a thorough analysis of the causes of the depression. The reader should be warned, however, that this is not a history, either of the entire post-War banking situation in this country, or of post-War American economic life, or of the depression itself in its entirety: rather, the emphasis is upon an analysis of those factors in banking and economic development which were basically causal to the Great Depression.

As the depression has been denominated primarily a central banking phenomenon, it will also be desirable to attempt to unravel some of the changes caused in the structure, organization, and operation of the American banking system by the establishment of the central banking system represented by the Federal Reserve System. The special character of the depression is traced to the hyper-elasticity of the Federal Reserve System, and to the operation of that system as exemplified in the “managed currency” experiment of the Federal Reserve Board, working in opposition to what D. H. Robertson labels “the over-mastering tendency of prices to fall”7 after a war financed by inflationary measures. By virtue of that experiment, the Board succeeded in holding up the price level for a surprising length of time, but in so doing unwittingly aided in producing the boom and its consequent depression. The depression, in other words, was the price paid for the experimentation with currency management by the Federal Reserve Board during the period when the dislocations caused by war had not as yet been corrected and when the post-War deflation of prices had not been completed. Nor were the effects of this Federal Reserve Board action confined solely to the United States; the banking and industrial systems of leading commercial nations are interrelated so closely that the mistaken policy of one large central banking organization may be highly conducive to the precipitation of a world-wide depression.

Furthermore, some of the causes of the depression are to be found in the provisions of the Reserve Act itself, the nature of which and their effects upon the banking system did not become noticeable or fully operative until after 1922. The first of these is simply the establishment of a system of central banking, without sufficient appreciation on the part of its sponsors of the fact that central banking is inherently inflationistic in nature, in consequence of the play between gold inflows, bank reserves, and prices which central banking makes possible. Other provisions having like significance were the permission of payment of interest upon time deposits by National and other member banks, the fixing of a lower reserve ratio against time than against demand deposits, and the general reduction of reserve requirements contained in the original Act as well as the further reductions effected as an aid to war financing by the Amendment of June 21, 1917.

Through the purchase of investments commercial banks impart a positive upward impulsion to the business cycle. Coming in as a marginal determining factor in the price of bonds, purchases of investments by banks force down the long-term market rate of interest so that it becomes profitable, in view of the existing realized rate of return to capital at important new investment margins, to float new bond issues and to embark upon new capital development; this results in an investment boom which effects a change in the structure of production in favor of a more rapid growth of capital goods relative to the production of consumption goods. But the purchase of bonds by the banks has another influence which is directly connected with, and which helps make possible, the investment boom: the purchase of investments by banks creates new deposits in the banking system in much the same fashion as does the granting of loans. The banks thus place in the hands of entrepreneurs a volume of purchasing power in excess of the volume of real savings being effected voluntarily by the public, producing a disequilibrium between saving and investment that constitutes the heart of the boom. This enlargement of the stream of credit issuing from the banks permits and encourages the making of new investment commitments, without restraining consideration of the effect of such action upon the productive structures, and the resulting boom represents a movement of the economic system away from equilibrium, rather than toward it. When the rate of increase of current investment declines, or when the volume of investment actually decreases, depression ensues: the cessation of credit creation, or even a diminution in the rate of growth of credit, brings about the causally significant decline in the rate of investment.

But the ability of the banks to buy bonds as investment assets is conditioned by their reserve position. If the banks are possessed of a surplusage of reserves, they may buy bonds or otherwise expand credit; if they have no excess reserves, they may not do so. The volume of reserves in the member banks, however, is subject to enlargement or diminution by the action of the Federal Reserve Banks; that is to say, the Reserve Banks may “create” excess reserves for the member banks much as the member banks “create” credit. The adoption of such a policy by the Reserve System on three separate occasions during the ’twenties was the significant action leading to an expansion of total bank credit during that period.

The boom is brought to an end, not only because of the restriction upon the supply of credit and purchasing power, but also because of the rise in the market rate of interest on new bond issues and other instruments of borrowing resulting from that restriction. Moreover, the realized rate of return on new capital development tends to fall in the later stages of a boom because of the fact that increases in wage rates gradually pare down the share going to capital. There ensues a general disequilibrium throughout the system, not only between wage rates and the cost of living, between costs and prices, and between production and consumption, but also a disequilibrium between investment and saving the reverse of that which prevails during the boom. As long as these general disequilibria persist, and as long as new investment in the sense of the production of new durable goods continues at a low ebb, depression continues.8

Recovery from depression can proceed only when the disequilibria produced by the preceding investment boom are overcome. When the anticipated productivity of capital at new investment margins exceeds the price paid currently for the use of loanable funds, conditions again obtain in which there is prospect of profit in new investment activity. This can be brought about most effectively by correcting the disparity between costs and the value of current new investment, that is, by bringing costs into line with prices, particularly in the capital goods industries. And, since the major portion of the costs of industry represents payments to labor, it is particularly desirable that wage scales be genuinely flexible. Widespread wage-rate reductions would cause, temporarily, some diversion of the income stream away from employed laborers in favor of the capitalist-entrepreneurs. This procedure will alter the share going to capital by converting losses into profits; but it is upon profits, or the prospect of profits, that all expansive activities of modern industry depend. Laborers, considered collectively, would be richly compensated for accepting the temporary shrinkage of money income that would be entailed by the initial reductions in wage rates; the increased volume of employment and the reduced prices that would follow from such a policy would shortly raise the aggregate real income of labor far above any level at which it could be maintained in the face of depression conditions.

No less important than the problem of explaining the causes of the depression is that of explaining its severity and duration. Here again, Federal Reserve policy has occupied an important rôle. The expansionist policy of 1927 served the Board’s purpose in checking the decline in business which began in that year, but it also operated to sustain the boom for an additional two years and to force it to unprecedented heights. In particular, the stock market proved the beneficiary of the Reserve Board’s action in 1927. Yet when the stock boom eventually collapsed, it loosed business activity from its false and insecure moorings and the descent into the maelstrom of disaster began. The very height to which the investment and stock market booms attained was enough to indicate that the reaction would be severe; this statement has kinship with no “action and reaction” theory, but simply means that overcapitalization and misdirection of capital became so exaggerated during the last two years of boom that deflation and liquidation were likely to be protracted. Once business activity began to decline, every effort was made to avert or delay the necessary liquidation, both by Federal Reserve action aimed at sustaining the market situation, and by the widespread advocacy of a policy of maintaining wage rates on the part of government, trade unions, and employers. Furthermore, the enormity of the stock market crash itself, involving such a large percentage of the population in its ruins, contributed to the severity of the depression. Lastly, the fact that in no previous depression had there been such a wholesale destruction of bank credit, attributable in large part in this instance to the entanglement of the banking system with the preceding investment and stock market frenzies, aids in explaining the unprecedented duration of the Great Depression.

 

9 Foreign Exchange Before, During, and After the War (London: Oxford University Press, 3rd ed., 1925), p. 9.

10 Strategic Factors in Business Cycles (New York: National Bureau of Economic Research, 1934), p. 4.

11 “The Problem of Business Cycles,” in the Skandinaviska Kreditaktiebolaget Quarterly Report, January, 1933, p. 3.

12 Ibid., p. 3.

13 Cassel, G., The Theory of Social Economy (New York: Harcourt, Brace & Co., 1932), p. 538.

14 Strategic Factors in Business Cycles, p. 6.

15 Journal of the Institute of Bankers (June, 1931), Vol. LII, Part VI, p. 236.

16 “Depression has continued because there is no prospect of profitable investment. And why is there no prospect of profitable investment? Because costs, which by reason of the inflationary boom have become too high in relation to prices, have not been reduced.” Lionel Robbins, in Lloyds Bank Monthly Review (October, 1982), Vol. III (NS), No. 32, p. 432.

• 1Foreign Exchange Before, During, and After the War (London: Oxford University Press, 3rd ed., 1925), p. 9.
• 2Strategic Factors in Business Cycles (New York: National Bureau of Economic Research, 1934), p. 4.
• 3“The Problem of Business Cycles,” in the Skandinaviska Kreditaktiebolaget Quarterly Report, January, 1933, p. 3.
• 4Ibid., p. 3.
• 5Cassel, G., The Theory of Social Economy (New York: Harcourt, Brace & Co., 1932), p. 538.
• 6Strategic Factors in Business Cycles, p. 6.
• 7Journal of the Institute of Bankers (June, 1931), Vol. LII, Part VI, p. 236.
• 8“Depression has continued because there is no prospect of profitable investment. And why is there no prospect of profitable investment? Because costs, which by reason of the inflationary boom have become too high in relation to prices, have not been reduced.” Lionel Robbins, in Lloyds Bank Monthly Review (October, 1982), Vol. III (NS), No. 32, p. 432.
• 9In 1921, following the upheaval of prices which accompanied the primary post-War deflation, Professor T. E. Gregory, in writing on the situation then prevailing in the foreign exchanges, was moved to lament that:
• 10Thirteen years later, near the nadir of the Great Depression, Professor J. M. Clark wrote in like vein:
• 11Professor Gustav Cassel has said that “Our attention must now for a long time onwards be devoted towards a complete analysis of the upheaval now in progress.” The present study is directed to an inquiry into certain of the more fundamental aspects of major industrial fluctuations, and to the relationship of banking operations thereto, special reference being had throughout to the causes and relevant phases of the cycle beginning in the United States in 1922 and ending with the Great Depression. It is at the same time devoted to the formulation of a theory of business cycles—for “the present crisis is, in fact, a crisis also for the entire theory of business cycles.” The theory of business cycles here set forth, it is believed, is not only one which is applicable as a general explanation of depressions, but also one whose validity is particularly well illustrated by setting it against the background of the experience of the recent crisis. Accordingly, this theory of the cycle is correlated with the banking and financial situation in the United States during the post-War years into an explanation of the causes of the Great Depression.
• 12Professor Gustav Cassel has said that “Our attention must now for a long time onwards be devoted towards a complete analysis of the upheaval now in progress.” The present study is directed to an inquiry into certain of the more fundamental aspects of major industrial fluctuations, and to the relationship of banking operations thereto, special reference being had throughout to the causes and relevant phases of the cycle beginning in the United States in 1922 and ending with the Great Depression. It is at the same time devoted to the formulation of a theory of business cycles—for “the present crisis is, in fact, a crisis also for the entire theory of business cycles.” The theory of business cycles here set forth, it is believed, is not only one which is applicable as a general explanation of depressions, but also one whose validity is particularly well illustrated by setting it against the background of the experience of the recent crisis. Accordingly, this theory of the cycle is correlated with the banking and financial situation in the United States during the post-War years into an explanation of the causes of the Great Depression.
• 13“Causes” is used advisedly, it being “at once evident that no general or single theory is valid for so varying and varied a phenomenon as crisis.” And, as Professor Clark states, most “theoretical studies give us causes that are too few and too simple, such as over-production, under-consumption, over-saving, or failure to distribute to laborers their whole product or enough of the whole product of industry to enable them to buy the things they have produced.” The present apparent need is not for the propagating of novel theories, but rather for the orienting and synthesizing of extant knowledge.
• 14“Causes” is used advisedly, it being “at once evident that no general or single theory is valid for so varying and varied a phenomenon as crisis.” And, as Professor Clark states, most “theoretical studies give us causes that are too few and too simple, such as over-production, under-consumption, over-saving, or failure to distribute to laborers their whole product or enough of the whole product of industry to enable them to buy the things they have produced.” The present apparent need is not for the propagating of novel theories, but rather for the orienting and synthesizing of extant knowledge.
• 15As the depression has been denominated primarily a central banking phenomenon, it will also be desirable to attempt to unravel some of the changes caused in the structure, organization, and operation of the American banking system by the establishment of the central banking system represented by the Federal Reserve System. The special character of the depression is traced to the hyper-elasticity of the Federal Reserve System, and to the operation of that system as exemplified in the “managed currency” experiment of the Federal Reserve Board, working in opposition to what D. H. Robertson labels “the over-mastering tendency of prices to fall” after a war financed by inflationary measures. By virtue of that experiment, the Board succeeded in holding up the price level for a surprising length of time, but in so doing unwittingly aided in producing the boom and its consequent depression. The depression, in other words, was the price paid for the experimentation with currency management by the Federal Reserve Board during the period when the dislocations caused by war had not as yet been corrected and when the post-War deflation of prices had not been completed. Nor were the effects of this Federal Reserve Board action confined solely to the United States; the banking and industrial systems of leading commercial nations are interrelated so closely that the mistaken policy of one large central banking organization may be highly conducive to the precipitation of a world-wide depression.
• 16The boom is brought to an end, not only because of the restriction upon the supply of credit and purchasing power, but also because of the rise in the market rate of interest on new bond issues and other instruments of borrowing resulting from that restriction. Moreover, the realized rate of return on new capital development tends to fall in the later stages of a boom because of the fact that increases in wage rates gradually pare down the share going to capital. There ensues a general disequilibrium throughout the system, not only between wage rates and the cost of living, between costs and prices, and between production and consumption, but also a disequilibrium between investment and saving the reverse of that which prevails during the boom. As long as these general disequilibria persist, and as long as new investment in the sense of the production of new durable goods continues at a low ebb, depression continues.