IV. Overproduction, Underconsumption, and Maldistribution of Income as Cyclical Forces

CHAPTER IV OVERPRODUCTION, UNDERCONSUMPTION, AND MALDISTRIBUTION OF INCOME AS CYCLICAL FORCES

No less plausible and even more widely accepted than the theories which are based upon the shortcomings of the gold standard are those which seek to find the solution of our recurring depressions in alleged overproduction of goods and services, or in underconsumption of the same, or in maldistribution of wealth and income. These are fundamentally similar notions, each being a variant of what is commonly known as the underconsumption theory of cycles.

THE UNDERCONSUMPTION THEORY

The central thesis of the underconsumption theory concentrates attention upon the market for consumers’ goods. If equilibrium is preserved in that market, it is argued, then the whole complex industrial machine continues in equilibrium, on the theory that the demand for equipment and machinery (capital goods) to make the consumers’ goods is a derived demand from the consumers’ goods market. Later phases of the discussion will show that, as the system actually works, the reverse of the above argument is substantially correct. It is not denied that all production is intended ultimately to promote the production of consumption goods; nevertheless, the output of capital goods is at times determined by considerations which are in some respects quite independent of the conditions prevailing in the consumers’ goods market.

Common to all forms of the underconsumption theory is the argument that the industrial system as now organized fails to provide consumers with sufficient purchasing power to take the output of the industrial machine off the market. There is, it is alleged, a deficiency of consumers’ income which brings on the fall of prices and depression. In order to preserve equilibrium between consumption and production in a capitalistic society with an ever-increasing output of consumption goods, so the theory runs, there must be an ever-larger consumers’ income to buy those goods or else overproduction will occur.

The authors firmly believe that the unthinking acceptance of these theories has had a positive influence for evil, tending to prolong the depression by preventing the development of a proper understanding of its causes as a basis for combative action. Such theories unquestionably influenced the Hoover Administration, and the basic philosophy of the Roosevelt Administration’s attempts at recovery are obviously predicated upon them.

VARIANTS OF THE UNDERCONSUMPTION THEORY

As indicated above, there are three main variants of the underconsumption theory. The first, stressing the apparent surfeit of goods and attaching only secondary importance to income as such, is generally known as the overproduction theory. The second approaches the problem of depression principally from the standpoint of the alleged shortage of consumers’ incomes, the underconsumption theory proper. The third emphasizes not so much the absolute deficiency in income as the disproportion between income consumed and income saved, finding the explanation of depression in the maladjustments in the distribution of incomes. All three theories have common roots, but enough differentia exist among them to justify according separate treatment to each. It will be the task of this chapter to attempt to refute the arguments of these theories as explanations of the cause of depression.1

OVERPRODUCTION CONTRASTED WITH ILL-ASSORTED PRODUCTION

John Stuart Mill’s famous answer to the overproduction theory, first put forward in 1848 at a time when it was feared that labor-saving machinery involved loss of employment, is always deserving of repetition and is presented herewith in extenso:2

The doctrine [of overproduction] appears to me to involve so much inconsistency in its very conception, that I feel considerable difficulty in giving any statement of it which shall be * * * clear * * *. First, let us suppose that the quantity of commodities produced is not greater than the community would be glad to consume: is it, in that case, possible that there should be a deficiency of demand for all commodities for want of the means of payment? Those who think so cannot have considered what it is which constitutes the means of payment for commodities. It is simply commodities. Each person’s means of paying for the productions of other people consists of those which he himself possesses. All sellers are inevitably and ex vi termini buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply: everybody would be able to buy twice as much, because every one would have twice as much to offer in exchange. * * * the remuneration of producers does not depend on how much money, but on how much of consumable articles, they obtain for their goods. * * * A general over-supply, or excess of all commodities above the demand * * * is thus shown to be an impossibility. * * * there is no over-production; production is not excessive, but merely ill assorted. * * * Thus, in whatever manner the question is looked at, * * * the theory of general overproduction implies an absurdity.

Nearly forty years later, in 1886, a British Royal Commission was appointed to inquire into the depression which had continued almost without a break for the previous ten years. A passage from the report of this Commission runs in part as follows:3

* * * one of the commonest explanations of this depression or absence of profit is that known under the name of overproduction; * * * general over-production is of course impossible.

At about the same time that British industry was experiencing the depression referred to, American industry was undergoing like difficulties, and the overproduction argument was also much in vogue in this country. Shortly after the report of the British Commission on Trade and Industry was made public, David A. Wells, a leading American economist of the time, offered an equally critical statement with reference to the overproduction theory, as follows:4

No term has been used more loosely in the discussion of this subject of trade depression than that of ‘over-production.’ The idea that there can be such a thing as a general production of useful or desirable commodities in excess of what is wanted is an absurdity; but there may be * * * an amount of production in excess of demand at remunerative prices, or, what is substantially the same thing, an excess of capacity for production.

It is seen, then, that the idea of overproduction as an explanation of depression is an economic concept of long life, 5 and it is one which regularly provides the “popular” theory of the disastrous slumps in trade and industry. It was a frequent explanation of nineteenth century depressions, and “poverty in the midst of plenty” has become a commonplace of contemporary discussion. The world is represented as being drowned by the flood of its own output which it cannot consume; it is said to have brought on its present penury by the very diligence with which it has sought to devise aids to production.

It is necessary to be quite clear about what can validly be meant by “overproduction.” It does not mean production of more than can be consumed, nor even of more than can be sold at some price. Any quantity of a thing that is actually desired can be sold, if the price be fixed low enough. There is no reason to believe that there is any industry (or any combination of industries) that can, even during prosperity, always sell what it could produce at whatever price it may choose, without any regard for the conditions of demand operative at that price. What economists mean when speaking of overproduction is that more has been produced than can be sold at a price sufficient to repay full cost of production, that is, to bring returns adequate to induce producers to continue producing at the same rate. Production may be in excess of demand at what the producers consider remunerative prices, as Wells points out; nevertheless, all that has been produced can be sold, but in some cases only at a loss.

Price, the Key-Log

Price, then, is the key to the matter; and in any industrial jam, it is the key-log that has to be extricated before the economic system can again move smoothly forward. Production may be ill-assorted, as Mill puts it, or there may be partial overproduction. But there cannot be even partial overproduction—or at least not for any appreciable length of time, and not of sufficient dimensions to bring on a major industrial depression—if prices are “right.” Much less, of course, can there be any such thing as “general overproduction.” When partial overproduction makes its appearance, it is prima facie evidence that the price system is out of balance, that the pricing machinery is not performing its proper function of equating supply to demand. For right prices are prices that move goods, and there can be no jam of goods flowing into the market if prices are promptly adjusting themselves to the actual conditions of supply and demand. The smooth and proper functioning of the economic system is conditioned upon plasticity of prices. This does not require that price adjustments be instantaneous; neither does it contemplate, on the other hand, monopolistic and governmental efforts to withhold copper, cotton, wheat, or rubber from the market when prices are already too high to move all the supply off the market. Attempts to fix prices at a height which makes attractive the planting of rubber trees for future yield, the extension of wheat and cotton acreage, and the development of new mines, are not conducive to the avoidance of overproduction of those commodities at such artificially fixed prices.

Enlarged Production Constitutes Enhanced Demand

Here, then, are the fundamental points upon which all overproduction theories break down—that production gives rise to purchasing power, and that more of commodities that are desired cannot be produced than will be purchased if the prices of those commodities are right, or “marketclearing,” prices. Classical economics may have become antiquated in the eyes of the new school of “experimental economists” who would revamp the economic system according to their idea of modernization, but no system of “new economics” can successfully eliminate as one of its components the keystone of the arch of Classical economics. Lack of appreciation of Say’s théorie des debouches, that production is the source of consumption, that enlarged production means enhanced demand, or, as in Marshall’s statement, that “the National Dividend is at once the aggregate net product of and the sole source of payment for all the agents of production,” is what causes the structure of the so-called new economics to collapse of its own weight.6

A sufficient reason for completely discarding the older economics is hardly found in the failure of the Classical School to integrate properly this cardinal principle of all economic theorizing with a fully developed explanation of the operation of the pricing system. Progress toward this goal was given impetus by the Austrian School and the School of Lausanne, and was further advanced by the eclecticism of Marshall and others of the neo-classicals before the turn of the last century; a unified exposition of the modus operandi of a competitive pricing system was finally realized by virtue of the work of the early twentieth century economists, Davenport, Taylor, Cassel, and Knight.

Failure to understand, or even to be acquainted with, the tenets basal to neo-classical economics is at the bottom of most of the bad economics which has had such a popular reception during the last few years, descending, as it has, upon a distraught and bewildered world ready to listen to and to believe in anything in the way of criticism of the existing economic order, without first bothering to inquire whether the assumptions of the older economics have been fulfilled. It explains why such an un-economic monstrosity as “Technocracy” could enjoy the vogue it did, and even become the subject of semi-serious disputation, as well as why the gross inconsistencies and contradictions of the original NRA were regarded so lightly by a people ready to grasp at any straw promising surcease from their troubles.

Overproduction Apparent, Not Real

If overproduction had been the cause of the depression, it would seem that the physical volume of production should have been increasing at an inordinate rate in the period before the crash; if there had been absolute overproduction on a large scale, an acceleration in the rate of increase of production should so indicate. The statement of Carl Snyder of the Federal Reserve Bank of New York, whose work in providing factual information regarding the physical volume of production is such as to make his testimony conclusive, is as follows:7

Consider the last five or six years, to 1930. Therein the rate of industrial growth, so far as we may measure it, has been substantially identical with that of the pre-war average rate of growth * * *. The idea of an unusual rise in total production, preceding the crisis, was, so far as I can find, a fiction.

Moreover, if overproduction had existed prior to the crash, it should have been evidenced by a general increase of stocks of goods on hand, a general oversupply in the form of inventories which could not be marketed. Yet the fact that there was no increase of inventories during the late boom was iterated and reiterated by almost every writer up to the time of the crash.8 After the crash, general overproduction seemed apparent—as is always the case—but it should be remarked that the existence of stocks of raw materials and semi-manufactured goods is generally overestimated at such times, for the reason that during a depression the stocks are entirely visible and greater attention is focused upon them. However, in the months following the crash, as Professor Åkermann has shown, the world’s surplus stocks of basic commodities averaged much less than a normal year’s supply.9

Technological Unemployment

Inextricably connected with and an integral part of the overproduction theory of depressions is the notion that the cause of the overproduction is an over-rapid application of machinery to production. It is argued that inventions and technical progress have proceeded at so rapid a pace that goods are being produced in such excessive amounts that they cannot be marketed. This is again a long-lived argument, which made its first appearance during the early days of the Industrial Revolution, and which experienced a pronounced recrudescence during the post-War years. Far-reaching technical improvements were introduced during the post-War period, so extensive and so impressive as to be widely heralded as the advent of a “Second Industrial Revolution,” and, as unemployment existed concurrently with the extension of these technical improvements, it was perhaps inevitable that the one should be considered the cause of the other. As, despite boom conditions, there was still a lack of full employment of labor, it was natural that the pessimistic views of the effects of the introduction of machinery on labor which were widely held at the time of the First Industrial Revolution should be revived. A new phrase was coined to describe the phenomenon of unemployment during apparent boom conditions—“Technological Unemployment.” 10 While inventions and the machine were not regarded as unmixed evils, the question nevertheless was raised whether there was not a permanent unemployment attendant upon the introduction of improvements—the usual sense in which the term “Technological Unemployment “is now used.

Technical improvements and inventions do save labor, it is true, and therefore tend to displace some labor in specific occupations; but “the effect of a technical improvement for the entrepreneur introducing it must always be a diminution in money (or displacement) costs per unit of output; if it does not there will be no incentive to adopt it; and if it does it will always lead to an increase in production.”11 Labor is displaced only if the demand for the commodity on which the laborer is engaged cannot be expanded by the reduction in price which the improvement makes possible. It may happen, however, that the demand for the commodity is inelastic, in which case there must be a displacement of labor in the production of that particular commodity. A fact which is generally lost sight of, however, is that with the reduction in cost which the improvement makes possible, there will usually be a compensating increase in demand for some other commodity, provided the reduction in cost is passed on to the consumer in the form of a reduction in price of the finished article. The reduction in price consequent upon the cheapening of production will release a part of the income of the consumers for expenditure on other commodities, so that there will be an increased demand elsewhere in the market for goods on which the displaced labor can be employed. But for this absorption of displaced labor to take place readily, it is reiterated, prices must be plastic: attempts by entrepreneurs to realize immediately the full gain from the reduction in cost by capitalizing anticipated profits on the basis of artificially maintained prices, or refusals by laborers to accept (temporarily) lower wages in alternative occupations, eventually frustrate their own purpose.

The fact that technical progress may cause some economic dislocation is not disputed; an over-rapid increase of inventions may necessitate greater flexibility among costs and prices in order to preserve relative stability than would otherwise be required. There is a certain degree of validity in the concept of technological unemployment, and the more so if it be regarded—as it should be—as essentially a short-run phenomenon. It appears in some degree whenever our complex society experiences a period of industrial transition. Most major technological advances result in the displacement of some employees. Under “ideal” conditions these displaced laborers would quickly be reabsorbed elsewhere in the expanding industrial system, but actually neither men nor capital equipment are sufficiently mobile nor prices sufficiently flexible to prevent intervals of idleness, more or less prolonged. Some of the discharged laborers may be so advanced in years as to be debarred from entry into new fields of work in which wages are equal to those of their former occupations. In general, the more rapid the technical progress the larger will be the fraction of the labor group that at any given moment is suffering enforced idleness or is making painful occupational readjustments. But considered from the long-run viewpoint, it may safely be stated that technical progress never has reduced, nor is there any reason for thinking that it ever will permanently reduce, the percentage of the total population that industry is capable of employing in gainful activities. And, particularly important with regard to the point at hand, there is no clearly discernible relationship between such technological unemployment as did exist during the late ’twenties and the collapse of 1929. These two phenomena—technological improvements and unemployment—should not necessarily be considered as standing in the relation of cause and effect to each other; they may both be results of some other cause, or causes.

The long-run effect of inventions, technical improvement, and increased use of machinery, then, is to supplement rather than to displace labor, and to increase total production. When total production is increased, the share going to each factor of production is enlarged, and both total and per man real wages of labor increase, provided always that prices are decreased with improved productivity. Technical progress, therefore, cannot normally result in permanent unemployment, and even the displacement of labor as a temporary condition will not be of long duration if the adjustment of prices, including the price paid for labor itself, is sufficiently rapid.

Excessive Credit Expansion Leads to Misapplication of Capital

The possibility of partial overproduction must be granted: production may be “ill-assorted,” or there may be “an excess of capacity for production” at remunerative prices. Instances might be multiplied of overproduction in this sense in specific industries, both prior to 1929 and during the Depression, prominent among which are coffee, cotton, wheat, rubber, copper, and tin. The automobile industry was during and even before the Great Depression a notable example of an industry with capacity in excess of the apparent demand for its products. Excess capacity, however, is evidence of overinvestment, or of misapplication of capital. And therein lies the explanation of those cases of seeming overproduction. Overinvestment, which must be assigned the rôle of a positive disturbing factor, has its ultimate source in an excess of credit, however, and this returns the argument to the basic contention of the present study. One of the deeper causes of the recent depression was the overexpansion and overinvestment of capital in many lines of business at a rate so pronounced as to represent a positive misapplication of capital in view of the level of prices then prevailing, or which might have been expected to prevail in the future.

But the policy of overinvestment, with its attendant misapplication of capital, could never have been carried to the lengths that it was during the decade of the ’twenties if the banks and the Government had not supplied abundant credits at artificially cheap rates. This, together with the policies of hoarding, pooling, and valorization, also made possible by the inflation of bank credit, prevented the natural and gradual reduction of prices that might have been expected from improved productivity. Hence a disturbing factor in the situation was the overinvestment and misapplication of capital; the origin of the misapplication of capital, the reason for the misdirection of investment, was the excessive credit expansion brought about largely by the inflationistic bias of the Federal Reserve authorities, tinkering with the inherently inflationistic machinery of central banking in an ill-advised effort to maintain prices at an artificially stable level.

THE UNDERCONSUMPTION CONTENTION

Closely analogous to the notion of overproduction as the cause of the depression is the other side of a Janus-faced argument, the “underconsumption” theory proper. The argument of the underconsumptionists does not stress the excess of goods, as such, as being the cause of the trouble, but rather directs emphasis to an absolute insufficiency of purchasing power in the form of money in the hands of consumers to take the entire output of the industrial process off the market. Consumption rather than production is the focal point of attack; demand is differentiated from supply, and lack of demand because of insufficient consumers’ purchasing power is made the disrupting factor. It is asserted that the net money income of the final results of the productive process is not great enough to remove the gross product from the market.

Underconsumption Idea May Have Partial Validity Temporarily

It is conceded that in one type of situation which sometimes exists the underconsumption idea may be granted partial validity. That is during and following a serious monetary and banking panic, when unreasoning fear is the dominant emotion, and the disposal of goods and property rights in favor of “hard” money is an almost universal immediate objective. Under such conditions, as Davenport puts it, 12

The psychology of the time stresses not the goods to be exchanged through the intermediate commodity, but the commodity itself. The halfway house becomes a house of stopping. There sets in an abnormally developed emphasis upon money or credit as deferred purchasing power rather than as present purchasing power—on money for future purchases rather than as demand for present goods. The situation is one of withdrawal of a large part of the money supply at the existing level of prices.

But such a situation cannot endure for long, and it obviously occurs in conjunction with a period of crisis, rather than preceding it. In other words, to attribute some reality to the underconsumption idea in the brief period during which such conditions prevail is merely to recognize facts for purposes of description, but in no sense to explain the causes of the total situation.

With respect to other than panic conditions, it is patent that the underconsumptionists are wholly unmindful of the significance of Say’s Law (the briefest possible expression of which is that “the supply of goods constitutes the demand for goods”). But to offer this as a summary refutation of the underconsumption idea is hardly enough to lay bare the roots of the fallacy. These seem embedded in failure to distinguish properly between the gross product and the net income of society, and in lack of comprehension of the workings of the capitalistic, many-stage, process of production, in which gross income necessarily must exceed net income.

Refutation of Underconsumption Theory

Even if the system is in a condition of stationary equilibrium—that is, no net saving is being made—the gross product of economic activity will be considerably greater than the net income. The amount by which the first exceeds the second represents the repair and replacement of existing equipment—costs that must be covered if the system is to avoid retrogression. Indeed, it is not even necessary that the current money income of consumers should be equal to the net product produced, because of corporate and other business savings used to maintain and replace the existing stock of capital goods. Therefore, the net income in the form of money payments to consumers neither ordinarily will nor should be great enough to enable them to command the entire gross product of industry.

Furthermore, as our economic system is organized at present (the roundabout, many-stage, “capitalistic” process of production) the gross income—the total volume of money payments—necessarily exceeds the net money income or the net output of consumers’ goods. There are many stages of payments which go to make up the gross income but which are not involved in the computation of net income. The larger number of payments is not from consumers to producers, but is made between producers and producers, and tends to cancel out in any computation of net income or of net product value. “In fact, income produced or net product is roughly only about one-third of gross income.” 13 What is cost for one producer is in part income for some other producer, but part of that income the latter has to pay out in costs to other producers in another stage of the productive process (for intermediate products, raw materials, supplies, etc.), and so on. All that is necessary in order that equilibrium be maintained is that consumers’ incomes equal the cost of producing consumers’ goods; the total of producers’ payments necessarily exceeds that of consumers’ incomes.

But ours is a “progressive” economy, and not one in stationary equilibrium. It is one in which real saving is continually being made and being converted into real physical capital, and it is the net saving of the system which makes its progress possible. In such a situation the refutation of the underconsumption argument becomes even more convincing. If real saving is to take place—if the capital equipment of the society is to increase—then the gross product of the society very evidently must exceed the amount spent on consumption goods: the gross product must include that amount which makes possible the increase in capital equipment. A portion of the gross income must be put to the task of creating additional capital equipment in order to increase net income in the future. Not only must some of the total income be diverted from current consumption uses in order to maintain the stock of real capital, but some part of it must be used in ways which will result in an annual addition to that stock if the society is to progress. If all gross income were converted into net income it would mean not only that no progress would be possible, but also that the existing stock of capital goods would not be maintained, and the system would become retrogressive.14

This whole question, it is believed, is successfully disposed of by Dean A. B. Adams when he says:15

If the physical volume of the current output of consumers’ goods should equal the physical volume of all goods produced currently, there could be no accumulation of permanent capital—there could be no real savings. If real savings are to be made, the total volume of production must exceed the physical volume of consumers’ goods flowing to the market. Real investment is an ultimate demand for goods just as the purchase of consumers’ goods is an ultimate demand. When consumers and real savers purchase a physical quantity of goods equal to the physical quantity of production for that period, there can be no oversupply of goods or shortage of money income. Real savings and investment do not cause a shortage of consumers’ money income, but they make industrial progress possible.

If this analysis is correct, there is no reason to believe that industrial depression is brought about by an absolute deficiency of consumption. Rather, the writers incline to the position of Professor Robbins:16 “It may prove to be no accident that the depression in which most measures have been taken to ‘maintain consumers’ purchasing power’ is also the depression of the widest extent and most alarming proportions.” The same thought is expressed by Professor Åkermann:17 “The theories of price-level stabilization and consumption credit were unable to predict the crisis—their adoption was indeed a cause of the crisis; the same theories moreover seem unable to remedy the depression: indeed they have only contributed to make things worse.”

MALDISTRIBUTION OF INCOME AS A POSSIBLE CYCLICAL FORCE

Another variant of the underconsumption theory is that which maintains that depressions are brought about by the unequal distribution of income. The emphasis is placed upon a relative deficiency in consumers’ incomes, or else upon a relative oversupply of savings in the hands of the capitalist class. The argument commonly runs thus: the incomes of property owners, entrepreneurs, and rentiers in general are so great a proportion of the total national income that they are unable to spend all their incomes on consumption goods, and therefore they must save and invest heavily in new capital developments. These savings of the capitalist class are so great that, when turned into new capital goods which soon beget more consumers’ goods, the end-result is overproduction, because the consumers (laborers) do not command a sufficient percentage of the national income to enable them to take the additional supply of goods off the market.

This theory is based on the assumptions that the quantity of savings made and invested currently when the industrial system is operating at reasonably full capacity is large enough to produce a boom, and that investment of savings in new capital goods causes the physical supply of consumers’ goods on the market to increase more rapidly than the increase in consumers’ income. Because the percentage of national income going to capital is so great, it is argued, the capitalists are able to meet their living expenses with the lesser portion of their incomes, and the remaining larger portion cannot readily be expended otherwise than for new investments. This inordinate amount of saved income going to the creation of new capital equipment not only brings on and magnifies the boom, but also provides self-correction, for when the stream of new consumers’ goods flowing from these new capital goods reaches the market, prices fall abruptly and industrial activity slows down, and the share going to capital is reduced during the depression.

The over-saving, or maldistribution of wealth theory, like the overproduction and underconsumption ideas, again indicates lack of understanding of the dual relations of production and consumption. Proponents of any of these doctrines would do well to ponder the dictum of Alfred Marshall:18 “Economics from beginning to end is a study of the mutual adjustments of consumption and production: when the one is under discussion, the other is never out of mind.” Savings, it is true, do reduce the amount of money income which is available for the purchase of consumers’ goods, but savings do not reduce the amount of purchasing power which is available for the purchase of total goods and services. In any time period, the income which is saved and invested (in creating capital goods) plus the income used to purchase consumers’ goods equals the value of total production during that period; the demand for goods equals the value of total current production; the demand for goods is equal to the supply of goods. Where (as is normally true) savings from the current national income are invested in “goods used for the production of goods,” the total income of the economy is spent for goods (and services)—part for the stream of consumers’ goods flowing into market, and part for the current stream of capital goods. There can be no oversupply of consumers’ goods so long as the output of goods in general is being adjusted as between the production of consumers’ goods and capital goods in the same proportions as is the total national income between spending and investing; or, stated more concretely, if 85 per cent of the total annual production is in the form of consumption goods and services, and if 85 per cent of the annual monetary income of the nation is “spent” (not invested), there is bound to be sufficient purchasing power available to clear the markets of that output of consumers’ goods.

It is therefore illogical to assume that either the absolute amount of savings or the size of the distributive share going to capital can initiate a boom. So long as the percentages remain relatively constant as between the share going to capital and the share going to labor (consumers), there is nothing inherent in any particular method of distributing the national dividend which will cause disequilibrium in the productive process, even though the total volume of production is increasing. Progressive expansion of the national income normally accompanies capital accumulation; indeed, as already shown, the aggregate net income cannot grow unless there be saving (disregarding technical progress and population growth). Nor need the basis of apportionment between saving and spending be considered as a disequilibrating factor, so long as the proportion remains the same: as Bickerdike and others have shown, a uniform rate of accumulation of capital is not inconsistent with economic stability.19 What would result from a diversion of 50 per cent of the national dividend to savings, instead of the usual estimates of 10 to 20 per cent, would be that the rate of progress would be greater, prices and the rate of interest would fall, machinery would do more of the work of the productive process, the aggregate national real income would be greatly increased, and labor would have more leisure to enjoy the fruits of that enlarged income.

The views of the authors are largely compatible with Professor Hansen’s contention that disturbances to the even flow of our industrial life are attributable in the main to fluctuations in the rate of capital accumulation.20 In fact, it is just these fluctuations in the rate of capital accumulation which create instability, and which constitute the business cycle. But there is little reason to believe that alterations in the rate of voluntary saving can be of such magnitude or swiftness as to bring about the change in the rate of investment which is the central feature of the present exchange economy business cycle. Furthermore, the available statistics on the distribution of the national income do not show any such alteration in the proportion of the share going to capital as is assumed by the maldistribution-of-income theory—indeed, the reverse is true, as is observable in the following table:

TABLE VI

DISTRIBUTION OF NATIONAL INCOME IN THE UNITED STATES BY FUNCTIONAL SOURCES

YEAR OR YEARS	WAGES AND SALARIES	ENTREPRENEURIAL INCOME (Includes Rent)	INTEREST AND DIVIDENDS
1910	48.9	36.5	14.7
1913–1917	57.5	32.4	10.5
1918–1922	62.9	29.4	7.7
1924–1927	65.5	26.3	8.2
1928	65.1	24.7	10.2

Source: Encyclopedia of the Social Sciences, article on “National Income,” Vol. XI, p. 218.

Banking Policy a Disturbing Factor

It is indisputable that the rate of investment, change in which is the dominant characteristic of the business cycle, does fluctuate over wide limits. Wherein, then, is the chief source of variation in the rate of investment? The thesis of this volume is that it is to be found in the elasticity of the banking system, and subsequent chapters will be devoted to an elaboration of this contention. The banking system is able to provide the funds which permit investment in capital goods at a rate in advance of the increase of voluntary savings by the society in question. It is this availability of loanable funds which makes possible the misdirection of real capital that results in partial overproduction. It is the means of payment forthcoming from the banking system that makes possible the financing of excessive capital-creation activities, and it is the cessation or slackening of this increase of media of payment that operates to reverse the period of expansion.

There is even reason to believe, however, that depression need not necessarily ensue from an expansion in the rate of accumulation of capital goods per se, provided prices decline pari passu with the increased productivity brought about by this increase in investment. The fall in prices would in itself serve to constitute an effective check upon inordinate capital development because it would bring about a decline in the rate of return going to capital; as the rate of return to capital declined consequently upon the fall in prices the rate of accumulation of capital goods would tend to diminish. Under such conditions the system is automatically self-corrective. It is just this self-corrective process which is essential to the smooth functioning of the economic machinery. And it is in this way that the system would work were it not for the disturbing factor of credit. The injections of new credit not only permit an increase in the rate of capital accumulation, but also tend to disrupt progressively the normal equilibrium relationships between costs and prices over many sectors of the pricing front. The fundamental disequilibria are not discernible until the new credits are withdrawn or cease to increase, when it then becomes apparent that the anticipated earnings of capital based on the prevailing (artificially pegged) price level will not be realized, and the creation of capital goods ceases abruptly. The cessation of the production of new capital produces depression, and is at the same time the dominant characteristic of depression.

In order to guard against misinterpretation, it may be well to state explicitly that it is a particular type of banking policy, and not banking as such, at which the criticism of the above paragraphs is aimed. Banking is not necessarily and inherently malevolent in its effects; on the contrary, as will be shown in later chapters, it is an institution that may readily be utilized in pursuance of beneficent ends.

21 These theories, it may be remarked parenthetically, are mainly concerned with explaining the depression proper, or the collapse of a boom; they usually do not seek to explain the origin of the boom which precedes the depression. For this reason they are hardly entitled to be considered as theories of the business cycle; they are merely “depression” theories.

22 Principles of Political Economy (London: Longmans, Green & Co., 1923), Ashley’s edition, Book III, Chapter xiv, pp. 557–560.

23 Final Report of the Royal Commission appointed to inquire into the Depression of Trade and Industry (Cmd. 4893, 1887), p. xvii.

24 Recent Economic Changes (New York: D. Appleton & Co., 1889), pp. 25–26.

25 For a discussion of the development of the underconsumption theory from Lauderdale and Malthus, through Sismondi and Karl Marx, up to and including John A. Hobson and Messrs. Foster and Catchings, see A. H. Hansen’s Business Cycle Theory: Its Development and Present Status (Boston: Ginn & Co., 1927), Chapters II and III.

26 Devotees of the new school of economics well may ponder the estimate of the late Allyn Young of one of their foremost leaders: “I do not see how one who looks backward through smoked glasses can look forward with open clear eyes.” Economic Problems, New and Old (Boston: Houghton Mifflin Co., 1927), chapter on “The Trend of Economics,” p. 247.

27 “Overproduction and Business Cycles,” Proceedings of the Academy of Political Science (June, 1931), Vol. XIV, No. 3, p. 358.

28 “It will be remembered that during this period economic analysts were continuously stressing the fact that no undue accumulation of unsold goods was in evidence.” Moulton, H. G., The Formation of Capital (Washington: The Brookings Institution), p. 138. And see Snyder, op. cit., p. 358: “We know, moreover, there was no great piling up of stocks or inventories in recent years, or in 1929.”

29 Economic Forecast and Reality, 1928–1932 (Stockholm: Svenska Bokhandeln, 1933), p. 11. In the case of wheat Carl Snyder estimates an increase in the normal carry-over equivalent to about three weeks’ normal consumption; op. cit., p. 336.

30 In contrast with the First Industrial Revolution, however, there was a change of emphasis in the argument advanced against inventions and technical change. The earlier attacks were aimed directly at the machine as such as a displacer of labor, and sometimes eventuated in physical violence; during the recent period, the argument developed into more of a theoretical disputation regarding the socioeconomic effects of technical progress.

31 Nicholas Kaldor, “A Case against Technical Progress?” Economica (May, 1932), Vol. XII, No. 36, p. 186.

32 Davenport, H. J., The Economics of Enterprise (New York: The Macmillan Company, 1925), p. 320.

33 Slichter, Sumner, Towards Stability (New York: Henry Holt & Co., 1934), p. 7 (note to p. 6).

34 In fact, it is just this situation which has come to pass during the present depression—and it is precisely because of this fact that the present depression has persisted! Cf. Slichter, op. cit., p. 6, note: “The estimates of the Bureau of Foreign and Domestic Commerce * * * indicate that during the present depression the income paid out as salaries, wages, interest, dividends, net rents and royalties, and withdrawals of owners has exceeded the net income produced.” See also Chapter VII, this volume.

35 Profits, Progress and Prosperity (New York: McGraw-Hill Book Co., Inc., 1927), p. 18.

36 “Consumption and the Trade Cycle,” Economica (November, 1932), Vol. XII, No. 38, p. 430.

37 Op. cit., pp. 45–46.

38 Principles of Economics (London: Macmillan & Co., Eighth Edition, 1930), p. 712, note.

39 Hansen, A. H., and Tout, H., “Annual Survey of Business Cycle Theory: Investment and Saving in Business Cycle Theory,” Econometrica (April, 1933), Vol. I, No. 2, p. 139.

40 Ibid., p. 119.

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.
9“Loans and Taxes in War Finance,” American Economic Review Supplement (March, 1917), Vol. VII, No. 1, p. 200.
10Phillips, C. A., Bank Credit (New York: The Macmillan Company, 1920).
11“The view that bank deposits are potential currency is inapplicable to the deposits created in the Government’s War loan account.” Leffingwell, R. C. (Assistant Secretary of the Treasury during the War), “Treasury Methods of Financing the War in Relation to Inflation,” Proceedings of the Academy of Political Science (June, 1920), Vol. IX, No. 1, p. 32.
12Bankers and Credit, p. 48.
13Professor Jacob Hollander attributes priority to Professor A. C. Pigou (1915) and to Professor O. M. W. Sprague (1916); see his War Borrowing (New York: The Macmillan Company, 1919), pp. 157–158.
14War and Lombard Street (1914); Our Money and the State (1917); The Business of Finance (1918); War-Time Financial Problems (1919).
15Bankers and Credit, pp. 24–25.
16See Phillips, op. cit., Ch. III; and see Hayek, F. A., Monetary Theory and the Trade Cycle (New York: Harcourt, Brace & Co., 1932), Ch. IV.
17This is true as long as the amounts pass from bank to bank and are not withdrawn in cash and hoarded, or so long as they do not represent larger cash balances circulating in the hands of the public. But the above is intended to illustrate a principle rather than to arrive at a mathematical result. It seems hardly necessary to add that the process just described is the same as obtains when banks utilize excess reserves to grant loans to customers, instead of buying bonds, and as when banks buy bonds on the stock exchange, instead of subscribing to a new Government bond issue.
18“Since the outbreak of War it is the second procedure in the main which has been followed, the surplus cash having been used to subscribe for Treasury Bills and other Government securities. The money so subscribed has again been spent by the Government and returned in the manner above described to the bankers’ cash balances, the process being repeated again and again until each £10,000,000 originally advanced by the Bank of England has created new deposits representing new purchasing power to several times that amount.” First Interim Report of the Committee on Currency and Foreign Exchanges After the War (The Cunliffe Committee Report), Cmd. 9182 (1918), Paragraph 10, note.
19“* * * the fourth Liberty loan has been placed in a very large degree by the use of bank credit. Precisely how much such credit * * * is not yet certain * * *. In addition to this large use of direct bank credit is to be reckoned the fact that the bonds * * * have been taken by the banks as collateral to secure notes running for long periods * * *. These factors make not only for a serious condition of inflation but also for the maintenance and continuance of the inflation much longer than would otherwise be probable.” “Washington Notes” (unsigned), The Journal of Political Economy (December, 1918), Vol. XXVI, No. 10, pp. 977–978.
20Friday, David A., Profits, Wages, and Prices (New York: Harcourt, Brace and Howe, Inc., 1920), p. 133.
21In 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:
22Thirteen years later, near the nadir of the Great Depression, Professor J. M. Clark wrote in like vein:
23Professor 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.
24Professor 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.
25“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.
26“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.
27As 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.
28The 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.
29The World War was probably the worst-financed war in history from the viewpoint of sound fiscal policy. Less of the monetary costs of the War was financed by taxation and more by inflation of one form or another than any of the wars of the nineteenth century. Mr. Hartley Withers estimates that 17½ per cent of the cost of the War to England was covered by taxation, and Sir Josiah Stamp states that England’s showing in this respect was better than that of any other European belligerent. Elsewhere Stamp estimates that 63 per cent of the cost of the Napoleonic Wars to England was raised by taxation. The Report of the Committee on War Finance of the American Economic Association estimates the portion of World War costs covered by taxation in the United States at 25 per cent. As previously stated, all of the countries involved in the World War, with the exception of the United States, resorted to the age-old expedient of inflation of the note currency. But the United States, along with virtually all of the other nations, made use of that form of war financing which Mr. Withers denominates “quite the worst way of raising money for war or any other purpose” and which Professor 0. M. W. Sprague says is “the most potent single cause of the general advance in prices during periods of war,” namely, that of securing money from the banks either by issuing bonds directly to them for which they pay by creating new credits in favor of the Government, or by selling bonds to individuals who cover their subscriptions by borrowing from banks the credits that are newly created for this purpose. Such was the means by which the major portion of the monetary costs of the War was raised by all countries involved, and it is probably a safe assertion that it was employed on a more extensive scale than during any previous war. It is therefore desirable to inquire more fully into how the banking machinery was utilized to serve that end. In order to do so, however, it is necessary to set forth in some detail a particular point of banking theory which was neither understood nor recognized by writers on the subject until the period of War finance brought it into sharp relief.
30That banks “create” credit by granting loans has long been known and recognized. The precise nature of the process of creation of credit was not generally realized nor adequately analyzed, however, until after the termination of the World War. The correlative process of creation of bank credit, by means of purchases of investments on the part of the banks, is far from having universal recognition even today. It seems quite certain that some of those responsible for the way in which the War was financed in this country were not cognizant of the procedure by which it was done—they were, as Withers puts it, “making reckless use of a delicate machine which they did not understand and producing consequences which they neither foresaw nor recognized.”
31That banks “create” credit by granting loans has long been known and recognized. The precise nature of the process of creation of credit was not generally realized nor adequately analyzed, however, until after the termination of the World War. The correlative process of creation of bank credit, by means of purchases of investments on the part of the banks, is far from having universal recognition even today. It seems quite certain that some of those responsible for the way in which the War was financed in this country were not cognizant of the procedure by which it was done—they were, as Withers puts it, “making reckless use of a delicate machine which they did not understand and producing consequences which they neither foresaw nor recognized.”
32That banks “create” credit by granting loans has long been known and recognized. The precise nature of the process of creation of credit was not generally realized nor adequately analyzed, however, until after the termination of the World War. The correlative process of creation of bank credit, by means of purchases of investments on the part of the banks, is far from having universal recognition even today. It seems quite certain that some of those responsible for the way in which the War was financed in this country were not cognizant of the procedure by which it was done—they were, as Withers puts it, “making reckless use of a delicate machine which they did not understand and producing consequences which they neither foresaw nor recognized.”
33So far as is known to the writers, this process of the manufacture of credit on the part of the banks by purchasing investments was first discerned by Withers. In several books published during the War period he indicates an increasing understanding of it in connection with war finance. In his Bankers and Credit, however, published in 1924, he elaborates the theory most clearly, and it is appropriate to quote at some length from that work:
34So far as is known to the writers, this process of the manufacture of credit on the part of the banks by purchasing investments was first discerned by Withers. In several books published during the War period he indicates an increasing understanding of it in connection with war finance. In his Bankers and Credit, however, published in 1924, he elaborates the theory most clearly, and it is appropriate to quote at some length from that work:
35So far as is known to the writers, this process of the manufacture of credit on the part of the banks by purchasing investments was first discerned by Withers. In several books published during the War period he indicates an increasing understanding of it in connection with war finance. In his Bankers and Credit, however, published in 1924, he elaborates the theory most clearly, and it is appropriate to quote at some length from that work:
36The operation of the machinery of bankers’ banking made possible the creation of the greater portion of the credit by means of which both the United States and England financed the War. It was not the effect of such transactions as Withers describes that had the most significant influence upon prices in this country; rather, it was the superimposition of bankers’ banking upon the commercial banking structure that led to the compound creation of bank credit. For whenever bankers’ banking becomes operative, the inflationistic nature of commercial banking is greatly reinforced and accentuated. In the simplest possible illustration, in a banking system requiring a 10 per cent reserve against deposits, a bank having a reserve of one million dollars in excess of the required ratio may use that reserve to buy one million dollars worth of bonds, giving the Government deposit credit for that amount. As the Government draws checks against this deposit credit and pays them to government contractors, munitions makers, etc., and as they in turn deposit the checks in their (other) banks, the bank which originally bought the bonds tends to part company with cash—but that cash reappears as new, excess, reserve, for some other bank (or group of banks) in the system. The second bank in turn may now use 90 per cent of its new reserve to buy, let us say, $900,000 worth of bonds (it being required to set aside $100,000 to satisfy the requirement for a 10 per cent reserve against the deposit of the government contractors), and as the Government checks against the $900,000 deposit created in its favor in exchange for the bonds, the second bank (or group of banks) in turn tends to lose cash to a third bank (or group of banks) in the system. The third bank (or group of banks) may now use its new reserve of cash to buy $810,000 worth of bonds (90 per cent of $900,000 deposited with it) and to create $810,000 of Government deposits, and so the process is repeated again and again.
37As this is done, each bank in subscribing for bonds to the extent of 90 per cent of the amount deposited with it creates an equivalent increase in deposits either for itself or for other banks in the system, and it becomes clear that the original creation of credit ultimately makes possible manifold new deposits in the banking system. That is to say, the total credit created on the basis of the excess reserve originally utilized to buy bonds is not simply equal to the amount of that reserve, but is (for a system with a 10 per cent legal reserve ratio against deposits) roughly ten times that amount. The original one million dollars of excess reserve permits the creation of ten million dollars new deposits in the banking system. And to the extent that all banks in the system are possessed of excess reserves and use them simultaneously to buy bonds issued by the Government the expansion is more widespread and proceeds more rapidly. Thus it is seen that deposits are basically the offspring of loans and investments for the banking system as a whole.
38As this is done, each bank in subscribing for bonds to the extent of 90 per cent of the amount deposited with it creates an equivalent increase in deposits either for itself or for other banks in the system, and it becomes clear that the original creation of credit ultimately makes possible manifold new deposits in the banking system. That is to say, the total credit created on the basis of the excess reserve originally utilized to buy bonds is not simply equal to the amount of that reserve, but is (for a system with a 10 per cent legal reserve ratio against deposits) roughly ten times that amount. The original one million dollars of excess reserve permits the creation of ten million dollars new deposits in the banking system. And to the extent that all banks in the system are possessed of excess reserves and use them simultaneously to buy bonds issued by the Government the expansion is more widespread and proceeds more rapidly. Thus it is seen that deposits are basically the offspring of loans and investments for the banking system as a whole.
39The machinery of central banking was exploited indirectly to create credit with which to finance the War, moreover, when individuals subscribed to the bond issues and secured the funds with which to pay for the bonds by borrowing from the banks, pledging the bonds as collateral for the loans, provided the central banks were able and willing to make such advances to the local banks as would enable them to maintain adequate legal reserves. This process increased the deposits in the banking system as effectively as when the banks subscribed to the bond issues directly. It was encouraged and facilitated in the United States by the policies of the Treasury Department and the Federal Reserve Board, acting in cooperation under the leadership of Mr. William G. McAdoo in his dual rôle of Secretary of the Treasury and member of the Board. From this procedure, as in that first described, there ensued a great increase in purchasing power that was unaccompanied by an equal increase in production, and hence resulted in inflation.
40Dr. David Friday, in his book Profits, Wages, and Prices, professes not to understand this remarkable rise in the price level during the War period. Speaking of the American situation he says:

Banking and the Business Cycle