Banking and the Business Cycle

CHAPTER IX THE ECONOMIC IMPLICATIONS OF RECOVERY

Thus far our inquiry has been directed primarily to events prior to 1933. The statistical material presented has purposely not been extended beyond December, 1932. The Banking Panic of 1933 and the inauguration of the so-called New Deal economic policies may be considered as marking the termination of the secondary post-War business cycle. Our major interest is with the causes and aspects of that cycle, not with either the New Deal program or the current recovery. A host of volumes treating of the Government’s recovery program has appeared since 1933; it is not our desire merely to add to that list. Rather, it is just because so many of the books of the last few years which have dealt with recovery display so little understanding of the causes of the Great Depression that an analysis of those causes is in order. Also, the fact that many Governmental policies aimed at promoting recovery reflect inadequate appreciation of the fundamental causes of the last cycle is added justification for the concentration of major attention upon the depression and the events leading up to it. If no lessons have been learned from the last depression, then eventually the evils of depression may be but worse compounded. With the necessity for regulating “the coming boom” already a subject for comment, and with a racing stock market again confronting us, a sober backward glance at the causes of the last boom can scarcely be amiss.

Diagnosis without prescription, however, admittedly is of little therapeutic value. It is not enough to direct attention to the phases of the last cycle and to the causes of the last depression, to the exclusion of the causes and the conditions for recovery as such. An explanation of the causes of the Great Depression will not of itself point the way to a satisfactory and enduring recovery. The diagnosis inherent in that explanation should, nevertheless, indicate the line of treatment to be followed if the economic system is to be relieved of its depression illness; recovery measures should take account of the causes and nature of depressions, and of business cycles generally. If, therefore, the theory of the business cycle and the explanation of the Great Depression herein developed are accurate, an adequate recovery program should be related thereto. It should be equally self-evident that recovery measures which are based upon those theories of the business cycle whose essential falsity we have already emphasized may end by producing even more far-reaching disaster. Foolhardy procedures which are divorced from economic realities, or whose economic implications are not understood by their promoters, do not perforce become sanctified and wise merely by designating them as “action”; tilting at windmills does not draw water.

We turn at this point, then, to a brief examination of certain aspects of the current recovery, and to the task of indicating, at somewhat greater length, certain conditions which we believe it is imperative should be present to assure a better balanced and more lasting recovery. That the United States is at this time experiencing a marked degree of recovery is now apparent to any well-informed observer of the contemporary economic scene. Proposals of alternative policies, or criticisms of the deficiencies of the present recovery program, therefore run the risk not only of being unwelcome but also court the danger of increasing “out-of-dateness” as the pace of recovery may quicken. Why discuss the causes and conditions of recovery when Recovery is here? To say “what should have been done,” or to propose “what must be done” even now, if difficulties for the future are to be averted, will no doubt appear to many as merely Cassandra-like croakings. But when a recovery program, which, while it may appear effective, depends for its efficacy upon much the same kind of “cheap money” inflation which our analysis has shown was the main cause of the Great Depression, then the present recovery must ultimately prove as illusory as the New Era of the ’twenties; and it is the duty of economists to pierce the veil of illusion.

Although, as just stated, we have at long last turned the corner from depression to recovery, it is nevertheless true that many unpleasant reminders of depression are still with us. To those who take a realistic view of the current situation, its paradoxes must at least give cause for wonderment. Certainly the recovery movement to the date of this writing is a peculiar one: it is shot through with anomalies. With the estimates ranging from as little as 8 million to as great as 12 million unemployed, with governmental relief rolls still at high levels, and with the United States ranking sixth among the nations of the world in degree of recovery from the depths of depression, there very obviously is something wrong, somewhere. The paradox of rising profits accompanied by increased and extra dividends for many corporations while the earnings of capital in many important industries is still negative, the anomaly of rising wage rates for men in employment in some industries at a time when widespread unemployment still prevails, and the phenomena of higher tax rates, higher governmental income, and greater Treasury deficits than have been witnessed in any peacetime period in our history, all demand explanation. The pleasing prospect of a runaway bull market in the Stock Exchange should not again be permitted to delude us into an ostrich-like attitude toward other sectors of the economic field.

The fact would seem to be that the authorities who are undertaking the “management” of the current recovery, and congratulating themselves that prosperity is returning because they “planned it so,” are utterly oblivious of the fact that recovery is being engineered largely by the same means which produced the last boom—and depression. With this difference: whereas the banking system during the ’twenties was producing an investment credit inflation by extending credit to business men and corporations, Government is now assuming the rôle of inducing new deposit currency in the banking system and thereby producing a consumption credit inflation. The Federal Government, instead of private corporations, is issuing the bonds which the banks are now purchasing, thereby inflating the deposit currency structure all over again. These “created” funds are in this instance being used principally to finance consumption expenditures through relief disbursements, make-work projects, and the like. This newly created Bank Money, in circulating through the economic system, is ultimately finding its way into corporate treasuries in the form of newly created profits and into individuals’ bank accounts as newly created monetary income. The profits are again being used to finance new capital development, and the enhanced income of individuals is helping to promote the stock market boom. Thus the inflationary procedure of the current cycle reverses somewhat that of previous ones, when the new credit first entered the system through the capital goods industries and from there filtered through the economic system to the consumption goods field and to the stock market. Perhaps the boom will thereby be a little slower in gaining headway than previous ones; but the point to be noted is that the two procedures are in essence the same: they both depend upon an inflation of bank credit at a rate faster than the rate of increase of physical production. And the fact to be emphasized is that the current inflation tends to conceal and to preserve the fundamental disequilibria which so prolonged the Great Depression and which we are now carrying over therefrom without having once squarely faced the problem of correcting them. It is doubtful whether any given amount of inflation will cure these disequilibria. When the inevitable depression succeeds such an artificially created boom as is now being engendered, we may no doubt expect the “managers” of the recovery, judging by their published and spoken utterances, to assess blame for that depression almost anywhere but where it rightfully will belong.

For these reasons, it is at this point desirable to gain a closer but brief view of the chief means by which recovery is being effected. The underlying philosophy of the Administration’s attempts at recovery rests in the underconsumption theory of depressions. The familiar “prime the pump” argument is but an expression of this idea: all that is necessary, it is argued, is that new monetary purchasing power be generated in the economic system, and the pump of production will again function. This neglects the fact that if the pump were in good working order, priming would be unnecessary, and that if the pump is not in order, then it were better to find out why it is not. For if its continued functioning is dependent only upon continued priming, then the priming deserves to be termed by its proper name, inflation; and as soon as the priming ceases, so will the pumping.

Now, whence comes this new purchasing power? The explanation is simple, but significant. It carries us back to familiar ground already traversed in previous chapters. We have pointed out that when the banks purchase new bond issues, they thereby increase bank deposits, just as when they increase their loans. In the one case, corporate credit is being monetized by the banking machinery; in the other case, it is the Government’s credit which is being monetized; in both cases, new monetary purchasing power is being created in the form of deposit currency. Specifically, when the Government issues ten billion dollars in Government bonds and sells them to the banks, the banks in purchasing these bonds give the Government new deposit credit on their books to the extent of ten billion dollars. Against this ten-billion-dollar deposit credit the Government may now write checks to pay relief recipients, WPA workers, bonuses for not raising wheat or cotton, or any of the many disbursements now being assumed by the Government.

It is illuminating to follow the course of these checks as they circulate throughout the economic and financial systems. They are turned over by the original recipients to their landlords, to their grocers, or used to pay old debts; or they are used to buy new shoes, new automobiles, or for amusements. These secondary recipients commonly deposit the checks in their banks. We now find that these individuals, collectively, are possessed of ten billion dollars of bank deposits that they did not have before; instead of the newly created deposits standing to the credit of the Government on the banks’ books, a like amount now stands to the credit of business concerns, corporations, and individuals. There is thus an increase of ten billion dollars in the total of bank deposits. We might follow this new deposit currency through several more circuits, but the process should by now be familiar. The important thing to note is that the Government, in its policy of financing relief and recovery by issuing bonds which are purchased principally by the banks, is aiding in the creation of new deposits in the banking system, which begin by being a credit to the Government’s account and continue as credits to individuals and corporations. For one thing is certain: these newly created deposits are not self-liquidating in character; once ten billion dollars in new deposits has been created in this fashion, that amount of deposits continues in the banking system so long as the deficit borrowing continues and the bonds are not retired.1

NO EASY ROAD TO RECOVERY PROM DEPRESSION

There is, unfortunately, no broad, smooth, “royal road” to Recovery. Instead, we are almost always confronted with the somber prospect of being obliged to double back over virtually the same paths by which we descended to the trough of depression if the recovery is to have a solid foundation. It is usually necessary to retrace our steps until we arrive at a condition in some respects similar to that prevailing at the inception of the previous boom; ill-advised attempts to “short-cut” that route are foredoomed to fall short of their mark. It is gross folly to expect genuine and balanced recovery to flow from conditions and measures which maintain the disequilibria which characterize depression.

The discussion which follows, therefore, has general applicability to recovery from any depression—past, recent, or future—originally generated by monetary means. Although making use of the analysis of the causes of the recent depression as set forth in earlier chapters, the proposals which follow merely utilize the processes which in the main have been followed in effecting recovery from all past depressions. As the original impulsion for the last boom came from the monetary side during a period of relative equilibrium, producing an alteration in the structure of production which terminated in general disequilibrium for the whole economy, it is first necessary to restore at least some semblance of that original equilibrium so that new capital development once more becomes possible and genuinely profitable. Had attempts at recovery since 1929 aimed simply at the restoration of equilibrium in the economic system, it is most unlikely that the “spottiness” of the present recovery would be so marked.

The pressing need is still to restore a measurable state of economic balance within the system, rather than to restore superprosperity. Prosperity of the 1927–1929 sort can wait; indeed, it may even be hoped that that particular brand of prosperity never returns. What is now essential is to put men back to work—in a word, to produce; and the restoration of employment, and production, are dependent upon equilibrium. At the same time, it is imperative to eliminate the inflationary uncertainties inherent in the continued unbalanced budgets and deficit borrowing that constitute ominous threats to the future stability both of the currency and the credit of the Federal Government, and also to discontinue the damage to the public morale inherent in our Americanized system of the dole under the thinly disguised name of relief work.

SAVING VEKSUS SPENDING OUR WAY TO PROSPERITY

Although the fundamental causes of depression are footed in the inherently inflationistic character of the banking machinery, it by no means follows that monetary influences are the sole cause for continuance of depression, nor that the only way of escape is via the monetary route.2 The severity and duration of the recent depression are attributable to the third of the links in the chain of causation elaborated above, the loss of equilibrium. The fact that general disequilibrium has persisted, particularly that between costs and prices, is the reason why so little new investment has been made for a number of years; and because investment activity is still at a low ebb, unemployment has continued.3 To recover from depression it is necessary that the capital-goods industries should revive and that investment activity should again proceed under its own power. In other words, we must save our way out of depression, we must increase the real savings that make the creation of real capital possible, instead of spending our way to recovery by cumulating governmental deficits which concentrate attention on consumption as has now been done for five years.4 But in order for real savings to be forthcoming (or to be used) to finance new investment it is first essential that at least relative equilibrium be restored.

EQUILIBRIUM BEGETS PURCHASING POWER

Dean A. B. Adams is correct, it is believed, in holding that each cycle tends to terminate in equilibrium5—which is but another way of saying that recovery cannot make real progress until an equilibrium condition obtains. During the Great Depression, however, virtually every conceivable action was taken to postpone the termination date of the last cycle and to prolong the lack of equilibrium in existence at the time the slump set in. There seems little evidence that this problem has yet been seriously faced or that the necessity for facing it is yet widely appreciated. Until the problem is recognized, it seems doubtful that the character of the recovery can prove altogether satisfactory to its sponsors.

The focal point of attack in the restoration of equilibrium is the cost-price relationship. The most significant disequilibrium still persisting is that between costs, prices, and profits. The level of prices is a given datum, however, a fait accompli. There is, as a matter of fact, no good reason why recovery could not proceed from a low level of prices; but there are, on the other hand, serious flaws in the doctrine that recovery is impossible until prices have risen to some mythical level. Most of the positive action aiming at recovery so far has sought to correct the disparity between prices and costs by raising the price level up to the cost level by means of credit expansion, rather than by increasing the real volume of purchasing power by enlarging production employment irrespective of the price level. There is no necessary objection to an enlarged volume of credit, as will be explained shortly; there is, however, ample cause for dissent from the idea that worth-while recovery can be effected solely by monetary means, as well as for disagreement with the view that the timing of the expansion of credit is a matter of but slight importance. To engineer a price rise by inflationary measures without first correcting the more important maladjustments inherited from the past boom, while it may generate a temporary recovery or even a boom, is tantamount to “freezing” those maladjustments at their depression level and thus preventing a more genuine and lasting recovery. It should be pointed out, further, that to carry those maladjustments over to the depression which ensues when the present inflationary price-raising experiment comes to an end is but to court possible worse disaster at that time. We have already shown that the prosperity of the ’twenties, fed by bank credit inflation, concealed disequilibria which we carried over from the 1920–1921 depression; the recovery of the ’thirties, likewise financed by bank credit inflation, conceals maladjustments which were not corrected during the Great Depression. The absolute level of prices, it must be repeated, is not so important as the relationships between particular prices and particular cost margins. It seems much less hazardous for long-run stability, therefore, to effect the needed adjustments between costs and prices by reducing costs rather than by forcing prices up by means of inflationary credit expansion.

COST REDUCTION, EARNINGS ON CAPITAL, AND THE STANDARD OF LIVING

But the question of cost reduction, unfortunately, is inextricably mixed up with those larger questions of wage levels and purchasing power, of ideas of social justice and the standard of living, and can be dissociated from political implications only with great difficulty. These are issues which almost always arouse controversial misunderstandings, because rooted in popular misconceptions of the real relationships between costs and prices, between wages and purchasing power. Nevertheless, popular prejudices and specious rationalizations should not be permitted to obscure the logical conclusion that what is needed, if relative equilibrium is again to appear and if the recovery is to be more than an ephemeral one, is a reduction of certain wage rates which are out of line with the accomplished reduction in prices and the cost of living. “The present plan is a war against unemployment and its success is purely a matter of fairly simple organization to overcome the existing disequilibrium between commodity prices and money costs of production.”6 “It will of course appear nonsensical to those who hold that the cure for unemployment is to be found in raising wages and so increasing consumption and the demand for consumption goods. Of course, if wages could be raised without making any other change whatever, that argument would be plausible.”7

The objection will doubtless be raised that, even though cost reduction may be the only sure way out of the dilemma, there may be possibilities of lowering costs other than by reduction of wage rates, and that cost reduction should not be achieved exclusively at the expense of the wage-earner. Why should not Capital, in other words, be made to bear some part of the burden? It may be answered, in the first place, that the wage contract is the most flexible of the contracts involved in the processes of production: the terms of employment are rarely definite in time, nor of long duration. Secondly, Capital during the depression experienced larger cuts than is generally appreciated, in the way of conversions, reorganizations, and scaling down of interest payments, not to mention bankruptcies, for many classes of bonds, and in the form of reduced or passed dividends for many stocks. Furthermore, conversions of bonds bearing high rates of interest to lower schedules have been proceeding in 1935 and 1936 at a prodigious pace. Such dividend schedules as were maintained during the depression in most cases were cared for out of past-accumulated surpluses, net earnings to capital in general being realized only in the last year or two. Thirdly, employers generally during the depression effected cost-saving economies in other directions to the limit of their abilities; indeed, in many instances it was only by virtue of savings in overhead costs and by postponement of repairs and replacements that production was possible at all. But the consequences of the policy of refraining from providing for obsolescence and depreciation proved to be that the capital-goods industries suffered the more severely and that unemployment was thereby more widespread. Lastly, it should be noted that although the contract of employment is highly flexible, the wage rate itself proved to be one of the most inflexible of the many rigidities in evidence during the depression: an attempt to appraise the significance of this fact leads into the questions of real wages as contrasted with money wages, of wage rates as compared with total wages, and of total wages and total effective purchasing power.

The Common and Current Misunderstanding of Relations between Monetary Wage Rates and “Real” Purchasing Power

What is hoped to be accomplished by a reduction of wage rates is an increase of aggregate purchasing power. To many persons, unfortunately, this may seem to be a paradoxical statement. For the greatest confusion has reigned on the subject of wages and purchasing power throughout the depression, during the years of hyper-prosperity when the doctrine of high wages was at its zenith, and now. All too many writers who discuss wages and purchasing power point to the fact that the indexes of weekly earnings are below their pre-depression levels, and hence argue that wages have already been reduced as much as labor can stand; and they are quite correct in contending that total purchasing power has been reduced because weekly earnings have declined. They neglect, however, to call attention to the fact that there was no great reduction of wage rates during the depression, and they refuse to see any connection between the rigidity of wage rates (the hourly rate as contrasted with the daily or weekly wage payment)—making it necessary to resort to part-time working schedules, share-work schemes, and other similar uneconomic programs—and the reduction in weekly earnings.

The arguments in opposition to the reduction of wage rates (as a means of increasing total purchasing power during a period of widespread unemployment) rest on the confusion of wage rates and total wage income, and indicate an inability (or unwillingness) to understand the difference between money wages and “real wages.” Perhaps a more accurate statement would be that the real nature of wages is obscured by the monetary label which attaches to them.8 All arguments opposing reductions in monetary wage rates during a period when unemployment prevails reveal a lack of comprehension of the interrelations among wage rates, unit costs, prices, and volume of employment. They seek to stress the purchasing power of wages as an influence upon consumption without recognizing that wages enter prominently into costs for the producers and into prices for the consumers. It is contended that as wage rates are reduced, purchasing power is also diminished; with a lower level of wages, costs, and prices, it is frequently argued, the incomes of the wage-earners will still be insufficient to generate an increase in demand for consumers’ goods, and all that will result from a reduction of wage rates is a lower standard of living. Hence the reduction of costs through wage rate reductions is said to lead inevitably to an endless spiral of deflation, with falling prices being followed by further wage reductions, and so on, resulting in ever-greater unemployment and ending in complete collapse.

Such theories look only on one side of the account. They view money wages as original purchasing power, coming from out of the blue. They fail to take into consideration the fact that the incomes of individuals are for the most part made up of, i.e., are identical with, the expenditures by business enterprises; abstention from expenditure by business concerns results directly and indirectly in the loss of income both for other business concerns and for individuals, f or9 “* * * most of the dollars which they [individuals] receive come to them because business enterprises have been willing to buy services and commodities for them.” And the reason entrepreneurs are willing to buy labor services in exchange for a price (wages) is because they are able, in view of the relations of costs and prices, to market their products at a profit, or because they think they can do so. When the money price of wages is such as to induce entrepreneurs to go on producing, employment is steady. Money is simply a convenient means for exchanging goods and services, a convenient way of expressing the purchasing power which is ultimately bottomed in the exchange of goods and services.

Furthermore, opponents of a policy of wage rate reductions as a recovery measure persist in confusing the issue by stressing the purported relationship between wage rates and the standard of living. Either they erroneously infer that those arguing for a reduction of wage rates are plying a campaign for the reduction of wages, or else they designedly imply that a reduction of wage rates will automatically lead to a lowered standard of living. They do this by confusing, either by intention or from ignorance, a reduction of wage rates with a reduction of wages. As a matter of fact, the primary objective of the sincere proponents of a policy of wage rate reductions is the increasing of aggregate wages. There is no direct connection between the hourly rate and the standard of living; the standard of living, on the other hand, is a function of the total wage income and the cost of living. A program of reduction of wage rates, which brings costs into line with prices so that entrepreneurs are induced to embark upon greater productive operations, will put unemployed workers back onto jobs, will expand the aggregate of wage payments, and will enhance the total volume of consumer purchasing power. For surely it is futile to talk of a sacrosanct standard of living when eight million people are unemployed. Whose standard of living is contemplated? Only those in employment? A “standard” necessarily connotes an average, and it is the average of the whole population (employed as well as unemployed) which is involved in the computation of a standard of living. The brutal truth is that the standard of life for the American people has fallen drastically since 1929 for the simple reason that the policy of maintaining high wage rates has resulted in reduced employment and decreased production of the goods and services that constitute “real income.”

If all workers were employed, it is possible that a reduction of wage rates would bring a reduction of total purchasing power, because in that situation total wage payments would also be reduced.10 But given a situation where, say, only half the employable population has work but wage rates are maintained at the level which prevailed when the unemployment set in, purchasing power is reduced by half, for11 “an unemployed laborer has no purchasing power at all, however high may be the wage rate he would get if he had a job.” If, now, wage rates are reduced by 30 per cent, so that it becomes profitable in view of the new relationship between costs and prices to employ 100 per cent of the workers again, purchasing power is increased by 40 per cent (from 50 per cent to 70 per cent of the original figure), even though it stands at 30 per cent less than the level prevailing during the previous period of full employment. But if prices and the cost of living are also 30 per cent lower than in the first period of full employment there is no relative reduction of purchasing power whatever—“real wages” are the same in each instance.

REDUCING WAGE RATES WOULD LEAD TO INCREASED WAGES—AN ILLUSTRATION

What, it may be asked, will induce entrepreneurs to increase their aggregate costs by embarking upon the larger spending programs involved in hiring back that half of the population which was unemployed, with no assurance of an increase in prices? The answer involves an obvious but very important point—namely, that the reduction of wage rates enables the manufacturer to reduce his unit costs materially, and this follows because his income is increased more than proportionately to the increase in his total costs, including overhead and labor costs. This point is seldom adequately stressed by the proponents of a policy of wage rate reduction, and is commonly neglected altogether by the opponents of such a policy; it will perhaps be made more clear by the following illustration, admittedly unrealistic in some of its assumptions (as all specific examples of general propositions are apt to be), but sufficiently close to the real state of affairs in the business world to clarify the principle involved.

Assume (Case I) an economic system with 10,000,000 men employed at $1 a day working 6 days a week, or an aggregate weekly wage of $60,000,000 (it is convenient to use a daily wage rate instead of an hourly one to simplify the calculation; it does not vitiate the illustration if it be assumed that the number of hours worked per day at the $1 wage does not change throughout). Add an assumed $30,000,000 for overhead and other costs and weekly total cost is $90,000,000. If the 10,000,000 workers produce 60,000,000 units of product during a week, the cost per unit is $1.50. If the product sells for $1.50 the entrepreneurs just break even (it is also convenient to leave the question of profit out of consideration, and to assume that the entrepreneurs are content to go on producing at full capacity if they neither gain nor lose).

Let us now assume that this situation is altered (Case II): The price of the product falls (for reasons beyond the control of the entrepreneurs, as happens during any depression) by 30 per cent, to $1.05 per unit. At this price the entrepreneurs see fit, let us say, to discharge 30 per cent of the workers; overhead costs are reduced 30 per cent; and a 5-day week is inaugurated (a very realistic assumption during this depression!) for the remaining 7,000,000 workers in employment, but their daily wage rate remains at $1.12 The total wage bill is now $35,000,000 per week, overhead costs are $21,000,000, and total weekly costs are $56,000,000. But if those workers now in employment produce at their same daily rate per man, the number of units of output is now 35,000,000 weekly and the cost per unit is no longer $1.50, but $1.60; unit costs have risen with a reduced volume of output, and a loss of 55 cents per unit is experienced at the price of $1.05.13 It is apparent, furthermore, that this situation cannot continue for long, because such heavy losses will “wipe out” more and more employers and in consequence unemployment will grow progressively.

Now assume further (Case III) that the daily wage rate is reduced 30 per cent. At a 70-cent daily rate the 3,000,000 unemployed are rehired and the full 10,000,000 again work 6 days a week for a weekly wage of $4.20 per man, or a total weekly wage of $42,000,000 as against the $35,000,000 weekly wage in Case II. If overhead costs remain at $21,000,000, total costs per week are now $63,000,000. But as weekly output is again 60,000,000 units, the cost per unit falls to $1.05. Since the price is (assumed to remain at) $1.05, an exact equivalence of costs and prices is attained once more; instead of a 55-cent loss per unit, the entrepreneurs again break even. And this situation provides for full re-employment and an increase in aggregate purchasing power of $7,000,000 weekly, or 20 per cent, over Case II.

It is of course true that the 7,000,000 men now working 6 days a week at the $4.20 wage are situated less favorably than when they were working 5 days for $5.00; however, as was pointed out above, their former advantage was necessarily of a temporary and highly precarious nature. Moreover, it is surely self-evident that general social and economic welfare is enhanced greatly by having the full 10,000,000 employed, even at the reduced daily and weekly rate. And the 7,000,000 are no worse off in Case III than they were in Case I, because the $4.20 wage will buy as much “real income” at a $1.05 unit price as did the $6 wage at a price of $1.50 per unit.

Oversimplified as it admittedly is, the above illustration goes to the heart of the matter of wage rates and wages, or “real” wages and “real” purchasing power. The business man’s calculations and activities are ultimately bottomed on the relation between his unit costs and his unit selling prices. As his unit costs fall, he is motivated to increase output; doing so, he will hire more workers, even if his total costs go up. As soon as he rehires workers, however, he automatically starts to circulating the additional purchasing power that is needed to take the increased output off the market. For as Professor Slichter has well stated, the income of consumers depends directly, and largely, upon the volume of business spending:14 “This means that the fluctuations in consumer incomes, which produce fluctuations in consumer spending, are the result of changes which have already occurred in business spending. Consequently, the explanation of fluctuations in the total volume of spending must be sought, not in spending by consumers, but in spending by business enterprises.”

THE FALLACIOUSNESS OF THE DOCTRINE THAT HIGH WAGE RATES ARE SYNONYMOUS WITH FULL PURCHASING POWER

Perhaps no single action taken during the depression had more to do with its prolongation than that of former President Hoover, acting under a mistaken notion as to the real nature of wages and deluded by the doctrine of high purchasing power (possibly a pardonable delusion, in view of its widespread popularity), when he asked employers in November of 1929 to maintain their wage rates (unless it was the instituting of the NRA—but it is probable there would have been no NRA, nor New Deal either, had it not been for the Hoover experiment of November, 1929). Professor Viner’s judgment on Mr. Hoover’s action in this connection, as well as his views on the subject of wage rates and purchasing power in general, are in point:15

President Hoover would have rendered a service instead of a disservice to labor if instead of pledging employers to maintain wage rates he had obtained from them a pledge to maintain their total employment, with freedom to reduce wages as circumstances made necessary. * * * ALL THAT IS GUARANTEED BY WAGE RATES HIGHER THAN EMPLOYERS CAN AFFORD TO PAY AND STILL GIVE EMPLOYMENT TO THE AVAILABLE SUPPLY OF LABOR IS UNEMPLOYMENT. * * * LARGE PAYROLLS DO MEAN HIGH PURCHASING POWER, BUT HIGH WAGES MAY AND OFTEN DO REDUCE RATHER THAN INCREASE THE SIZE OF THE TOTAL PAYROLL. * * * It would be very nice if simply by doubling or tripling all wage rates overnight, we could end the depression, but its effect would be rather to make unemployment complete instead of partial.

WAGE RATES, DEPRESSION AND RECOVERY—1920–1921 AND 1929–1936

In previous depressions wage rates were generally reduced rather drastically, and with comparative rapidity. And recovery from past depressions proceeded from the time when a comparative equilibrium of wage costs and prices was again achieved. The rigidity of wage rates during the Great Depression, on the other hand, is one of the outstanding features which differentiates it from previous ones. An examination of the index of wage rates in manufacturing industries will suffice to indicate the rapidity and extent of the reduction accomplished during the 1920–1921 depression. In the third quarter of 1920 (the quarter in which the depression set in) the index number of wage rates stood at 245 (using 1914 as the base year); during the fourth quarter of 1920 the index did not change; but during the respective quarters of 1921 the wage-rate index declined successively to 229,217,205, and 192. Prices in the meantime declined from a high of 247 in the second quarter of 1920 to approximately 140 in the third quarter of 1921. The following table, by contrast, indicates the slowness with which wage rates gave way during the recent depression. It shows that wage rates in manufacturing industries after three years of this depression were as high as they were at the end of 1921; yet the price level was below the 1913 level and the cost of living was only 28 per cent above the 1913 level. Wage rates declined in one year, from the third quarter of 1920 to the fourth quarter of 1921, by 22 per cent; from the third quarter of 1929 to the third quarter of 1931, two full years, wage rates declined but 4 per cent, and there was no change at all during the first year of the Great Depression.

TABLE XXV

WAGE RATES IN MANUFACTURING INDUSTRIES (1914 = 100)

YEAR	MANUFACTURING WAGE RATES, HOURLY
	Quarter I	Quarter II	Quarter III	Quarter IV
1929			239	240
1930	240	240	240	236
1931	233	231	229	221
1932	213	205	196	190

Source: The National Industrial Conference Board.

Mention has already been made of one charge frequently made against a policy of wage rate reduction, namely, that it is inevitably deflationary, leading to a sequence of falling prices followed by falling wage rates which in turn result in further price declines, the whole process cumulating unemployment and ending in complete prostration. This indictment might deserve some measure of serious consideration if it were not made with complete disregard for existing disparities between prices and wages, were it not that price deflation is an accomplished fact without a corresponding reduction in wage rates. Furthermore, this argument neglects to consider that there is some point at which falling wage rates will catch up with falling prices; at that point, prices will cease to decline because of the greater demand engendered by increased employment made profitable at the new (equilibrium) level of costs and prices. The above table aids in refuting the contention that wage rate reductions can only result in a cumulative further fall of prices. The most rapid decline in prices occurred during the first two years of depression when wage rates were reduced but little; and, on the other hand, the period of the most marked reduction in wage rates was also the period when the decline in prices slackened.16 The reduction of wage rates from the third quarter of 1929 to the third quarter of 1931 was but 4 per cent, and during these two years prices fell precipitately; from the third quarter of 1931 to the third quarter of 1932 wage rates were reduced 14 per cent, and in this twelvemonth the decline in prices slowed down markedly; and beginning in the third quarter of 1932 there was a positive recovery in business activity. The maintenance of wage rates at 90 per cent above the 1914 level (at the end of 1932) would not have worked havoc if prices and the cost of living had also been 90 per cent above the 1914 level. The fact remains, however, that prices in 1932 were below the 1914 level and the cost of living was but slightly above the 1914 level. Hence there existed an uneconomic level of real wages, and the inevitable result of a level of real wages that is too high is unemployment.17

But what, it may be asked, is the justification of this long discussion about the necessity of reductions in wage rates? The answer is that it is purposed to establish conclusively the nature of this requisite step on the road to recovery.

RESTORATION OF EQUILIBRIUM BETWEEN NATUBAL AND MARKET RATES OF INTEREST

It is essential to reduce wage rates so as to restore the equilibrium between costs and prices in order that there may emerge at least a reasonable prospect of profits to induce business concerns to expand production and increase employment. This directs attention once more to the realized rate of return to capital and its relation to the market rate of interest. It has been shown that when there is a disequilibrium between the natural and market rates of interest in favor of the former, new investment becomes profitable; it has been indicated that the market rate is the more variable of the two rates of interest; and it has been further shown that under some circumstances the market rate may be artificially depressed below the natural rate by the liberal issuance of bank credit which is inflationary in its effects.

It is possible, however, to achieve the same end by raising the “natural” or “productivity” rate, that is, by making the currently anticipated return at important investment margins a profitable one by lowering wages and other “direct” costs. When losses are being sustained generally over a wide range of industry, the marginal productivity rate of capital approaches zero; but by reducing variable costs, losses may be converted into profits and the anticipated rate of return to capital at new investment margins increased. It is therefore necessary to bring about a reemergence of those conditions where the expected rate of return to capital is in excess of the cost paid for loanable funds: the market rate of interest conceivably may stand at zero, but if the average return to capital is represented by positive losses and all that will result from borrowing is more losses, loanable funds will not be employed to finance new productive activity.

Stated bluntly, it is desirable to bring about a redistribution of the national dividend, to the temporary detriment of certain classes of (employed) labor, and in favor of the capitalist-entrepreneur in the form of profits which will stimulate investment activity and restore employment in the capital-goods industries. The important “structural” disequilibrium still persisting is that between consumption and saving, between the production of producers’ goods and the production of consumers’ goods, and this disequilibrium must be corrected before anything like normalcy can be expected to return. When the output of consumption goods declines by some 15 per cent while that of production goods falls 50 per cent and more, it is obviously essential to bring about a greater degree of correspondence between the two in order to restore the balanced relations which are necessary for the orderly progress of production. This restoration of balance can be effected by reducing wage rates, by bringing variable costs into such relation with prices that profits are no longer impossible of attainment, so that entrepreneurs again have a rational basis for making use of loanable funds.18 A further consideration that makes important the rehabilitation of profits is that profits in large part are used to finance repairs and replacements, in order to take care of depreciation and obsolescence. It has already been pointed out that a large share of total saving is corporate saving, which is converted into investment goods directly through the process of “plowing back earnings” into plant improvements, new machinery, and the like, without the intermediation of the capital market. Not all business spending, in other words, is directly involved with the output of finished goods; some of it normally goes to the producers of capital equipment in order to maintain the existing machinery of production in good working order. When profits are not being made, when business income is negative, then maintenance, repairs, and replacement are postponed, with the effect of continuing unemployment in the capital industries.

ACCELERATED ACTIVITY IN PRODUCTION OF DURABLE GOODS A KEY TO EMPLOYMENT AND RECOVERY

The great unsolved problem of the recovery movement is that of stimulating investment activity, whether through the reinvesting of business earnings in maintenance and in new equipment or through the conversion of the savings of the public into new investment goods by resort to the capital market. The greatest unemployment still prevailing is that among the makers of durable goods. Colonel Leonard Ayres in the Cleveland Trust Company Bulletin for January, 1934, estimates that of a total of almost 14 million persons without jobs at the peak of unemployment in March, 1933, 6½ million were from the durable goods industries, nearly 6 million were from the “service” industries, and only 1½ million were from the consumption goods industries.19 Investment activity, in a word, is the tail that wags the industrial dog.

It is in the capital-goods industries, and in the construction industry in particular, that the greatest rigidity of wage rates appears. And it is precisely for this reason, in large part, that the construction industry and other durable goods industries are still depressed. The construction industry has been traditionally one of the most important in the country. In 1920 there were 2,467,500 employees in the building trades, as compared with 1,108,000 employed on steam railroads, 1,019,000 in mining, and less than a million in textiles; the iron and steel industry (essentially a capital-goods industry itself) with 3,107,000 workers, alone exceeded construction in number of employees.20 The construction industry normally employs almost 18 per cent of those in non-agricultural pursuits, and from ten to eleven million people are estimated as being directly dependent upon construction for a living.21 The industry’s wage bill in 1926 was larger than that of any other industry, totaling approximately $3,000 million, in comparison with the $658 million wage bill of the motor vehicle industry.22 It is estimated that in 1926 the volume of construction in the United States aggregated more than $7 billion in value; this may be compared with the figure of $6.5 billion gross operating revenues for the steam railroads, and with a value of $3.4 billion for the motor vehicles produced in 1925.23

The construction industry, however, is financed to a large extent by savings forthcoming from persons and business units outside the industry. The situation differs from the case of the consumption goods industries, where the workers in a sense constitute (at least a large part of) the market for their own output; the purchasers of the output of the construction industry are the savers and other business concerns, whose incomes are not directly dependent upon personal employment in that industry. But the greater part of the incomes of the workers in the construction industry is spent for consumers’ goods, so that revival of construction activity automatically increases demand, hence profits, hence employment, in the consumption goods industries. Logically, therefore, the cycle of revival starts in the construction industry (and other capital-goods industries), for increased constructional activity sets in motion a whole series of repercussions in allied and related lines which bring with them the return of high-level consumption.

DESIRABILITY OF LOWER PRICES IN CAPITAL-GOODS INDUSTRIES DICTATES LOWERED WAGE RATES THEREIN

Unquestionably one of the pressing problems involved in the restoration of general equilibrium is that of regaining balanced relations between the prices of capital goods and the prices of other goods. It is in the capital-goods industries that the smallest relative decline in prices has occurred. This is but natural, however, in view of the relatively slight decline in wage rates that has taken place in those industries, and in consideration of the fact that labor costs constitute a greater proportion of total costs in the construction and durable goods industries in general than in the case of other industries. A survey conducted by the New York Herald in 1921 showed that labor received 85 cents of every dollar of cost in steel making, and 85 cents in building construction;24 what the respective proportions may be today is difficult to ascertain, but estimates commonly place the percentage of labor costs in these industries in the neighborhood of 65 cents of each dollar. Thus prices for capital goods are high because wage rates in those industries are high; and it is imperative that the prices of capital goods approach the level of raw material and other prices before capital development can again proceed in any great volume.25

At this point it is desirable to drop the simplifying assumption used in the illustration of pages 226–228, above, that no change occurs in prices with a reduction of wage rates. For, actually, if wage rates decline in the industries producing durable goods the prices of such goods will tend to decline likewise, and as the prices of capital goods fall, savings and corporate surpluses will be used increasingly to finance new capital development or replacements, instead of lying idle in the banks or being used to purchase Government bonds to finance relief, as now. And as the demand for capital equipment revives, employment in the industries making capital goods will increase, setting in operation the reverberations in the consumption and other industries alluded to above. Therefore, instead of a program of universal wage rate reductions taking no account of the disequilibria prevailing among certain prices, there appears to be sound practical justification for the advocating of concentration of reductions of wage rates in the construction and other durable goods industries for the specific purpose of lowering the prices of capital goods.

Index numbers of wage rates in some of the principal building trades, based upon wage scales in effect in 1913 as 100, calculated from figures given in the Monthly Labor Review, are shown in the following table.

TABLE XXVI

WAGE RATES IN THE BUILDING INDUSTRY (1913 = 100)

OCCUPATION	JULY, 1932
Bricklayers	193.7
Building Laborers	323.1
Carpenters	201.4
Cement Finishers	205.5
Inside Wiremen	237.2
Painters	248.0
Plasterers	200.2
Plumbers	201.8
Stonecutters	208.7
Structural-iron Workers	206.8

It will be seen that notwithstanding the reductions in wage scales made between 1929 and 1932, average rates in the above-named trades were still more than 100 per cent above the 1913 level. Here, then, is one of the key logs in the wage-jam which must be extricated before investment activity can effect any measurable recovery.

The wage and price policies of the United States Steel Corporation during the 1920–1921 depression, and during the Great Depression, offer an interesting comparison. Steel plays so prominent a rôle in all construction activity, and in the production of virtually all durable goods, as has already been pointed out, that the course of steel prices throws much light on the low state of activity in the capital-goods industries. In February of 1920 wages in the Steel Corporation were 46 cents an hour, up 130 per cent from 1914. On May 16, 1921, Steel’s wages were reduced to 37 cents an hour, and on the 29th of August, slightly more than a year after the beginning of depression, to 30 cents an hour. This represents a reduction of 35 per cent from February, 1920, to September, 1921. The price of steel billets in February, 1920, was $60 a ton; in May, 1921, the price was $37 a ton; and on the first day of September, 1921, the price was set at $29 a ton, down 52 per cent in 19 months.26 The low point in steel prices and wage rates in the Steel Corporation coincided almost exactly with the beginning of recovery from that depression; and following almost immediately upon the last cut in prices and wage rates, employment in the Steel Corporation began to increase.

By 1924, Steel’s wages had risen from the depression low of 30 cents an hour to 50 cents (incidentally showing that a reduction of wage rates is not necessarily even semipermanent). This rate was continued until September, 1931, when a 10 per cent reduction was put into effect, bringing the hourly rate to a point but 1 cent less than the 1920 peak of 46 cents, and still 50 per cent higher than the rate in effect in September, 1921. This reduction, two full years after the onset of the Great Depression, was the only one effected by the Steel Corporation; and since the inauguration of the New Deal, wage rates have actually risen above the 1929 peak. The price of steel billets, in contrast with the 1920–1921 experience, averaged $32.67 a ton for 1929 and $26.52 a ton for 1932. This represents a decline of 18 per cent in three years, and is below the 1921 price, but it is approximately 30 per cent above the price of steel billets in 1914.

Herein is found one of the foremost explanations why construction activity has been around 30 per cent of the 1923 average, why the railroads have not been buying steel rails, why the production of freight cars declined 99½ per cent during the depression, and why the index of machine tool production stood at 13 in February of 1933 as contrasted with 336 in February of 1929. How much less hope is there for any other than an evanescent recovery in the face of a situation in which wage rates in the steel industry are higher in 1936 than in 1929 and the new prices are also above the 1929 level! Of what use is governmental insurance of housing construction when a compilation of the Dow Service Daily Building Reports of New York show that a residence which cost $5,000 before the depression and whose cost had finally fallen to $2,560 in 1933, had its cost back to $4,675 in 1934, due to “the bulk effect of the codes”;27 and most of the building code prices and wage rates are still being maintained.

EXPANSION OF BANK CKEDIT, EXPANSION OF BUSINESS—A QUESTION OF ORDER

A further step on the road to recovery involves a larger use of business credit. If a condition of equilibrium can again be attained, through the process of reducing the proportion of the national dividend now going to labor (which is simply too high a proportion to permit the employment of all labor) in favor of capital, so that the anticipated rate of return to capital is once more equal to or above the market rate, there will again emerge that possibility of profit which is necessary to new investment activity. If and when new investment activity promises a profit, the situation in the capital market will alter: new bond issues to finance new construction can be floated more readily, and the current supply of real savings will be translated into new capital equipment, instead of being hoarded, or piling up as excess reserves in the banking system, or going into Government securities in a search for liquidity, or being used to finance a speculative stock exchange boom in old securities. That is to say, current savings and idle or hoarded bank deposits will be used to purchase new issues, and the injection of these bank deposits into the system via the investment and capital markets in the form of actively circulating reproductive credit will provide the necessary means to finance the new construction and capital-goods production. Furthermore, banks will again become purchasers of corporate issues instead of Government bonds, thereby providing additional new monetary purchasing power to corporate users thereof. The greater general activity fostered by greater production in the durable goods industries will also tend to call forth a greater amount of commercial credit in the form of working capital, and recovery should proceed along better balanced lines.28

In connection with this question of the timing of credit-creation the writers’ recommendation differs from the widely held view that we should lift ourselves from depression by an inflationistic price-raising procedure (as we are now doing)—that bank credit should first expand and that production will then follow. There is no quarrel regarding the desirability of higher prices for some classes of goods, but there is disagreement with the view which holds that monetary and credit manipulation alone will suffice to cure the unbalances left over from the depression. Recovery is always accompanied by increasing prices in many lines because of the greater demand engendered by increased employment, and there is no objection to such a rise of prices. But there is nothing inconsistent in holding that such a natural price rise is desirable coincidentally with rejection of the idea that the rise in prices should come first, brought about solely by artificial, inflationistic measures, regardless of what happens to employment. An inflationary policy aimed at lifting the level of prices to the so-called 1926 level, or any particular level, but without correcting fundamental disequilibria, is undesirable and provocative of subsequent disaster.

A “NATURAL,” AS OPPOSED TO A FORCED, RISE IN PRICES

There is a highly important distinction to be made between a rise in prices which comes about because business men expand their production and use additional bank credit in the process, and those price increases which take place in anticipation of inflation or as a result of positive inflationistic action irrespective of whether or not the errors of the past period of inflation have been corrected. In other words, what may be called a natural rise of prices, induced by the greater demands for goods that result from the employment of a greater number of workmen, is quite different from a price rise engineered entirely by forced expansion of bank credit, devaluation delusions, “doing something for silver,” or other inflationistic measures. As a matter of fact we have witnessed for four years and more a policy of deficit borrowing which has forced Government bonds on the banks and has created new credits to such an extent that the demand deposits of the member banks of the Federal Reserve System are now higher than they were in 1929 ($16,324 million on June 29, 1929, $19,161 million on March 4, 1936); and for almost five years we have experienced excessively low rates of interest for short-term capital coincidentally with unprecedented excess reserves in the banking system; both conditions indicate that the basic immediate need is not for more credit, but rather that conditions in the investment market are still such that extensive long-term investment is not being made.29

The view of the writers is, then, that the emissions of bank credit should follow, not precede, a restoration of equilibrium which as yet has not been achieved. If the situation is regarded apart from political and other incidental considerations, it would even appear preferable that recovery should be attained without resorting to any further expansion of bank credit. If the necessary new investment activity could be financed by current real savings and by the utilization of idle funds now in the banking system awaiting investment, the possibility of another inordinate boom would be mitigated. The total volume of bank deposits now in existence is in excess of the 1920 total ($51,335 millions of deposits [exclusive of interbank deposits] on June 30, 1936, as against $37,721 million in June, 1920), yet the price level and the cost of living are both below the levels prevailing in 1920–1921. Between December 30, 1933, and December 31, 1935, total deposits (exclusive of interbank deposits) increased by $10,459 million, or at the rate of $100 million a week.30 What is to be desired is a greater use of bank credit now in existence rather than a greater absolute volume of credit. The present volume of bank credit or bank deposits conceivably might be doubled or tripled, but if this resulted only in piling up deposit balances in the banks there would not necessarily ensue any permanently stimulating effect upon prices or the volume of production and trade. Indeed, the very existence of the present huge excess reserves in the banking system, together with the current relatively low deposits turnover, indicate that business men and bankers do not consider conditions propitious for a further expansion of bank credit. Some of these newly created bank deposits undoubtedly represent hoarded monetary savings; and if they do, so long as the existing imbalances in the capital-goods industries continue, employment in those industries will not increase materially. What is necessary is a revival of activity in the new-issues market, a greater use of these unused bank balances to purchase corporate new issues, thereby stimulating new investment activity.

The crux of the argument here developed at length is neatly summed up in a single paragraph of Mr. R. H. Brand’s Addendum to the Macmillan Report (p. 211):

As a result of the great fall of prices without an equivalent reduction of costs, production all over the world is resulting in losses instead of profits. It is sometimes argued that a reduction of costs (in particular wage costs) will do nothing to alter this situation, because the reduction of costs is a reduction of incomes, and involves therefore a destruction of purchasing power. But costs do not represent the whole of the incomes derived from production and still less do wage costs. These incomes include profits, and it is upon profits being normal that the whole activity of private enterprise depends. The first impact of a reduction of costs is felt in an increase of profits or a substitution of profits for losses. A re-distribution of the present proceeds of industry so that more of the proceeds would accrue to the shareholder and entrepreneur would not reduce the existing volume of purchasing power, but would induce entrepreneurs, by additional orders for raw material, plant and labour, to expand the volume of employment and thus should lead rather to an increase than a decrease of purchasing power. So long as enterprise promises a loss rather than a profit, no one will borrow and the normal process by which money is generated through the lending operations of the banks is interrupted. But a reduction of costs would alter the outlook, borrowers would come forward and money would become available to pay the additional incomes arising from the additional production.

THE PRICE LEVEL AND THE DEBT LEVEL

One other question relating to the matter of prices and costs merits separate consideration. It is argued by those who hold that it is necessary to raise prices to the 1929 level (or the 1926 level) that there must be an adjustment of the price level to the debt level: that at the lower level of prices the debt burden constitutes too large a charge upon the national income and results in inequity between debtor and creditor. That is to say, the view is held in many quarters that an adjustment by means of a fall of costs rather than by means of a rise of prices is objectionable because it would still leave the debt burden too high in terms of prices. But if, by an adjustment of costs and prices, there results increasing employment and enhanced output, the real burden represented by debt charges upon output as a whole becomes smaller. A burden of fixed debt charges which, in consequence of a low level of output, constitutes a third of the national dividend, becomes, when output is doubled, only a sixth of that dividend (assuming new debts would not be created as fast as production expanded, and also disregarding entirely the alleviation of the debt burden which would come from a natural rise of prices accompanying an increase of productive output).

Secondly, there is no proof that the whole of the existing burden of debt was created at the high level of prices prevailing from, say, 1927 to 1929. It seems probable, rather, that the price level now prevailing would more accurately represent the average at which the bulk of existing indebtedness was contracted. And finally, it must be borne in mind that the refunding of old debt obligations (which has been proceeding during 1935–1936 at a tremendously accelerated rate) during a period of low interest rates will serve to reduce progressively the burdensomeness of the debt overhead. All in all, it would seem that the debt-burden bugaboo is less terrorizing and much less significant than many persons have believed it to be.

CONCLUSION

It will be objected, perhaps, that the foregoing recommendations for recovery are more easily prescribed than carried out. Nevertheless, despite the dangers attendant upon prediction in economic affairs which are so largely influenced by political considerations and actions, it seems a safe enough assertion that unless certain wage rates and certain prices are reduced, unless there be restored a more “economic” balance between costs and prices, we must look forward to a long period such as that referred to by Sir William Beveridge, the continuance in this country of a substantial volume of unemployment which will in itself be proof that the price being asked for labor as wages is too high for the conditions of the market. For, “It is a well-known generalisation of Economics that a wage which is held above the equilibrium level necessarily involves unemployment * * *. The history of England since the War is one long vindication of its accuracy.”31 May it be hoped that the history of the United States after 1929 will not longer continue to be a further vindication of it.

 

32 Or unless the bonds are sold by the banks to the public, who pay for the bonds by writing checks against deposits.

33 “We are required to assume that if it is true that trade fluctuations are primarily monetary phenomena, therefore the only way we can get out of the muddle is by the Central Banks taking action. It may very well be that the main reasons for fluctuation in the volume of trade and for the existence of the cycle are to be found in the mismanagement of the credit system by Central or Commercial Banks. I do not think that it follows that you can therefore show that the proper method of overcoming the depression is by means of Central Bank action.” Gregory, T. E., in his discussion of O. M. W. Sprague’s paper on “Major and Minor Trade Fluctuations,” in the Journal of the Royal Statistical Society (1931), Vol. XCIV, Part IV, p. 549.

34 “I find the explanation of the current business losses, of the reduction of output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment. I see no hope of a recovery except in a revival of the high level of investment.” Keynes, J. M., “An Economic Analysis of Unemployment,” in Unemployment as a World Problem, p. 12.

35 “It is not necessary here to repeat all the arguments in support of the view that, during this depression no less than in all previous ones, intensive saving is an essential condition for an increased output of capital goods. * * * It is now generally agreed that the main function of any policy that aims at combatting the crisis is to create possibilities for increased production in the means-of-production group, in which unemployment is most serious. * * * There is manifestly no surplus of money awaiting long-term investment; if there were the Stock Exchange and the investment market would present quite a different aspect. Within the extremely contracted field of savings there is now, during the depression, a relatively large supply of short-term credit awaiting short-term investment in the banks, * * * but there is in particular a lack of that type of credit that is a sine qua non of an increase in the long-run production of fresh capital goods.” Johan Åkermann, Economic Forecast and Realty, 1928–1932, p. 19.

36 Adams, A. B., Economics of Business Cycles (New York: McGraw-Hill Book Co., Inc., 1925).

37 Graham, F. D., The Abolition of Unemployment, p. 89.

38 Beveridge, Sir W. H., Unemployment: A Problem of Industry, p. 89.

39 “The tendency upon the part of labor to estimate wages solely in terms of dollars frequently leads to serious economic error. The real significance of the wage labor receives is not the dollar in hand but rather what the dollar will buy. Wages are always comparative. Cheap money means dear commodities; dear money means cheap commodities.” The Labor Banker, issued by the Brotherhood Investment Company, an organization affiliated with the Brotherhood of Locomotive Engineers: quoted in the National City Bank Letter, October, 1932, p. 159. And cf. Pigou, A. C.: “To a great extent people—employers and employed alike—think in money. Our income is [stated in terms of] our money income, and it requires an effort to realize that, provided the price of the things we buy with money has halved, we are really no worse off with a money income that is also halved.” The Theory of Unemployment (London: Macmillan & Company, 1933), p. 294.

40 Sumner Slichter, Towards Stability, p. 4.

41 This would not necessarily follow, however, if prices and the cost of living declined proportionately.

42 Jacob Viner, Balanced Deflation, Inflation, or More Depression (The Day and Hour Series, the University of Minnesota, No. 3, 1933), p. 11.

43 In the interest of simplification, no figures for marginal returns per unit of costs are introduced in the above illustration. As the figures stand, they may seem to indicate that marginal productivity per man per day is $1.05, and therefore that additional men might profitably be employed at a wage of $1.00 per day. This conclusion is not intended, of course; the discrepancy in the figures arises out of the fact that no account is taken of the cost of materials and other variable costs, and this again in order to simplify as much as possible.

44 Unit costs need not rise above the previous figure, in actuality; but they almost certainly will stand at some point above selling price.

45 Slichter, op. cit., p. 4.

46 Balanced Deflation, Inflation, or More Depression, p. 12.

47 Cf., in this connection, Åkermann’s Economic Forecast and Reality, 1928–1932, p. 22: “The time-factor connecting the fall of the price level with that of the wage level really calls for special inquiry, but even without it we can at any rate draw attention to the fact that during the present depression the price level fell most heavily during the first two years (1929–1931), when the wage level was maintained virtually unaltered, whereas the first three quarters of 1932 witnessed a tendency towards stabilization of the price level combined with a heavy all-round reduction of the wage level. if it were true that a reduction of the wage leva would cause a simultaneous and corresponding fall in prices, there would of course be no way of accounting for this fact.”

48 “Under the present social system real wage rates cannot be raised beyond a point without inducing unemployment. Apart from improvements in methods of production and so on, it is impossible both to maintain existing money wages when commodity prices are falling and to raise them parallel to commodity prices when these are rising except at the cost of a large number of people being unable to find work. Since January, 1930, the Board of Trade index of general commodity prices has fallen some 20 per cent; the cost of living index some 14 per cent; and the index of money wages 5 per cent. During this period of heavy depression there has thus taken place a substantial rise in the rate of real wages for persons in employment. I think that we should be frank about this matter. It is, in my opinion, beyond question that this state of things is responsible for the high level of unemployment. Maybe this is an unpopular doctrine. If so it is the more the duty of economists to announce it.” Pigou, A. C, in a letter to the London Times, August 4, 1933, p. vi; and cf. Beveridge, W. H., Unemployment: A Problem of Industry, p. 371: “* * * as a matter of theory, the continuance in any country of a substantial volume of unemployment which cannot be explained by specific maladjustments of place, quality, and time, is in itself proof that the price being asked for labor as wages is too high for the conditions of the market; demand for and supply of labor are not finding their appropriate price for meeting.”

49 “A redistribution of the present proceeds of industry, such that more would accrue to him [the entrepreneur], would not reduce the existing volume of purchasing power, but would induce him, by additional orders for raw material, plant and labour, to expand the volume of output and employment. * * * The mere fact that unemployment was falling would restore to the industries producing consumption goods part of the demand which they might temporarily have lost.” Gregory, T. E., Gold, Unemployment and Capitalism, p. 39.

50 “The central fact about the great depression as we enter its fifth year is that there are nearly five million providers of services out of work because more than five million producers of durable goods are unemployed. These unemployed people in the durable goods industries are the controlling factor in our depression problem, and the whole program for increasing consumer purchasing power promises little help for them.” Cleveland Trust Company Bulletin, December 15, 1933.

51 Article on the Construction Industry in the Encyclopedia of the Social Sciences, Vol. IV, pp. 265–266.

52 Ibid.

53 Ibid.

54 Ibid.

55 See Jordan, David F., Practical Business Forecasting (New York: Prentice-Hall, Inc., 1927), p. 239.

56 “It is not simply a problem of how to raise prices. It is a problem of how to raise some prices and how to hold down, and even depress, other prices. For what is needed is to close the gaps which the depression has opened, and that means not only raising farm and raw materials prices, but holding down retail prices, and pushing down prices entering into capital equipment. For the prices of capital goods are still inordinately high as compared with other goods.” Walter Lippmann, in the New York Herald Tribune, November 10, 1933.

57 Survey of Current Business, January, 1922, pp. 11 and 43.

58 The National City Bank Letter, May, 1934, p. 72.

59 “* * * it is not difficult to see further that once given the emergence of profits to the average entrepreneur, a series of repercussions in the field of credit-creation are likely to take place, which will remove the danger (if any) that the expansion of production and employment will be checked by insufficiency of purchasing power. For entrepreneurs are more willing to borrow, and bankers more willing to lend, in a period when profits are emerging than in a period when industry as a whole is sustaining losses. It may be argued, therefore, that the adjustment of costs to prices is the necessary preliminary to the inception of monetary processes which will initiate an upward movement of prices, and thus assist such adjustment in those portions of the field of production where it has not already taken place.” Gregory, T. E., Gold, Unemployment and Capitalism, p. 40.

60 “Clearly a mere offer of cheap money does not suffice; banks at times of depression may go on offering cheap money for months or even years together before any recovery happens.” Beveridge, W. H., Unemployment: A Problem of Industry, p. 331; and see Robertson, D. H., Banking Policy and the Price Level, p. 81: “* * * while there is always some rate of money interest which will check an eager borrower, there may be no rate of money interest in excess of zero which will stimulate an unwilling one”; also see p. 79, ibid.: “* * * those theorists are right who have found the cause of ‘crises’ in a ‘deficiency of capital.’ But what is deficient is not money, otherwise the situation could be cured, as all experience shows it cannot, by continued inflation.”

61 “As measured by the volume of purchasing power in the form of demand deposits in our banks, we recently have been inflating at an average weekly rate some six times as great as we did in the commodity price inflation of 1914–1920 and in the stock price inflation of 1921–1929.” Ralph West Robey, “Fiscal Policy and Credit Control,” Proceedings of the Academy of Political Science (May, 1936), Vol. XVII, No. 1, p. 12.

62 Robbins, Lionel, An Essay on the Nature and Significance of Economic Science (London: Macmillan & Company, 1935), p. 148.

• 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.
• 21See the Journal of the Royal Statistical Society (1931), Vol. XCIV, Part IV, p. 549.
• 22“Thus Europe raised our prices * * *.” Profits, Wages, and Prices, p. 139.
• 23“Unquestionably it was the impetus from Europe that started American prices on their upward course.” American Economic Review, Supplement (March, 1920), Vol. X, No. 1, p. 131.
• 24The average reserve requirements of all banks prior to the Federal Reserve Act are estimated to have been 21.09%; under the provisions of the original Act, 11.61%; and under the terms of the Amendment of June 21, 1917, 9.76%. See The Practical Operations of the Federal Reserve System, issued by the Federal Reserve Bank of Richmond, p. 243.
• 25Cf. the Report of the Committee on War Finance of the American Economic Association, The American Economic Review, Supplement No. 2 (March, 1919), Vol. IX, No. 1, pp. 96–97: “Recent improvements in our banking system, growing out of the establishment of the Federal Reserve System and its subsequent development, have made our reserve money * * * more efficient than it formerly was; in other words, have enabled a dollar in reserve to do more money work than before. This in effect is equivalent to increasing the supply of reserve money.” It has been calculated that if the requirements of the National Bank Act were in vogue December 31, 1924, member banks would have required $3, 200,000,000 more in reserves than they held to support the credit then outstanding (The Practical Operations of the Federal System, p. 238); and the Committee on Bank Reserves of the Federal Reserve System estimated that on the same basis in 1931 member banks would have needed $4, 400,000,000 of reserves instead of the $2, 900,000,000 actually held.
• 26Under the old system, when a bank’s reserve fell below the legal minimum it was prohibited by law from making additional loans; and if its reserve was exhausted it was declared insolvent. Under the new system, borrowing from the bankers’ bank is the equivalent of going into the reserve under the old system, but without any penalty; indeed, the process of borrowing serves to replenish, or add to, the borrowing bank’s reserve.
• 27It is also to be observed that henceforth the same twenty-nine-fold expansion is made possible in connection with each new influx of gold from abroad, whether the gold is deposited directly in the Federal Reserve Banks, or in commercial banks and by them redeposited in the Federal Reserve Banks.
• 28It should be stressed, once again, that this example demonstrates the possible maximum expansive power; that is, it is assumed that the entire excess reserve of the Federal Reserve Banks is employed for the purpose of supporting additional Federal Reserve Bank deposits, and hence creating additional reserve for the member banks. To the extent that this excess of 650 million dollars (assumed to be gold) is used to support issues of Federal Reserve notes, which cannot be counted as legal reserve by member banks, this expansive power is diminished. As a matter of fact, a substantial portion of the gold reserve of the Federal Reserve Banks has been used for this latter purpose.
• 29Keynes, J. M., Essays in Persuasion (London: Macmillan & Company, 1931), p. 77.
• 30Ibid., p. 78.
• 31London: J. M. Dent and Sons, Ltd., pp. 87–88.
• 32In 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:
• 33Thirteen years later, near the nadir of the Great Depression, Professor J. M. Clark wrote in like vein:
• 34Professor 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.
• 35Professor 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.
• 36“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.
• 37“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.
• 38As 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.
• 39The 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.
• 40The 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.
• 41That 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.”
• 42That 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.”
• 43That 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.”
• 44So 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:
• 45So 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:
• 46So 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:
• 47The 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.
• 48As 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.
• 49As 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.
• 50The 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.
• 51Dr. 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:
• 52Nevertheless, the thing is explainable according to the time-honored laws of economic theory; all that is necessary is to substitute bank credit for irredeemable paper. Bank credit in this day and age is more potent in determining the price level than are circulating notes, or irredeemable paper currency. As Mr. R. G. Hawtrey rightly points out, “It is not gold that controls money, but money that controls the value of gold. * * * Gold necessarily follows money; the idea that money follows gold is a fallacy.” Bank credit, as is generally known, now does 90 per cent or more of the money work of the country, and is the most important influence affecting the price level, and hence the value of money.
• 53Dr. Friday explains the rise in prices in this country as due to enlarged European demand for American goods for war purposes. Professor W. C. Mitchell states the same idea. It will be conceded that enhanced European demand had an appreciable tendency to raise prices in this country, but this alone is far from sufficient to explain the whole of the phenomenal increase. For it is significant that as late as September, 1915, after a year of European demand and after the influx of over three hundred million dollars in gold from abroad, the price level in this country still stood at 100 (with 1913 as the base year).
• 54Dr. Friday explains the rise in prices in this country as due to enlarged European demand for American goods for war purposes. Professor W. C. Mitchell states the same idea. It will be conceded that enhanced European demand had an appreciable tendency to raise prices in this country, but this alone is far from sufficient to explain the whole of the phenomenal increase. For it is significant that as late as September, 1915, after a year of European demand and after the influx of over three hundred million dollars in gold from abroad, the price level in this country still stood at 100 (with 1913 as the base year).
• 55In the first place, by the terms of the original Act the minimum average legal reserve requirements of member banks were reduced approximately 50 per cent from those prevailing under the old National Bank Act, thereby doubling possible credit in the banking system. A billion dollars in reserves which would support about five billion dollars of deposit credit under the terms of the National Bank Act could support about ten billion dollars of credit under the new reserve provisions of the Federal Reserve Act. Yet reserve requirements were further reduced after our entrance into the War by the Amendment of June 21, 1917, which also contained the highly important provision that from then on all lawful reserves of member banks should consist only of deposit credits on the books of the Federal Reserve Banks. The effect of this amendment, as well as the reduction of reserve requirements contained in the original Act, was to enhance the effective reserve base of the banking system, just as effectively as though gold reserves had been increased.
• 56In the first place, by the terms of the original Act the minimum average legal reserve requirements of member banks were reduced approximately 50 per cent from those prevailing under the old National Bank Act, thereby doubling possible credit in the banking system. A billion dollars in reserves which would support about five billion dollars of deposit credit under the terms of the National Bank Act could support about ten billion dollars of credit under the new reserve provisions of the Federal Reserve Act. Yet reserve requirements were further reduced after our entrance into the War by the Amendment of June 21, 1917, which also contained the highly important provision that from then on all lawful reserves of member banks should consist only of deposit credits on the books of the Federal Reserve Banks. The effect of this amendment, as well as the reduction of reserve requirements contained in the original Act, was to enhance the effective reserve base of the banking system, just as effectively as though gold reserves had been increased.
• 57Quite apart from the reduction in reserve requirements, however, a magnification of the reserve base came about simply as a result of the creation of a central banking system. This is because of the fact that a system of central banking operates to dilute cash, so that reserves in effect go further. In a system devoid of bankers’ banking, reserves consist of lawful money in the vaults of individual banks; in a system incorporating central banking, legal reserves for the member banks of the system exist simply as deposit liabilities of the bankers’ banks. When the Federal Reserve Act, and the amendment thereto of June 21, 1917, required the member banks to transfer their reserves to the Federal Reserve Banks they became reserves for the Reserve Banks, and the transfer gave rise to deposits to the credit of the member banks. These deposit liabilities owed the member banks by the Reserve Banks likewise assumed the rôle of reserves for the member banks. Against such deposits the Federal Reserve Banks were required to hold only a fractional reserve, amounting to but 35 per cent of the deposit liabilities. The difference of 65 per cent constituted free or excess reserves for the Reserve Banks, on the basis of which they could grant loans to the member banks, increasing the deposits of the latter with the Federal Reserve Banks. And as these increased deposits with the Federal Reserve Banks represented increased reserves for the member banks, the latter were able to increase their deposits by granting additional loans to their customers. Hence it is apparent that central banking is inherently inflationistic, at least during the period following its introduction, on account of the greater expansion of credit it makes possible on a given amount of reserves.
• 58Thus it is seen that, whereas the billion dollars in the vaults of the commercial banks supported a credit structure of 10 billion dollars (on the assumption of a 10 per cent reserve-deposit ratio), the same billion dollars may, as a result of the creation of the central banking system, support a credit structure of 29 billion dollars when transferred to the vaults of the Federal Reserve Banks. The superimposition of the system of central banking by and of itself thus virtually triples the possible expansive power of the banking system.
• 59This illustration assumes the existence of a 10 per cent reserve-deposit ratio for the commercial banking system. But it was not until the Federal Reserve Act came into effect that such an average reserve ratio legally obtained. The Federal Reserve Act increased the credit-creating possibilities of the commercial banking system in two distinct ways: it reduced average reserve requirements from about 20 per cent to about 10 per cent, thereby doubling the power of credit expansion, and it set up a system of central banking, which tripled this power. The real effect of the Federal Reserve Act, therefore, was to increase the credit expansion potentialities of the banking system not merely three-fold, but virtually six-fold. A billion dollars in reserves, which under the old system would support total deposits of five billion dollars, could under the new system theoretically support nearly six times that amount, or thirty billions. The full effect of the Federal Reserve Act was thus the same as though five billion dollars in new reserves had been acquired by the banking system.
• 60“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency.” How close the capitalist system in America has come to destruction in consequence of the inflationary debauch of the currency indulged in during and since the War by the manufacture of deposit currency is as yet uncertain. For “it is a process that engages,” in the vivid language of Mr. J. M. Keynes, “all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” The European countries achieved but little liquidation of credit during the 1920–1921 debacle, and several of them went on to further note currency inflation that reached astronomical heights. In the drastic, but brief, deflation of prices in 1920–1921 the United States did not complete the liquidation of inflated bank credit created during the War period: neither prices nor the structure of production and finance arrived at complete equilibrium relationships. The result was that the recovery following the immediate post-war depression rested on a foundation of prior inflation and upon a price level which could by no means be considered “normal.”
• 61“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency.” How close the capitalist system in America has come to destruction in consequence of the inflationary debauch of the currency indulged in during and since the War by the manufacture of deposit currency is as yet uncertain. For “it is a process that engages,” in the vivid language of Mr. J. M. Keynes, “all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” The European countries achieved but little liquidation of credit during the 1920–1921 debacle, and several of them went on to further note currency inflation that reached astronomical heights. In the drastic, but brief, deflation of prices in 1920–1921 the United States did not complete the liquidation of inflated bank credit created during the War period: neither prices nor the structure of production and finance arrived at complete equilibrium relationships. The result was that the recovery following the immediate post-war depression rested on a foundation of prior inflation and upon a price level which could by no means be considered “normal.”
• 62In a small volume published in 1916 entitled The Economy and Finance of the War, by Professor A. C. Pigou of Cambridge University, appears a significant passage: