Common Sense Economics

The following articles are reproduced here as Appendices I and II because they give a picture of the events in the field of monetary and credit policy in the United States from 1949 to the middle of 1954, and of the comments they called for.

Appendix I PROSPERITY BY INFLATION1

The United States is again flooded with forecasts on the economic future. The consensus, at least until recently, seems to run as follows. The year 1953 will be one of continued high level economic activity; a depression of moderate extent and duration is bound to set in during 1954 at the latest. The boom will end mainly for three reasons: armament spending will decline, industrial investment for enlarged and improved production will have reached its peak, housing construction will be lower.2 A protracted depression, however, is not to be feared if for no other reason than the fact that the government will be able and willing to replace dwindling demand by deficit spending and other devices.

To a younger generation of economists brought up to think along the lines of the Keynesian employment theory, such a forecast and argumentation seem entirely normal and in order. For they consider employment as depending on demand, and demand in turn as depending on propensities to consume and invest which appear predestined or at least calculable in advance. And they believe in the ability of the government to prolong a boom indefinitely by deficit spending.

To the older generation of economists, who have not forgotten their neo-classical education and have managed to keep their heads clear of the Keynesian neo-mercantilism, this whole approach seems highly perverse. They are shocked in the first place by the distinctness of the forecasts and by their presentation as scientific and objective, whereas they are, at best, only rationalizations of subjective feelings. I have dealt with this illusion lately in an article “Predicting the Unpredictable.”3 Here it suffices to recall that in an economy still free in essential parts, the maldistribution of demand over time —called the business cycle—is dependent on the behavior of innumerable individual consumers and producers. But who believes seriously in the possibility of forecasting, for instance, future consumer spending which directly and indirectly influences aggregate demand more than anything else? Especially after the unexpected saving spree of the past two years, it should be clear to everyone that the consumer’s waiting or hurrying with spending can be less accurately forecast than the weather six or twelve months hence. And as to investment-spending no prediction is possible without definite knowledge of the future in general, and future wage and monetary policies in particular. For they determine the all-important cost calculations—and therefore the profit expectations—of the entrepreneurs, as also does, incidentally, the so-called political climate which can change overnight.

Errors in judging the future made by the majority of the people are a necessary concomitant of and one of the chief reasons for cyclical movements. Therefore forecasting future markets can always only be a highly subjective art, never an objective science. It is not pure chance that all forecasts by the overwhelming majority of economists, analysts and statisticians since the war have turned out to be wrong. A sort of law of necessity of forecasting errors seems to be at work. It is highly probable that the present studies of “Markets after the Defense Expenditures” will prove, for all practical purposes, as valueless as the wartime studies of “Markets after the War” on which so much money and work were spent.

The prevailing approach shocks old-fashioned economists furthermore by the fatalism with which the let-down of the economy after the exhaustion of the momentary stimuli is considered as unavoidable. There is, at least in theory, nothing unavoidable in a slump. For an economy is not a sort of lame horse that slows down from a maximum speed if not continually whipped. It is rather a horse that a reckless driver allows to run quicker at times than its forces allow, with the result that a speed below average is occasionally needed in order to recover the force spent during the above average speed. If the present boom leads a year hence to a depression, this would only prove that consumers’ and producers’ demands had been allowed to grow too strong in the present, that the horse had not been reined in in time. In other words, the banks, with the assistance of the Federal Reserve System, have through the granting of inflationary credits created in the present an excess of effective demand which will be lacking at a later date. If this is correct, then the logical attitude toward a future depression is not to forecast and await it fatalistically, but rather to prevent it by putting brakes on the boom before it enters its excessive phase.

If neo-classical economists do not share the fatalism concerning the inevitability of the slump, they share still less the optimism of the Keynesian planners concerning the ability of governments to prolong a boom indefinitely by artificial devices such as deficit spending. They rather believe that such spending, if begun before the maladjustments of the preceding boom have been liquidated, can only lead to needless exhaustion of valuable ammunition to be used against the so-called secondary deflation, and ultimately to the ruin of the credit of the State.

A Crucial Moment in the Current Prosperity Phase

But is not all this only of theoretical interest? Has the current prosperity phase really reached or even already over-reached the point where restrictive measures have to be applied?

I personally think that it is indeed high time to take steps toward a restrictive monetary policy which would transfer part of the present effective demand to the future. I believe that if we let the boom run, we are just repeating the mistakes of the war (which cost the dollar 50 per cent of its purchasing power), and of the period following the outbreak of the Korean war. The recent increase in the re-discount rate undoubtedly is a step in the right direction. But if the demand for credits should not subside, much more drastic steps would have to be taken. Still no interests are paid on demand deposits and only very low ones on time deposits—and a change is not even considered. This proves how far off we still are from what in the pre-easy-money days would have appeared a necessary condition of any fight against inflation.

In order to support our view, we shall first examine the features and the strength of the present inflation as it has developed since the autumn of 1949, the period usually referred to as the second post-war boom—the first post-war boom extending from the beginning of 1946 until the end of 1948. We shall also confront the present second post-war boom with the second post-war boom from 1921 to 1929 after the first war. Comparisons between the two second post-war periods are indeed illuminating. In spite of all differences in detail, history seems to repeat itself in a somewhat frightening way.

Industrial Production Since 1949

As is well known, industrial production as measured by the Federal Reserve Index has risen from about 175 to about 234. Whatever the shortcomings of an index based upon the so-called physical volume may be, one cannot fail to be very impressed by this increase of almost 33 per cent, especially if one considers that the new top surpasses the top of the first post-war boom at the end of 1948 by roughly 40 points.

This tremendous increase has been achieved with an increase of non-agricultural employment from roughly 50 to only 55 million persons, or only roughly 10 per cent; and with hardly any increase in the average weekly work-hours. It must therefore to a large extent be the result of higher productivity through rationalization of the productive process, higher capital investment, and maximal and optimal utilization of all resources through their full employment.

An achievement of this sort is as such, of course, highly commendable. There remains, however, the question whether and to what extent this achievement is due to the special conditions of inflation, and also whether the same high production could not have been obtained without it. In other words, whether we never “had it so good” only because of an unnecessary inflation.

Loan Inflation

How strongly has inflation progressed since 1949? When we examine developments in the field of money and credit, our attention is immediately drawn to the appalling increase in loans of commercial banks during the last three and a half years. These loans have increased from roughly $40 billion to well over $60 billion, i.e. by more than 50 per cent. This compares with an increase from roughly $25 to $35 billion during the eight years of the 1921-29 boom.

Not all the additional loans granted during boom periods are inflationary, i.e. granted through new demand deposits, new bank money. Some parts of bank loans are granted out of genuine savings and are therefore not at all inflationary, as for instance loans granted by savings banks against mortgages.

It is, theoretically and practically, extremely difficult to decide which part of an increase in loans of commercial banks is inflationary and which not. Obviously loans are not inflationary which only replace other assets in the balance sheets of the banks, as happened from 1946 to 1949. At that time the increase in loans was accompanied by a decrease in the holdings of government securities, with the result that the total of loans and investments remained pretty stable. Since 1949 the holding of government securities no longer decreased, so that the net effect of the loan increase of $20 billion, plus the increase of some other assets, is an increase in total loans and investments of commercial banks from roughly $114 to roughly $145 billion, an increase of $31 billion. This corresponds to an increase from about $38 to $50 billion, i.e. $12 billion, during the whole eight-year period from 1921 to 1929.

But how much of this increase of $31 billion in total assets and of $20 billion in loans has been financed by inflation? Some—but unfortunately not quite sufficient—light can be shed on this question by the debit side of the balance sheets of the commercial banks.

Total deposits with commercial banks increased since 1949 from roughly $145 to about $176 billion, demand deposits increasing from $96 to about $112 billion, and time deposits from roughly $35 to $43 billion. As people hardly ever save genuinely in demand deposits from which they receive no interest, the increase in demand deposits may roughly correspond to the increase in circulating bank money. We can, therefore, conclude that of the $31 billion increase in the total assets of commercial banks, $16 billion, or 50 per cent, have been financed through inflation.

Bank Money Inflation

Looking at the situation from the money side, we find that since 1949 demand deposits of all banks have increased from about $96 billion to about $112 billion, or almost by 20 per cent. This compares with an increase from $18 to $21 billion, or only 15 per per cent, during the eight-year period from 1921 to 1929.

But in order to judge the extent of inflation, not only the quantity but also the velocity of turnover of bank money has to be taken into account. The annual rate of turnover of demand deposits at member banks in New York increased since 1949 from about 28 per cent to about 36 per cent, and in other leading cities from about 18 per cent to about 22 per cent—on average, therefore, somewhere between 20 per cent and 30 per cent. We may, therefore, conclude that effective demand emanating from bank money during a unit of time has increased from $96 billion to say 125 per cent of $112 billion, or $140 billion, i.e. roughly 50 per cent.

Currency Inflation

People pay, of course, not only with bank money but also with cash. Currency in circulation increased during our period from about $27 billion to about $30 billion, or roughly 10 per cent. Thus currency has increased much less than bank money.

It is interesting to compare what happened during the period from 1921 to 1929. Although bank money increased from $18 to $21 billion, or 15 per cent, currency in circulation did not increase at all; it even declined slightly. The obvious explanation is that some of the money hoarded during the war was still coming back into circulation, as, incidentally, it also did during the first post-war boom from 1945 to 1949, when demand deposits increased whereas currency in circulation dropped. The return of hoarded currency may explain why circulating bank money now again has increased much faster than circulating currency.

Our contention that the quantity of bank money has increased almost 25 per cent is, incidentally, confirmed by the movements of the counterpart of demand deposits, the reserve balances of member banks with the Federal Reserve Banks. These have increased from roughly $16 to roughly $20 billion, or 25 per cent.

Price Inflation

What have been the effects on the price level of such a credit and money inflation?

Consumers’ prices have risen from about 170 per cent to about 190 per cent of the 1935-39 averages—or about 12 per cent. Wholesale prices rose at first—until spring 1951—from about 99 per cent to 115 per cent of the 1947-49 averages. They have since declined to 110 per cent, with the net result that wholesale prices, too, have over the whole period increased roughly by 12 per cent. Thus price inflation has been much weaker than money and credit inflation.

This development has again an interesting parallel in the second post-war boom period of 1921—29. In spite of the strong credit inflation consumers’ prices remained practically unchanged during the whole period, whereas wholesale prices, after some increase in 1925 and a persistent fall from then on, returned to where they started. This inflation without inflation was at that time widely discussed and various explanations advanced—the best being that productivity per man-hour had increased simultaneously. Whatever the explanation, the development during the twenties shows that price stability is quite commensurable with strong inflation. Price stability alone can therefore never prove the absence of money inflation.

Money Inflation With and Without Price Inflation

Money inflation since 1949 which—taking into account the increase in the velocity of turnover—was in the magnitude of roughly 50 per cent, has undoubtedly been partly a money inflation with price inflation, the price level having risen by roughly 12 per cent. But it has obviously been, too—repeating the phenomenon of the twenties—partly a money inflation without price inflation. As far as this is the case, the higher monetary demand must have spent itself not on higher prices but on the larger product which indeed came to the markets as a result of the tremendous increase in productivity mentioned above.

This leads to the very important question: is a money inflation going along with price stability an inflation at all? Does it create all the dangers of a money inflation with price inflation, especially that of a later deflationary slump? In other words is inflated money neutral money as long as it has no effect on the price level? This is maintained nowadays by even conservative economists. I think the experiences of the twenties have given a clear answer. In spite of an almost total price stability over the whole period the credit inflation of the twenties ended with probably the biggest deflationary crash of all time.

Thus neutrality of money cannot be judged without taking into consideration whether or not cost-lowering factors working simultaneously have counteracted the effects of money inflation on the price level. If they have, money is not neutral and the boom is inflationary in spite of price stability. It is an important criterion of an inflationary boom that entrepreneurs expand production under the impact of profit-margins increased by inflation. It is irrelevant whether the increase has come about by higher prices with costs remaining stable or lower costs with prices remaining stable. The latter is just what happens in the case of inflation without inflation. Costs decline through increased productivity of production factors—at least as long as these have not adjusted their demands fully to the change. And prices remain stable because demand expanded by inflation prevents them from declining in accordance with sinking costs.

Inflation with price inflation must at some time come to an end in one way or another. Inflation without price inflation can no more go on forever than inflation with price inflation. A credit system cannot expand indefinitely, if for no other reason than the fact that every stimulus must exhaust itself. When inflation no longer progresses, goods produced under the assumption of ever-rising demand become unsalable. Depression sets in.

Greater Production and Higher Employment During Inflation

If this is correct—and the experiences of the twenties seem to prove the accuracy of the statement—then also the popular argument, that a higher bank money and currency circulation is justified and made innoxious by higher production, must be considered an error. It is due to thinking along the lines of a very crude quantity theory of money. If production increases with employment unchanged, it is because the employed have become more productive and unit costs have thus declined. Declining costs lead in a non-inflationary environment to lower prices. If, in spite of lower costs, prices remain stable, it can only be due to a simultaneous inflation without inflation not less dangerous than any other.

Nor does an increased labor force justify a higher quantity of money and/or a higher velocity of its turnover. In order to employ, say, 10 per cent more labor at the same wages entrepreneurs need 10 per cent more funds—not taking into consideration the capital needed to buy the material and the equipment to work on and with. If such funds are provided by newly created money, this means inflation, even if through a rising productivity prices remain stable on the markets where the new money is spent. The inflation profits mentioned above and all their consequences will thus appear in spite of an increased labor force. Although this fact will hardly be grasped by our inflation-minded generation, the labor force can be increased without recourse to inflation only if either genuine saving furnishes the funds necessary to pay and equip the workers, or if wages are reduced as the number of employed increases.

Every Cycle is Inflationary

There is nothing astonishing in the serious credit and money inflation experienced since 1949. Credit and money inflations are—this is the essence of all so-called monetary business cycle theories—if not the sufficient reason then the necessary condition for every cyclical upswing. But this does not solve the question of whether the present inflationary prosperity is not, or has not already been, moving for some time above what could be called the trend-line of long-term economic growth.

The decision on whether this is the case or not depends on the judgment of where and when the boom would collapse anyway. The middle of a way can obviously be determined only after the length of the whole way is estimated. Such an estimate is, however, as mentioned, wholly subjective and dependent on the business cycle feeling, the Konjunkturgefühl of the individual observer.

I can, therefore, in the following give only the reasons why, in my own opinion, any further increase of bank credits should be prevented by all means, and why even some reduction in the present level of inflation should be aimed at.

As already mentioned, entrepreneurs decide during the upswing to expand their production mainly under the impact of extra profits resulting from inflated demand. If production is to be expanded, new loans have to be asked for and granted. This brings new money into circulation, with the result that demand for the products coming to the markets is again higher than expected. A new impulse to expansion is given—la hausse amène la hausse.

This situation can still be regarded as sound as long as expectations of future prices are based on what has happened in the past on the markets. But after a certain time entrepreneurs, having experienced over and over again—maybe for years—that demand turns out to be stronger than expected, begin to reckon with a permanent repetition of such favorable developments. They plan and carry out investments meant to meet an ever-increasing demand. The result is a still stronger inflation. The boom is now carried forward by a sort of mass psychological infection to the optimistic side.

This is just what is happening nowadays. The thirteen pre-war, war and post-war years, with their almost uninterruptedly increasing demand, seem to have rendered entrepreneurs unable to believe that this increase can one day stop or be reversed.

In such a psychological situation enterprises are founded or expanded although the new plants can only show profits within an inflationary environment. Again this is just what, to my mind, has happened during the past years. This cannot, of course, be proved objectively as long as the boom lasts. It is only after the collapse that it becomes clear which of the new investments have been mistakes. But we should consider that abnormally high break-even points were allowed to develop even in the best situated enterprises —which, incidentally, will have to be corrected through a painful cost-price adjusting process. This strongly suggests that many marginal ventures have been undertaken which will have to be liquidated.

To summarize my diagnosis: there is no doubt in my mind that since about a year or so we have entered what may turn out to have been the later and critical phase of the upswing. Comparing the present post-war boom with the post-war boom of 1921-29 I believe the year 1952 can be considered as roughly corresponding to the years 1926 or 1927.

Business Cycle Consciousness

To such a pessimistic prognosis it is often objected that entrepreneurs are, in fact, on the average not over-optimistic nowadays; that they do not expect demand to stay high indefinitely. Now, there is indeed a profound difference between the situation of today and that of the twenties. Whereas at that time the new era idea of eternal prosperity prevailed, our generation of entrepreneurs has learned the hard way that there is nothing like an eternal prosperity. It has grown business-cycle conscious. And this cycle consciousness has indeed prevented until now the boom from becoming excessive.

However, if we analyze closely what can be called the present general opinion, we see that, in fact, people anticipate the coming of a depression, but that they are also convinced that it will be only a very short and mild one. In other words, it is expected that demand will be lacking only in the short and not in the longer run. Consequently entrepreneurs seem in fact in the aggregate not to be over-optimistic in their decisions for the nearer future. They watch very carefully, for instance, whether inventories are not excessive. But for the more remote future their decisions are by no means based on pessimism. They are committing themselves to long-run investments that seem warranted only under the assumption of a permanently expanding demand. In short, entrepreneurs are adjusting to a short and mild but not to a long drawn out and severe depression.

But in the past few weeks even a short and mild depression seems no more to be envisaged. The fact that the depression expected by many for 1951, and then for 1952, has not materialized until now has not only induced the forecasters to postpone the day of reckoning further into the future, but after the future has approached it has also induced some of the official and semiofficial forecasters to postpone the moment of the depression to Calendas Graecas. Already a fresh “new era” slogan allegedly justifying permanent optimism is beginning to appear. We hear of the “inherent strength of American economy,” of “increasing needs of a growing population,” of “consumer needs being really unlimited if only newer and better products are offered.” In short, people are slowly forgetting the lessons of 1929. Expectations turn again toward an eternal prosperity.

Objections to a Restrictive Money and Credit Policy

A really restrictive money and credit policy will, of course, be met by many with strong resistance.

They are first those eternal skeptics who, as they did during the strongly inflationary first post-war boom, doubt that a higher interest rate would have the desired counter-inflationary effect. They can pride themselves on having prevented until lately even the weakest attempt to curb inflation indirectly rather than artificially through price ceilings, rationing and so on. Interest rates have become somewhat flexible during 1952, although only on a homeopathic scale. The effect of even this slight departure from permanent easy money may have, or should have, convinced the easy-money economists of the effectiveness of higher interest rates as an anti-inflation weapon.

Nor can it be argued that while higher interest rates may have been effective during the first post-war boom, when investments in the private sector increased rapidly, they cannot be successful in times when government and industry spend huge amounts directly or indirectly for armament. It is correct that such spending is insensitive to changes in the interest rates. But during the past years a tremendous amount of long-term investments have been made in the private sector quite independently of rearmament. Such long-term investments—most sensitive to change in interest rates—could and would have been deferred into the future under the impact of high interest rates. But the will to really curtail credits was lacking, as clearly shown by the fact that restrictions on consumer credits were loosened and the construction boom kindled rather than dampened.

Another objection to an anti-inflationary money and credit policy—paradoxically often advanced by the same economists—contends that such a policy would, on the contrary, be too effective, that once deflation started “no one knows how far it will go.” To this we shall only reply that it is still much easier to stop a so-called secondary deflation, if the boom is curtailed voluntarily before it has become too excessive than when it has been allowed to run unhampered to the inevitable collapse.

Many other objections, mostly concerning the debt management, are heard. The allegedly strongest argument against a deflationary or even anti-inflationary policy is, of course, that such a policy would be incompatible with the full employment policy to which the government is committed. Conservative economists agree, of course, on the paramount importance of avoiding unemployment. But they do not agree with the Keynesian way of achieving full employment. There are obviously two ways. Keynesians analyze the economy in terms of effective demand only. They naturally conclude that only by preventing monetary demand from declining from high levels can full employment be maintained. Full employment on a lower level of monetary demand is (as they consider wages as fixed) unthinkable, and a restrictive money policy therefore taboo to them. Conservative economists analyze an economy in terms of demand and supply. They believe that at every level of monetary demand full employment can be maintained if only the supply prices of the factors of production are adjusted to the price level. To them the propensity to work and not the propensity to spend is the foundation of full employment for any length of time.

In an economy that has been doped by the poison of inflation for twenty years a sort of stabilization crisis with some unemployment could, of course, develop. But it should prove, as all stabilization crises do, of very short duration. To endure it means to pay the price for the avoidance of further inflation and the crash that looms at its end.

The most serious hindrance to a sound money policy that would brake a boom voluntarily in time is, of course, that such a policy is extremely unpopular. Great courage and fortitude are required by those who wish to adopt it. It is much easier to let things run, and to represent the inevitable deep depression following an exaggerated boom as an unavoidable fate under the unholy capitalistic system, and then to cry for government intervention.