The Economics of Illusion

Excerpt from Howard S. Ellis, German Monetary Theory, 1905-1933, Harvard University Press, 1934, 1937, Chapter XVIII, “The Schumpeter-Hahn Type of Cycle Theory” (pp. 327-34).

HAHN’S THEORY OF PRODUCTIVE CREDIT

The enthusiastic popular reception accorded Hahn has already been the occasion for comment; but The Economic Theory of Bank Credit in particular enjoys such wide recognition that academic economists, somewhat grudgingly,1 have had to take cognizance of its claims. Indeed, as Haberler remarks, there has grown up of late a sort of separate Hahn literature; scarcely a work can be published in the field of money and credit without a fairly exhaustive critique of his doctrines.2

The necessary foundation for a theory of business cycles, says Hahn, is a correct apprehension of the nature and functions of credit in the economic process. In Germany the conventional view nowadays represents credit as a store of permanent or temporary savings deposited with the banks by the public.3 Classical economists made no mistake in tracing down every credit to abstinence, at a time when the volume of currency was definitely limited. Today the quantity theory does indeed take account of elastic bank credit, but the tradition is still preserved that credit originates in saving. Not primary but created deposits are the basic phenomenon. No longer are banks merely offices for borrowing and lending money, but dealers in “credit” in the literal sense of “confidence”; and interest, from being at one time a payment for saving, has become a price paid for confidence.4

In the sphere of goods this change signifies that “capital formation is not the consequence of saving but of the extension of credit.”5 This follows from the logical primacy of demand over actual production, a primacy concealed by the temporal precedence of the latter before the former. The real prerequisite for the appearance of a capital good is effective entrepreneurial demand, which credit extension brings into being.6 It is not asserted that lending itself actually produces goods, but that it induces an increase in production through a change in distribution. How this transpires will appear from consequences attending a bank rate lower than the expected yield of capital goods, arising either from an absolute reduction of the former while the latter remains constant, or from a rise of the latter with bank rates unchanged.7

Lower interest charges reduce costs to all entrepreneurs operating upon credit, not merely those to the producers of durable goods.8 As a result all production expands, competition for labor and raw material grows more intense, and there appears at first that strictly inverse correlation of prices and discount rates described by the quantity theory. But in the modern industrial system, the introduction of labor-saving technique set over against a virtually constant volume of capital has resulted in an underlying tendency for interest to rise and wages to fall.9 The marginal laborer has passed over into the extra-marginal “not-laborer,” choosing to subsist entirely upon his rentes. Consequently an expansion of credit operates, on the one hand, through rising wages to draw into active employment many members of this reserve army, including women and children, and thus to induce a fuller utilization of existing plant capacity; and on the other, through rising prices, to transfer income from the fixed salary and rentier group to entrepreneurs. The stream of goods is both broadened and lengthened: more of everything is produced and more capitalistic, more roundabout methods are employed. Not saving but altered distribution produces these results—distribution changed “interpersonally” by the forced rise of wages and fall of interest, and “intertemporally,” by the forced deflection of goods out of present consumption. “Credit produces goods out of nothing, in that, without it, they would not have been produced.”10

A by-product of this expansion of production may be11 a rise of prices for consumers’ relatively to producers’ goods. But the expansion could persist as long as new credit drew additional labor power into production.12 Experience shows, however, that ordinarily before this point is reached the rising conjuncture is broken off by a universal glut. How can this be accounted for? Simply by the fact that in the period of high earnings the laborer, having a fairly fixed standard of living, saves instead of spending his income; “circulating deposits metamorphose into savings accounts”; and the disappearance of this demand precipitates a fall in prices, production, and employment.13 But a way lies open to the state to prevent this termination of the boom either by continued interest reductions through the central bank, enabling the producer to hold his finished products, or by removing the interest burden entirely through the purchase and storage of the goods on government account.14 “. . . theoretically, at any rate, the assumption of the possibility of a ‘perpetual boom’ does not belong to the realm of Utopia.”15 Whether or not to purchase greater and greater production by expropriating the salaried and rentier classes is a question belonging not to economics but to politics.

The course of Hahn’s original argument, culminating in a supposed dethronement of frugality and an apotheosis of credit creation, has evoked emphatic denial at every stage. Aside from the identification of capital and money markets and a tendency, decried by Hayek,16 to recognize no more ultimate determinant of interest than bank liquidity, Hahn proves to be particularly vulnerable in arguing that capital originates in fundamentally different ways in a cash economy and in a cashless economy. As Neisser, Mannstaedt, and Haberler observe, the difference between the two systems is purely a matter of payment technique: bank deposits function just as money does, and in both cases interest is paid for the surrender of purchasing power, not, as Hahn would have it, for the cession of money in the earlier and for “confidence in the modern system.17 To go below the merely superficial phenomena of credit and cash exchange media, we must agree with Lampe that it is quite as possible for coinage in a cash economy to make purchasing power available without saving as for credit creation to accomplish the same end in a bank deposit regime.18 By consequence, if capital comes into being in another way in the latter than in the former, it will have to be on other grounds than merely the creation of new purchasing power.

That the existing volume of bank deposits originates preponderately from loans is of course a far cry from the proposition that capital formation proceeds from credit creation and not from saving. It is not surprising, therefore, to find that Hahn tries to support the latter notion by some other argument than this flimsy confusion. Demand, he says, precedes production. But the really surprising thing is that this homely truth, equally valid for cash and credit economies, should somehow demonstrate that capital formation does not nowadays proceed from saving. Probably, as Lampe suggests, Hahn has unwittingly fallen victim to an ambiguity in his term “demand.” If demand be interpreted as applying to the products of a capital instrument, it is of course apparent that the instrument would not be produced unless such a demand were expected. On the other hand, without demand in another sense, that is, actually available purchasing power in the form of a bank deposit, the entrepreneur could not undertake production at all. But Hahn, who says his proposition pertains to the first sort of demand, actually applies it also to the second, i.e., he assumes that whenever a bank extends credit to a customer, a sure market must exist for the capital good and its products. Of course, even if every bank loan did result in economically useful capital-good formation, it would not be true that “no capital good can be produced without credit creation,” as Hahn states literally,19 unless, furthermore, no new capital were produced on the basis of bank loans of accumulated savings. It is not necessary to argue against this absurd proposition inasmuch as Hahn himself blows hot and cold within the confines of a single paragraph. Admitting that current production proceeds out of “a certain stock of goods produced in the past capable of covering the need for nourishment, clothing, and shelter,” he concludes, “If this certain stock is present, then the founding of new enterprises is independent of the supply of capital!” 20 Indeed, far from supporting the earlier dictum that capital formation is solely the product of credit creation, Hahn’s description of the period of rising conjuncture indicates at the utmost that new credit increases the quantity of capital, and even then he concedes that this does not invariably transpire. And so the thesis of a totally new origin of capital is abandoned by the author himself.

The theory of business cycles, based upon the more modest claim of a productive effect of expanding bank credit, has been most adversely criticized at three points: the course of wages relative to prices during the upswing, the cause of crises, and the final outcome of the whole evolution. Hahn, it will be remembered, relies upon mounting wage rates to activate the industrial reserve army during boom times. To object, as Haberler does, that this contradicts his admission that consumption goods are enhanced in price does not dispose of the matter,21 because Hahn argues that through the competitive tendency of prices toward cost, consumption costs are indeed raised by the increase of nominal wages, but this is partly offset by the low interest charges which generated the upward movement.22 On purely a priori grounds one might agree with Lampe that forced saving imposed merely upon the small class of non-laboring and non-entrepreneurial rentiers would scarcely support an increase of real income for the whole wage-earning population.23 Or again, simply deductively, one may object that Hahn has given to laborers the conjunctural gains which were supposed to be in the hands of entrepreneurs, supplying the motivating factor in the whole upward movement. But the most effective answer would be Burchardt’s appeal to the fact that real wages lag,24 if economists could be more certain that the statistical evidence is clearly in this direction. If Hahn had not relied upon a strictly rationalistic calculus to account for the existence of the reserve army in the first place—that technical progress so raises interest rates as to induce the rentier to prefer idleness—and had instead attributed ordinary unemployment to economic friction and inertia, he might more easily have accounted for increased employment and output attending falling real wages in the period of recovery. But unless real wages actually decline, the amount of forced saving would not be such as to lend much color to Hahn’s expectation of a substantial increase in capital.

Furthermore, if forced saving supplies the driving power to a period of industrial expansion, why should not the voluntary savings of laborers, which Hahn supposes on the increase in the late stages of boom times, support the expansion indefinitely? It is enigmatic why he should believe that banks allow savings deposits to pile up without investing them, when the universal characteristic of the system according to his account is extending more credit than it receives.25 This version of the overinvestment theory, it will be observed, rests not upon the fading out of forced saving, but upon the (altogether improbable) growth of hoards.

No single feature of the entire structure has occasioned a more general outcry than Hahn’s suggestion that proper authoritarian measures at the time of impending crisis might support a “perpetual high conjuncture.” It scarcely requires an academic economist26 to point out that either continued injections of credit at progressively lower interest charges or the purchase and storage of unmarketable products by the state would signify a nationalizing of industry, and that even such drastic measures would only intensify the final debacle, the more the longer they persisted.27 Far from leading to a progressive diversion of resources into capital form, as Lampe suggests,28 such policies mean outright and violent inflation, and the disappearance of all accumulation.

Finally the question presents itself whether, aside from such attempts to protract the boom indefinitely, artificial credit creation attending the ordinary cycle leaves society at the end better provided with usable capital. The answer naturally varies from the enthusiastic affirmative of Hahn’s own followers to the categoric denials of the Vienna school. Midway lie the appraisals of the majority of special Hahn critics whom we have just mentioned. While maintaining that credit extension per se means only capital displacement, Diehl concedes that it may lead to an increase of capital formation, depending upon the success of the ventures it fosters.29 Lampe, as we have seen, proposes the same test. Considerably more skeptical is Haberler,30 for whom the “spark of truth” in the doctrine of the productive effect of “inflationary” credit is first, that it prevents declining prices in a progressive society, and secondly, that it overcomes the frictional resistance of an indolent entrepreneurial community. But the new undertakings called into being by inflation would not persist longer, with the return of interest to its natural level, than the life of their fixed capital equipment. Mannstaedt concludes that in a free exchange economy where banks exercise control only through prices, any policy may be thwarted by a tendency for the public to react upon these prices negatively; in other words, though banks may give an initial impulse toward the liberation of productive factors through credit creation, ultimate success depends on the public’s voluntary continuance of the additional saving.31 This is practically what Lampe and Diehl have said: the answer depends on whether the ventures based upon forced saving succeed. It is certainly not a foregone conclusion, as Hahn assumes, that even while the artificial depression of interest persists, the new produce will cover interest and depreciation costs, nor pro tanto that this will be the case if the cessation of the forcing is accompanied by a sag in the magnitude of saved income.

Since the appearance of the first and second editions of the Volkswirtschaftliche Theorie, Hahn has abated his radicalism at certain points and at others altered the supporting argument. Most noteworthy is the disappearance of the idea of maintaining a “perpetual boom.” Although proposals to overcome glutted markets by state assumption of interest changes or by inflation were repeated as late as 192632 their omission in Hahn’s widely read contribution to the Handwörterbuch on “Kredit”33 is a matter of general comment. In the third and completely revised edition of his magnum opus,34 Hahn retains nearly all of the catchwords around which the underlying theory was originally developed. But there are some very significant departures. Although we still read that “every increase of credit increases goods through a change in their distribution,” we discover also that even aside from such debacles as the German inflation, the stimulating effect of credit sometimes proves to be quite short-lived.35 Credit expansion now becomes an “essential condition” for the development of cycles, not the unique cause.36 But most notably, the explanation of crises from laborers’ savings, or rather hoards, disappears completely. There is some evidence that the reason is an uncertainty on Hahn’s part as to whether real wages advance as much above the standard of living as he had imagined in boom times.37 Be that as it may, crises occur simply because a time must “necessarily” come when the stimulus of conjunctural gains to entrepreneurs has exhausted itself.38 Although he continually lays great stress upon “intertemporal and interpersonal changes in distribution” wrought by artificially low bank rates, Hahn does not recognize that this distortion of productive factors into the capital category can itself account for a breakdown. In this he resembles Schumpeter, and it may be ventured that the failure to perceive the dangers of overinvestment accounts for the sanguine attitude of both writers toward the outcome of credit inflation.

A section on Hahn should not close without reference, at least, to his study of German bank series over the period 1900-13.39 Here Hahn writes as a practical banker, and the analysis has been widely recommended. From the angle of the history of German theory, however, the early and more radical writings of Hahn are more significant, presenting a bold thesis 40 which gives rise to an equally bold antithesis on the part of the Vienna group.

41 E.g., Friedrich A. Hayek, Geldtheorie und Konjunkturtheorie, Vienna, 1929, p. 84.

42 Cf. Gottfried Haberler’s review, Archiv 56, p. 803. Hahn himself gives three or four pages of references upon his doctrines in the third edition of his opus, Tübingen, 1930, pp. xiv-xvi.

43 L. Albert Hahn, Volkswirtschaftliche Theorie des Bankkredits, 1st ed., Tübingen, 1920, p. 6; 2nd ed., Tübingen, 1924, p. 6. Until the concluding section, page references pertain to these two editions, which are identical.

44 Ibid., p. 51.

45 Ibid., p. 120. (Italics author’s.)

46 Ibid., p. 121.

47 Ibid., pp. 131-132.

48 Ibid., p. 130.

49 Ibid., p. 139.

50 Ibid., p. 141.

51 Sic, ibid., p. 133. Hahn does not seem to appreciate that his previous reasoning calls for “must,” and so this sentence is merely a parenthetical observation.

52 Ibid., p. 145.

53 Ibid., p. 148.

54 Ibid., p. 151.

55 Ibid., p. 159.

56 Konjunkturtheorie, pp. 103-104.

57 Neisser, Tauschwert, pp. 70-71; Heinrich Mannstaedt, Ein kritischer Beitrag zur Theorie des Bankkredits, Jena, 1927, pp. 13-15; Haberler, Archiv 56, p. 814.

58 Adolf Lampe, Zur Theorie des Sparprozesses und der Kreditschöpfung, Jena, 1926, pp. 134-135.

59 Volkswirtschaftliche Theorie, p. 121. “Ohne Krediteinräumung” might be ambiguous were it not for the previous statement “Krediteinräumung ist also Schaffung kaufkräftiger Nachfrage” (ibid., p. 120. Italics mine).

60 Ibid., p. 142. (Italics mine.)

61 Archiv 56, p. 817.

62 Volkswirtschaftliche Theorie, p. 137.

63 Sparprozess, p. 161.

64 Fritz Burchardt, “Entwicklungsgeschichte der monetären Konjunkturtheorie,” Welt. Arch. 28, p. 131.

65 An objection levied by Burchardt, loc. cit., and by Haberler, Archiv 56, p. 818.

66 Diehl, Theoretische Nationalökonomie, III, 582.

67 Cf. Wilhelm Röpke, “Kredit und Konjunktur,” Jhrb. für N. & S. 126, p. 263.

68 Sparprozess, pp. 152-158.

69 Theoretische Nationalökonomie, III, 571.

70 Archiv 56, pp. 817-818.

71 Kritischer Beitrag, pp. 30-31.

72 According to Diehl, in Hahn’s article “Krisenbekämpfung durch Diskontpolitik und Kreditkontrolle,” Soziale Praxis 37, p. 931.

73 Hdwb. der Staats., 4th ed., Jena, 1923, V, 944-953.

74 Volkswirtschaftliche Theorie des Bankkredits, 3rd ed., Tübingen, 1930.

75 Ibid., pp. 125, 152,

76 Ibid., p. 154,

77 Ibid., pp. 119, 123-124. The increase of labor supply is sometimes made to turn merely upon the “illusion of a constant value of money.”

78 Ibid., p. 146.

79 “Zur Frage des volkswirtschaftlichen Erkenntisinhalts der Bankbilanzziffern,” Geld und Kredit, Neue Folge, Tübingen, 1929, pp. 149-189.

80 An illustration of the “idiot fringe” which all theories possess is afforded by Hans Honegger’s Der schöpferische Kredit, Jena, 1929. Capital is necessary to production only when it has to be pledged as collateral for a loan. So long as confidence persists, there is no limit to the profitable extension of bank credit. The entire pamphlet is a panegyric to “creative credit.”

• 1Tübingen, 1st ed., 1920; 2d ed., 1924; 3d ed., 1930.
• 2Berlin, 1930; Tübingen, 1931. These articles, as well as those mentioned above, are available in the New York Public Library.
• 3A summary of this volume will appear in German in “Ordo,” Zeitschrift für Ordnung von Gesellschaft und Wirtschaft, 1949, and in French in Economie appliquée, Archives de l’Institut de Science Economique Appliquée.
• 4Remarks on my priority are to be found in Gottfried Haberler, Prosperity and Depression (1939), Wilhelm Lautenbach, “Zur Zinstheorie von John Maynard Keynes,” in Weltwirtschaftliches Archiv (Vol. 45, 1937), Heimann, History of Economic Doctrines (1945), and others.
• 5In my first criticism of The General Theory in 1936, mentioned above.
• 6Vol. 57, pp. 803 ff. (Tübingen, 1927).
• 7Claude William Guillebaud, The Economic Recovery of Germany, London, 1939, p. 21.
• 8On September 21, 1931, Great Britain suspended the gold standard, and on December 8, 1931, the Brüning government cut all income from interest, wages, social insurance, and relief, as well as prices; see Reichsgesetzblatt, 1931, I, p. 699.
• 9Guillebaud, op. cit., pp. 63-65.
• 10Reichskreditgesellschaft, Deutschlands Wirtschaftliche Lage in der Jahresmitte 1939, Berlin, 1939, p. 5.
• 11In a Reichstag address of September 1, 1939: Monatshefte für auswärtige Politik, 1939, p. 907.
• 12Banker (London), February 1937, p. 114; Fritz Lehmann and Hans Staudinger, “Germany’s Economic Mobilization for War,” National Industrial Conference Board, Conference Board Economic Record, New York, 1940, pp. 290-309.
• 13Banker, July 1938, p. 14; Guillebaud, op. cit., p. 63.
• 14Allen Thomas Bonnel, German Control over International Economic Relations, Urbana, 111., 1940, p. 118.
• 15Harris, op. cit., p. 38.
• 16Schacht in Frankfürter Zeitung, November 19, 1927.
• 17Young Plan Advisory Committee Report, Economist, Supplement, January 2, 1932, p. 5.
• 18The Problem of International Investment (cited above), p. 13.
• 19Statistisches Jahrbuch, 1938, p. 254.
• 20Ibid., 1938, p. 254.
• 21In the early days of the Nazi regime exports were promoted by giving the exporter as a subsidy the difference between the low market price paid in foreign exchange for the German bonds repurchased abroad and their nominal Reichsmark value. Blocked mark accounts were bought up by the “Golddiskont” bank at a heavy discount; the discount was also used to subsidize the exporter, as was the gain from the repurchase of the scrip certificates issued after June 1933 in part payment of interest on Germany’s long-term debt. In the middle of 1934, however, the issue of scrip was stopped and the buying of German bonds abroad through the Exportförderung was limited to cases in which payment did not become due until twelve months after the sale. From then on exports were subsidized from a fund (800 million marks in 1935 and 1,000 million in 1936) produced by a levy on the annual turnover. Throughout this period exports were subsidized also by the use of blocked marks (Banker, February 1937, p. 161).
• 22The German-Swiss dealings are a case in point. Although Germany owed money to Swiss citizens for the credits granted her from 1924 to 1930, Switzerland paid for the German coal deliveries of later years by putting the money at the disposal of German tourists traveling in Switzerland. Instead of seeing to it that her own nationals, who were Germany’s creditors, were paid out of the coal deliveries, Switzerland reciprocated by new services. Schacht cleverly used Switzerland’s biggest export industry, tourism.
• 23The Problem of International Investment (cited above), p. 238.
• 24Dr. H. Neisser in Social Research, August 1944, pages 369-381, has pointed out that my “position is surprisingly close to the position of certain Keynesians, who have argued . . . that the amount of saving necessary for expanding the current rate of output is always automatically created by increasing the current rate of investment.” He thinks that capital can be made by inflation only if a totalitarian government can tell the people “how much to save or how much to spend” and if “a certain historically obtained standard of living must be maintained for the major part of the population.” To this I would agree to a certain extent, but would raise the question whether a country urgently seeking capital abroad has not to lower rather than to raise “the historically obtained standard of living” by opposing instead of encouraging wage increases.
• 25Cf. Sumner H. Slichter, in Harris, op. cit.: “The fears which encourage the hoarding of cash may be partly fears of higher taxes, i.e., fears aroused by the deficit itself” (p. 250).
• 26There exists, in addition to the incorrectness of his factual assumptions, a methodological reason why Keynes’ theory cannot be considered a satisfactory analysis of a stable equilibrium but only of frictional maladjustments: in an equilibrium analysis it is inadmissible to assume that some of the data, the prices of goods, yield to inflation whereas the others, the wages, interests, profits remain rigid. Either everything or nothing must be considered as flexible. In the first case the quantity theory is valid; in the latter case we have a sort of regulated economy in which not economic but price- and wage-fixing laws reign over the market.
• 27I consider the refusal of the Brüning government to follow a reflationary policy in 1931 the most important cause of the victory of the Nazi party.
• 28For the distinction between structural and cyclical unemployment, cf. L. Albert Hahn, 1st Arbeitslosigkeit unvermeidlich?, Berlin, 1930. The reader will find in this booklet a summary of the views on unemployment expressed in Europe during a discussion which strikingly resembles the one going on at the present time in this country.
• 29Accordingly, in the third edition of my Volkswirtschaftliche Theorie des Bankkredits, the Interest Theory of Unemployment was developed as a cyclical theory.
• 30A Select Collection of Scarce and Valuable Tracts and Other Publications on Paper Currency and Banking, ed. by J. R. McCulloch, 1862.
• 31See Chapter 6, p. 62.
• 32See the corresponding remark by D. McC. Wright in “The Future of Keynesian Economics,” in American Economic Review, vol. 35, no. 2 (June 1945), p. 299.
• 33Abba P. Lerner, “Functional Finance and the Federal Debt,” in Social Research, vol. 10, February, 1943, p. 39.
• 34Kenneth E. Boulding, The Economics of Peace, New York, 1945, p. 215.
• 35W. H. Beveridge, in his Full Employment in a Free Society, London, 1944, demands strict control of the labor supply. This is probably nothing but the tacit acknowledgment of the changes in the labor supply we have described. Yet the restoration of a free labor market remains as an alternative—and a desirable one, at least as long as we wish to live in a truly free economy, rather than in Beveridge’s pseudo-free economy.
• 36Keynes, op. cit., p. 322.
• 37Ibid., pp. 97 and 109.
• 38Ibid., p. 164.
• 39National Income: A Summary of Findings (National Bureau of Economic Research, 1946), p. 18.
• 40Arthur F. Burns, Stepping Stones Towards the Future (National Bureau of Economic Research, 27th Annual Report, 1947), p. 13.
• 41I have attempted to counter to the best of my ability the noxious extremes to which monetary policy and theory seem to swing, pendulum-like, as if subject to a historical law. My first publication, the Volkswirtschaftliche Theorie des Bankkredits, it is true, was an inflationary book in an inflationary time; it was understandable, however, as a reaction against the hyper-classicism of prevailing theory in which the effects on the economy of manipulation of money and credit were entirely ignored. It is, to my present way of thinking, a typical soft money book and I attribute its success mainly to the fact that any soft money book—any book that promises prosperity by the relatively easy means of monetary manipulations—is eagerly taken up by readers who have recently witnessed the beneficial effects of inflation in its first phases.
• 42When in 1929 practice and theory again became deflationary in most countries, and especially in Germany, my fight was directed against deflationism, particularly of the Bruening-Luther brand which, I was convinced, would undermine the economy to the breaking point. The Nazi revolution was, in my opinion, largely the inevitable result of the deflationary policy of the last pre-Hitler government. By lectures and articles in daily papers, notably the Frankfurter Zeitung, and in journals, I tried in vain to combat this policy. Of longer articles that were published separately, 1st Arbeitslosigkeit unvermeidlich? (Is Unemployment Unavoidable?) and Kredit und Krise (Credit and Crisis) may be mentioned. Like that of all similar endeavors, their effect was frustrated by the strongly anti-inflationary editorial attitude of the influential Frankfurter Zeitung and the Deutsche Volkswirt which, even after the pound sterling had been devaluated, saw in every monetary adjustment an attack on the value of the mark and persistently warned against what they called unzulässige Währungsexperimente (inadmissible currency experiments). As occurs all too frequently, the people, politicians, and economists had forgotten the past and were solely under the impression of the immediately preceding experience—the hyper-inflation of 1921-23.
• 43These articles are reprinted in this volume with only slight alterations—some omissions to prevent repetitions, and a few supplementary footnotes. I am conscious that today I would express many things differently and, above all, that somebody else, more familiar with the English language and the technique of expressing theoretical statements usual in this country could do better. However, in view of the almost entire lack of anti-Keynesian literature, I have felt obliged to surmount my inhibitions in order to relieve this situation to the best of my ability.
• 44In rejecting Keynesianism, I am in a peculiar position. Keynesianism is a sin of my youth, for as early as 1920 in my Volkswirtschaftliche Theorie des Bankkredits I presented what to me are the basic Keynesian statements. As I confessed later, “all that is wrong and exaggerated in Keynes I said much earlier and more clearly.” Unfortunately I cannot refer to an English translation of my book to prove my claim to priority to English readers. However, Howard S. Ellis gives a very good résumé of my theories in his German Monetary Theory (Harvard University Press, 1934). In order that the reader may judge for himself, and because I refer several times to my work in the following articles, the chapter of Ellis’s book summarizing my theory is reprinted in Appendix I. For the same reason, part of Gottfried Haberler’s extensive résumé and criticism of my book, which appeared in the Archiv für Sozialwissenschaft und Sozialpolitik, has been translated (Appendix II). Another reason for adding these two excerpts is that what the authors say, with full justification, against my theses can be said with the same justification against Keynes, but has not been.
• 45In rejecting Keynesianism, I am in a peculiar position. Keynesianism is a sin of my youth, for as early as 1920 in my Volkswirtschaftliche Theorie des Bankkredits I presented what to me are the basic Keynesian statements. As I confessed later, “all that is wrong and exaggerated in Keynes I said much earlier and more clearly.” Unfortunately I cannot refer to an English translation of my book to prove my claim to priority to English readers. However, Howard S. Ellis gives a very good résumé of my theories in his German Monetary Theory (Harvard University Press, 1934). In order that the reader may judge for himself, and because I refer several times to my work in the following articles, the chapter of Ellis’s book summarizing my theory is reprinted in Appendix I. For the same reason, part of Gottfried Haberler’s extensive résumé and criticism of my book, which appeared in the Archiv für Sozialwissenschaft und Sozialpolitik, has been translated (Appendix II). Another reason for adding these two excerpts is that what the authors say, with full justification, against my theses can be said with the same justification against Keynes, but has not been.
• 46In rejecting Keynesianism, I am in a peculiar position. Keynesianism is a sin of my youth, for as early as 1920 in my Volkswirtschaftliche Theorie des Bankkredits I presented what to me are the basic Keynesian statements. As I confessed later, “all that is wrong and exaggerated in Keynes I said much earlier and more clearly.” Unfortunately I cannot refer to an English translation of my book to prove my claim to priority to English readers. However, Howard S. Ellis gives a very good résumé of my theories in his German Monetary Theory (Harvard University Press, 1934). In order that the reader may judge for himself, and because I refer several times to my work in the following articles, the chapter of Ellis’s book summarizing my theory is reprinted in Appendix I. For the same reason, part of Gottfried Haberler’s extensive résumé and criticism of my book, which appeared in the Archiv für Sozialwissenschaft und Sozialpolitik, has been translated (Appendix II). Another reason for adding these two excerpts is that what the authors say, with full justification, against my theses can be said with the same justification against Keynes, but has not been.
• 47But the spring of 1931 represented the turning point. The Reichsbank lost nearly 2 billion marks in gold and foreign currency in the two months after the crash of the Austrian Kreditanstalt in May of that year. In a panic the German Government sent the president of the Reichsbank to the European money centers in quest of new credits of at least 400 million dollars. On July 9 Dr. Luther arrived in London, on the 10th he was in Paris, and on the 11th he flew home. On the 13th he went to Basle to attend a meeting of the governors of the central banks. The credit of 100 million dollars which had been granted the Reich in June for three weeks was extended for three months—for all practical purposes it was frozen anyhow—but a new credit grant was refused. The creditors were no longer willing to pour money into the bottomless German barrel. Germany was forced to act alone. On July 14 the government announced a bank holiday, and on the 15th centralized all foreign exchange dealings in the Reichsbank, which meant the first step toward full currency control. Germany was embarking upon a new policy: to live without importing capital.
• 48The world expected a new collapse. True, a heavy deflationary crisis shook Germany. But the deflation was not caused by capital withdrawals or by the lack of new capital influxes; it was government-made, to enable German exporters to compete with the British, who were being favored by the devaluation of the pound.
• 49At the beginning of September 1931 the first moratorium agreement for short-term credits was concluded. In June 1933 a partial transfer moratorium for the service of long-term loans was announced, followed by an almost total one in 1934. Nevertheless, until her war with the United States, Germany continuously repurchased her loans in foreign markets, where they were devalued by default. Thus she recovered from the 1931 crisis not only without capital imports but even while reducing her foreign debt.
• 50Since the turning point Germany has produced capital in tremendous amounts, for domestic investment as well as for exportation. The Hitler era before the war was one of intensive industrial reconstruction, in which Germany’s capacity for production in general, and for the production of war material in particular, was enormously expanded. During those six years from 1933 through 1938 the capital produced for domestic investment was as follows (in billions of marks):
• 51Hitler’s statement that Germany spent 90 billion marks on her armament from March 1933 to the outbreak of the war in 1939 is corroborated by estimates made in Great Britain and in this country. And the output of armament represented capital production, inasmuch as it withdrew goods and services from consumption.
• 52Hitler’s statement that Germany spent 90 billion marks on her armament from March 1933 to the outbreak of the war in 1939 is corroborated by estimates made in Great Britain and in this country. And the output of armament represented capital production, inasmuch as it withdrew goods and services from consumption.
• 53As for capital exports, Germany transferred, from the turning point in July 1931 to the outbreak of war in 1939, approximately 4.5 billion marks on her debt service; of this, it must be emphasized, approximately 3 billion was transferred during the pre-Hitler era. In addition, her foreign debt was reduced during these years by 14.3 billion marks, as shown in the table above. Of that amount 6 billion marks was accounted for by the depreciation of the creditor countries’ currencies, and only part of the remaining 8.3 billion represented actual repayments, for Germany was able, as shown in preceding table, to repurchase loans and marks in foreign hands well under par. Nevertheless, very substantial exports took place, and the capital exported was replaced by domestically created capital.
• 54As for capital exports, Germany transferred, from the turning point in July 1931 to the outbreak of war in 1939, approximately 4.5 billion marks on her debt service; of this, it must be emphasized, approximately 3 billion was transferred during the pre-Hitler era. In addition, her foreign debt was reduced during these years by 14.3 billion marks, as shown in the table above. Of that amount 6 billion marks was accounted for by the depreciation of the creditor countries’ currencies, and only part of the remaining 8.3 billion represented actual repayments, for Germany was able, as shown in preceding table, to repurchase loans and marks in foreign hands well under par. Nevertheless, very substantial exports took place, and the capital exported was replaced by domestically created capital.
• 55It is very difficult to estimate the creditors’ losses. As far as the moratorium credits are concerned, it is generally estimated that the creditors lost 15 per cent when they sold their accounts; this would mean a loss of approximately 825 million marks, since 5.5 billion marks in these accounts was disposed of by 1939. Estimates on the repatriation of the foreign bonds range from 400 to 700 million dollars. Up to 1934, when approximately 300 million dollars in these accounts had been repatriated, the foreign creditors had lost about one-half through sales below par; later their loss was much higher.
• 56Another explanation that has been put forward is that the loans were used not for production but for consumption purposes, such as the construction of “stadia, swimming pools, and ornamental buildings.” This is true only to a small extent, however, for most of the loans were granted to private industrial firms and public utilities. Furthermore, Germany’s productive capacity, whatever may be meant by that rather vague term, was increased sufficiently after 1923 to create a surplus production equivalent to the amount necessary for amortization and interest.
• 57Still another explanation, frequently encountered, is that the default was caused by the German debtors’ lack of liquidity; especially the German banks are accused of having borrowed short and lent long. After the bank holidays, however, and the subsequent moratorium agreements of 1931, all short-term loans became long, and interest and amortization payments were nevertheless suspended in 1933.
• 58The best of the usual explanations, and one that seems to be generally accepted nowadays, is that in regard to the loans of that period—in contrast to the big international loans of the nineteenth century—it was no longer possible to transfer the interest and amortization burden to the creditor countries. The argument is accurately summarized in the report of the Study Group of Members of the Royal Institute of International Affairs: “In the nineteenth century . . . the chief lending country, namely Great Britain, herself constituted a market with unlimited possibilities of expansion for the produce of the countries to which she lent; and her lending served to increase the output of precisely the commodities which she was ready to consume. But when the United States lent . . . there was only a somewhat weak presumption that Germany’s capacity to sell goods in world markets would thereby be increased, and virtually no presumption at all that the United States herself would be willing to increase her imports in proportion to the growth of her interest claims.”
• 59Nevertheless, events since 1933 and particularly during the last years before World War II, show that the reasoning of the Royal Institute report is only partly correct. Although the creditor countries, reluctant to accept more imports, rationed them and imposed high duties on them, they could not prevent their arrival from Germany; these measures merely made importation harder for the debtor, who was forced to subsidize his exports. In the matter of a country’s ability to make payments abroad, it should never be forgotten that, despite the widely held opinion, no country is predestined to have an active or passive trade balance. A small deflationary pressure on the price level, or a small inflationary rise in the price level, will, under certain conditions, suffice to reverse the trend of the trade balance. This is especially clear from the change in the German trade balance between 1927, the year of the largest capital import, and 1931, the year of the largest capital export. In 1927 it showed an import surplus of 3,427 million marks, and in 1931 an export surplus of 2,872 million, a difference of 6,299 million.
• 60In the first period the balance of trade became unfavorable and the acquisition of foreign exchange ceased, simply because Germany started on a policy of credit expansion to combat unemployment. During this credit expansion the exchange rate of the mark was not lowered, although it had previously risen substantially through the devaluation of other countries’ currencies. In these circumstances it was only natural—according to all rules of the purchasing-power parity theory, the classical theory of exchange-that the balance of trade became passive; it turned from an export surplus of 1,072 million marks in 1932 to an import surplus of 284 million in 1934. Thus from June 1934 the default on interest and amortization on long-term loans was inevitable.
• 61In addition, exports were fostered. The technique of the so-called Exportförderung (promotion of exports) changed as time went on, but the fundamental idea was always that through defaulting on her foreign loans Germany could depreciate her foreign bonds. Furthermore, by restricting the use of certain mark balances and securities held by people abroad (Auslandssperrmark, Effektensperrmark, Auswanderer sperrmark), she depreciated these assets too, and was thus able to repurchase them at a fraction of their face value. With the profits from this procedure her exports were subsidized and, in consequence, substantially increased.
• 62Finally, it should be remembered that in all countries the position of creditors, in comparison with that of industrialists, suffers from an inherent weakness. Industrialists will continue their export business even if the debts accumulated from former exports have not been paid. They would rather give away goods, if the gifts come out of the pockets of the bondholders, than turn down new business. That is why most countries are reluctant to use all possible means of collecting their external debts, so long as there is a chance of continuing exports to debtor nations.
• 63From 1924 to 1931 foreign loans poured into Germany in the huge amounts mentioned above. But whether they actually augmented Germany’s productive capacity is open to question. Her balance of payments raises some doubts. Of the net capital import of 17.3 billion marks from 1924 to 1930, only 2.4 billion was used to buy merchandise; the remainder was spent on the transfer of interest payments (2.7 billion marks), on reparations (10.1 billion) and for the import of gold and foreign currency (2.1 billion). Thus only a relatively small part of the gigantic capital influx was used for really productive purposes, and we may therefore conclude that only a small part was needed for such purposes.
• 64Elasticity of production was the strength of the European countries after the 1914-18 war. They have since acquired in addition elasticity of money and credit. With the abandonment of the gold standard, governments and central banks are no longer forced to restrict their credits in order to maintain the parity of their currency. There is no longer such a thing as need for the so-called external discount policy. Now there exists only the so-called internal discount policy, which is used to manipulate the business cycle and the capital and credit supply. The supply of credit can be raised and the interest rate lowered at will; the effect is merely a change in the distribution of income between debtors and creditors. The “slight inflation” that arises from such inflationary expansions of credit restricts current consumption, through raising the prices of goods, and directs economic activity toward the production of capital goods, as described above.
• 65When employment is created by means of governmental deficit spending, the day will come when people realize that the real rates of earnings have been reduced and they will demand higher rates. Labor will not be satisfied with the prevailing wage level, less capital will be offered at the prevailing interest rate, and less entrepreneurial activity at the prevailing profit rate. All supply price schedules will move upward. Which of these upward movements will be the strongest depends upon whether labor, capital, or entrepreneurial earnings are expected to be taxed most heavily. The consequences for the structure of the economy are well known; in any case, a further increase in employment will not be possible. And if the government tries to compensate for the compensating reactions by spending still more, again still higher taxes will be anticipated, and so on in a vicious spiral. All this will happen at the latest when the first taxes to meet the larger government obligations are to be levied.
• 66Our conclusion is that the case Lord Keynes regards as the “general case” is in reality a special case, valid only under special conditions and for a certain time. His theory is a special theory of employment for the case when the money illusion works.
• 67Consequently, monetary manipulations will be effective in shortening the transition period from a cyclical depression to recovery. Lowering interest rates below the prevailing market rates and governmental deficit spending are defensible, even advisable at this juncture. But all this is nothing more than the discount policy, open-market policy, and fiscal policy recommended as a means of mitigating cyclical movements, long before Keynes, by almost every monetary business-cycle theorist.
• 68Now there is no doubt that Keynes’ employment theory was conceived during and under the impression of such a cyclical prerecovery and recovery period. This alone can explain his factual assumptions which are typical for such periods but entirely atypical for other periods. On the other hand, Lord Keynes certainly does not intend his theory to be merely a theory of fluctuations in employment during business cycles; these are treated as a special case toward the end of his work. He deals with the establishment of stable equilibria with larger employment, as distinct from the increase of employment during the dynamic process of the cycle. He means his theory to be, chiefly, a theory of noncyclical and thus stabilized, or—to use the European expression—structural employment and unemployment; in short, a general theory. And it is just and only as a general (not as a business-cycle) theory that it is original, challenging, and different from the classical. And it is at this point that there arises a phenomenon that is tragic for economic theory and dangerous for practical economic policy: what is really a theory of cyclical unemployment is formulated as a theory of structural unemployment. And once formulated, it leads its own life, detached from its premises, and becomes the basis and justification for policies concerning situations for which it is not valid, such as unemployment caused by wages which are structurally too high.
• 69To this case Keynes’ scheme is not applicable. In other words, neither lowering interest rates nor government compensatory spending is effective when unemployment prevails at a price level that is neither boom-inflated nor depression-deflated. The reason is simply that in this case the illusion effect does not work for any length of time and that the reaction period is therefore very short.
• 70The aim of science should be, in this as in every other field, to achieve a synthesis of divergent concepts. Such a synthesis was reached by David Hume in his Essay on Bank and Paper Money, 1752. He describes the strong effects of inflation on production during transitory periods and the ineffectiveness of purely monetary measures for longer periods. He recognizes the reason for this: inflation no longer works as soon as the various data of the economy have become adjusted to the increased quantity of money. Thus Hume avoids the overestimation of the Mercantilists as well as the underestimation of the Classicists.
• 71It is not necessary to decide whether an analysis in terms of effective demand alone was justified ten years ago. Today, an analysis in terms of effective demand that is not supplemented by analysis in terms of effective supply, especially of labor, is not justified in any circumstances. It seems both illogical and certain to lead to false conclusions if one indulges (as is so often done) in elaborate estimates of employment at various levels of effective demand, from private or public spending, without making the corresponding estimates of the employment that is created by the same effective demand at various wage levels.
• 72It is not necessary to decide whether an analysis in terms of effective demand alone was justified ten years ago. Today, an analysis in terms of effective demand that is not supplemented by analysis in terms of effective supply, especially of labor, is not justified in any circumstances. It seems both illogical and certain to lead to false conclusions if one indulges (as is so often done) in elaborate estimates of employment at various levels of effective demand, from private or public spending, without making the corresponding estimates of the employment that is created by the same effective demand at various wage levels.
• 73A second matter for consideration is that the devices to combat unemployment known as “government deficit spending,” “compensatory spending,” or “functional finance” are clearly an outgrowth of the idea that in the general case more investment leads to more employment. If our analysis is correct, this will be true only under special conditions. Thus, before applying government spending one has to study carefully to what extent the wage situation has caused the unemployment, and whether and to what extent wages can be held inflexible in an upward direction. Unless this is done, government spending, apart from all fiscal difficulties, will only lead to price inflation. The indiscriminate creation of purchasing power every time private demand slows down for whatever reason or whenever full employment is not achieved, as advocated by the proponents of “functional finance,” is indeed “like almost every important discovery . . . extremely simple.” It is, in fact, not only extremely simple but also an extreme oversimplification of very complicated problems. And if another proponent of “functional finance” wishes to “persuade people that inflation is impossible as long as there is serious unemployment, for under those circumstances a rise in money demands leads to a rise in output and employment, not to a rise in prices,” we should like to take the opposite position: people—economists and laymen alike—should be persuaded that even with serious unemployment the rise in money demand may, under today’s conditions, lead to a rise in prices rather than to a rise in output or employment. The widely held belief in an a priori parallelism of investment and employment is not justified.
• 74A second matter for consideration is that the devices to combat unemployment known as “government deficit spending,” “compensatory spending,” or “functional finance” are clearly an outgrowth of the idea that in the general case more investment leads to more employment. If our analysis is correct, this will be true only under special conditions. Thus, before applying government spending one has to study carefully to what extent the wage situation has caused the unemployment, and whether and to what extent wages can be held inflexible in an upward direction. Unless this is done, government spending, apart from all fiscal difficulties, will only lead to price inflation. The indiscriminate creation of purchasing power every time private demand slows down for whatever reason or whenever full employment is not achieved, as advocated by the proponents of “functional finance,” is indeed “like almost every important discovery . . . extremely simple.” It is, in fact, not only extremely simple but also an extreme oversimplification of very complicated problems. And if another proponent of “functional finance” wishes to “persuade people that inflation is impossible as long as there is serious unemployment, for under those circumstances a rise in money demands leads to a rise in output and employment, not to a rise in prices,” we should like to take the opposite position: people—economists and laymen alike—should be persuaded that even with serious unemployment the rise in money demand may, under today’s conditions, lead to a rise in prices rather than to a rise in output or employment. The widely held belief in an a priori parallelism of investment and employment is not justified.
• 75A second matter for consideration is that the devices to combat unemployment known as “government deficit spending,” “compensatory spending,” or “functional finance” are clearly an outgrowth of the idea that in the general case more investment leads to more employment. If our analysis is correct, this will be true only under special conditions. Thus, before applying government spending one has to study carefully to what extent the wage situation has caused the unemployment, and whether and to what extent wages can be held inflexible in an upward direction. Unless this is done, government spending, apart from all fiscal difficulties, will only lead to price inflation. The indiscriminate creation of purchasing power every time private demand slows down for whatever reason or whenever full employment is not achieved, as advocated by the proponents of “functional finance,” is indeed “like almost every important discovery . . . extremely simple.” It is, in fact, not only extremely simple but also an extreme oversimplification of very complicated problems. And if another proponent of “functional finance” wishes to “persuade people that inflation is impossible as long as there is serious unemployment, for under those circumstances a rise in money demands leads to a rise in output and employment, not to a rise in prices,” we should like to take the opposite position: people—economists and laymen alike—should be persuaded that even with serious unemployment the rise in money demand may, under today’s conditions, lead to a rise in prices rather than to a rise in output or employment. The widely held belief in an a priori parallelism of investment and employment is not justified.
• 76ii. The statement that “the remedy for a boom is not a higher rate of interest but a lower rate of interest” cannot be correct. Investment declines not because interest rates are high in view of the marginal productivity of capital, but because people no longer expect higher prices. To reduce interest rates would therefore be entirely inappropriate. Low interest rates, far from opening new investment opportunities in a technical sense, would merely encourage the use of credit for speculation on higher prices. They would only prolong the boom and prepare the way for an even more severe decline.
• 77Keynes believes in the possibility of an investment gap also in the long run. This is evident from the passages already quoted and from his remarks about the responsibility of the state “for directly organizing investment” in the future. These remarks laid the foundation for the theory of the maturity and stagnation of our economy and of the inevitability of state capitalism.
• 78Keynes believes in the possibility of an investment gap also in the long run. This is evident from the passages already quoted and from his remarks about the responsibility of the state “for directly organizing investment” in the future. These remarks laid the foundation for the theory of the maturity and stagnation of our economy and of the inevitability of state capitalism.
• 79The great significance many writers attribute to the long-run effects of saving induces the feeling that they have somewhat lost their sense of proportion. One gets the impression that people work only in order to accumulate wealth. In reality investment-additions to capital stock—plays in the long run a rather small role in keeping an economy going. According to Simon Kuznets, only 6 to 7 per cent of national income went to net capital formation in 1919-1938. Obviously it is much easier to find new investment opportunities for such a small percentage than for higher percentage of national income.
• 80There also seems to be no proof that in the long run the saving-income ratio rises with income. This ratio has been constant as far as the secular trend, not the cycle, is concerned. What may be correct for the case of an individual moving into a higher bracket seems to be quite wrong in—and should not be confounded with—the case of a whole community getting richer over time.