The Economics of Illusion

Translation of Gottfried Haberler, Albert Hahn’s Volkswirtschaftliche Theorie des Bankkredits (Archiv für Sozialwissenschaft und Sozialpolitik, 1927, vol. 57, pp. 803 ff.)1

Undoubtedly Albert Hahn deserves a prominent place in the history of the most recent German monetary theory. His complaint that science has not heeded his book (p. ix, preface to the second edition) would not be valid now. One could practically say that of late a Hahn literature has developed, inasmuch as scarcely a book is published today on money and credit that does not discuss Hahn’s teachings at length. His theory is indeed worthy of the greatest attention. For in the field of credit and banking it revolutionizes the accepted views based upon the classical economists. Starting from Schumpeter’s ideas, but making them more radical and extreme, Hahn has very skillfully and in an original manner taken up a case before the forum of science that one had been accustomed to consider completely settled (although the ideas still haunted popular economics). With splendid dialectic which handles in masterly fashion all the weapons in the arsenal of modern theory, Hahn attempts to rehabilitate completely the capital and credit theory associated with the names of Law and Macleod. He heads his book with the following quotation from Macleod: “A bank is not an institution to receive and to lend money, but an institution to create credit.”

The second part of the book, entitled “The World of Credit and Goods,” discusses the productive effects of credit. According to Hahn, to these teachings, whether or not they emanate from natural or monetary-economic ideas, and whatever concept of capital they may have, “the opinion is peculiar that the amount of credit available in the economy and therewith also . . . as a matter of principle the interest rate . . . depend upon the goods existing at any time and created in the preceding production period. . . . It will be the main object of what follows to prove the fallacy of this concept” (109).2

Hahn begins his positive statements with this sentence: “Capital formation is not a consequence of saving, but of granting credit. Granting credit is primary to the production of capital” (120). This statement seems indeed to contradict every principle of economics. However, we should never let Hahn confuse us with his paradoxical expressions. Essentially at least the second sentence, that granting credit is primary to the production of capital, is nothing but a not very apt expression for a self-evident matter. Let us not forget that we still talk of an economy depleted of cash. Hahn says correctly that the production of capital is merely a part of the production of goods. “Granting credit, however, means granting purchasing power” (120). The introduction of a production process is therefore accomplished in an economy depleted of cash in such a way that funds are placed at the disposal of the entrepreneur—regardless of their origin or whether they can be increased at will—thus enabling him “to buy machinery, etc., to pay wages, in other words, to develop demand for the means of production” (120). Before starting a production process, one must have the money necessary to acquire the needed means of production unless one already possesses them, which happens so seldom in a modern economy that one can neglect the possibility. Since in an economy depleted of cash these funds are in the form of bank credit, one may say that granting credit—that is, granting a banking account—is primary to the production of capital.

Whereas this sentence is obvious and self-evident, Hahn’s further statement—that the adoption of more devious ways of production is entirely independent of building up savings—is quite objectionable. We, on the contrary, are of the opinion that it makes a fundamental difference whether the credit to purchase means of production originates in savings or has to be created ad hoc (inflationary credit); in the latter case, reactions ensue that considerably limit the expansion of production. It is embarrassing to be called on to demonstrate constantly such well-known facts. However, we should not shirk the trouble inasmuch as in these quite vulnerable statements of Hahn there is a spark of truth that should be salvaged.

Through pages 122-52 Hahn depicts the course of a credit inflation, i.e., of a credit expansion that goes beyond the savings base. Its survey is difficult because Hahn fails to describe the process step by step chronologically as it happens, but dissects the problem into several not too well-chosen subquestions: 1. Effects of credit on the composition of goods (should be “on the composition of the stock of goods of a nation”); 2. Effects on the prices of goods; 3. Effects on the quantity of goods; 4. Influence on capital and national wealth.

Reduction of the interest rate leads to credit expansion. Thus unprofitable new enterprises and investments become profitable. Longer production detours are taken and “the composition of the goods of a nation changes . . . so that there are fewer perishable and more durable goods, more capital equipment and semifinished goods” (129). However, credit expansion has yet another effect. “Production detours naturally cause a temporary, but quite noticeable, scarcity of goods for current consumption, for which the future alone compensates” (130). Moreover, granting credit brings a general price increase which is stronger the longer the production detours introduced.

While at the time of the classical economists a price increase was the sole effect of credit expansion, nowadays it increases production also—for two reasons: 1. “The techniques were so primitive . . . that increased demand for goods could be satisfied only if labor too was proportionately increased” (130), while today’s techniques allow a definitely greater production from an insignificant addition of labor. The second reason is to be found in the fact that nowadays there is “an immense pool of unemployed, part-time employed, and persons who can be induced to work harder” (136), whereas at the time of the classical economists the entire population almost without exception was always at work in production. Thus Hahn makes the daring statement: “The establishment of new producing enterprises does not depend upon a more or a less large reserve of capital; therefore the adoption of new production detours can never be hindered by a lack of capital, because the necessary capital can always be produced by credit. . . . As long as its other prerequisites were met by the nature of the country,3 production has never been hindered by lack of essential factories or tools. If there were no factories, they . . . were simply built” (142). Once again, however, Hahn qualifies his statement. “Of course, no factories could have been built unless means of subsistence for the workmen during construction as well as the necessary tools had existed.” This, however, would be no impediment. “No doubt, the present stands on the shoulders of the past in that the people participating in the production process . . . cannot eat, clothe themselves, work . . . or have a roof over their heads unless in the past a certain stock of goods has been created. However, if this certain stock of goods . . . exists[!], the creation of new enterprises is independent of the capital reserve” (152). After having clearly demonstrated that a reserve of capital is entirely superfluous for the establishment of new enterprises, Hahn completes his exposition by explaining: “For an increase of enterprises does not presume the existence of a bigger stock of capital. The size of capital stocks does not determine whether more or less labor is employed” (142).

In reply it may be objected that the length of a production detour depends upon the existing stock of the means of subsistence, nay, is practically proportional to the size of the stock of goods, because obviously one thousand laborers require more clothes, food, and living quarters than one hundred men, and because after all it makes a difference whether they have to live on them a month, a year, or two years. One cannot brush this consideration aside with the remark that “if worst comes to worst, the price of current goods will rise” (142). Nor can the following sentence be deemed a satisfactory explanation: “The size of the capital stock does not determine whether the labor force can be employed to a smaller or greater extent. A nation working intensely does not necessarily require more food, clothes, or living quarters than a partly employed nation” (142-43).

However, still other far-reaching considerations are against Hahn’s thesis. First, it is very doubtful that a modern economy actually has at its disposal a tremendous labor reserve and that through credit inflation a significant proportion of this reserve can be employed. Hahn is of the opinion that higher wages spur people to work harder. They do not always do so. His statement that real wages rise, by the way, strikingly contradicts his former statement about the scarcity of current goods. Does he think that the scarcity affects only capitalists and rentiers? It is also possible that on higher wages one can retire sooner or be satisfied with an eight-hour working day while formerly one deemed a nine-hour day necessary. It may indeed be correct that rentiers and persons on fixed salaries are prompted to work because their incomes have been reduced by the rise in living costs, but not until prices have risen considerably. Then all the disadvantages of inflation emerge—Hahn does not even mention them—disadvantages that might curtail production more than taking new workers into the production process would further it. At present, since the great inflationary period, there is no excuse for neglecting the devastating economic consequences of monetary depreciation (which need not be discussed further). The important difference is simply that a production expansion financed by savings does not lead to price increases and thus no such countereffects are brought about. Hahn barely touches the decisive question how it actually happens that enterprises not profitable before credit inflation become profitable afterward and are able to remain in existence. The truth is that enterprises based upon inflationary credit can survive only as long as credit inflation continues. As soon as credit expansion stops and the rate of interest returns to its natural level they lose the basis of their profitability; they may still go on until their fixed capital is used up, then disappear. However, if credit continues to be created in order to keep these undertakings alive artificially, it would naturally bring about a progressive monetary depreciation which would eventually lead to a complete disorganization of the economy—how, does not have to be explained nowadays.

One can think of only two situations in which through credit inflation a permanent incorporation of new enterprises into the production process of an economy is conceivable: 1. If the sole effect of a credit inflation in an expanding economy (Hahn mentions this situation in passing but fails to recognize its special feature) is to arrest a necessary price decline, no countereffects are created that otherwise would destroy the profitability of the new enterprise. 2. If improvements in production methods that are profitable in themselves cannot be introduced because of “frictions” such as indolence or lack of entrepreneurial spirit, they can be forced by inflationary bank credit. As they are profitable and not introduced merely on account of temporary difficulties, such new undertakings survive even after credit inflation has been discontinued.

This is the spark of truth in the doctrine of the productive effects of inflationary credit. The second instance may be quite important in practice, even though compared with savings activity it hardly matters. When we discuss savings we do not have in mind only the little fellow’s bank account; the big bank, too, saves by not distributing part of its profits in the form of dividends, and applying it to productive use.

In Hahn’s system savings not only do not stimulate, but, on the contrary, impede production. According to him, there is only one limit to the beneficial effect of credit expansion on production: “When new credit cannot put new labor into the service of production,” a further expansion of credit does not effect further production increases (145). If, as experience teaches us, this limit is never reached, but a recession starts before full employment is attained, the cause can be found in the fact that consumption does not follow the increased production. This again is the result of the savings activity. “Checking accounts are transformed into savings accounts, are consolidated (i.e., stay in the account), and no longer create demand in the market for goods. Therefore, as production no longer meets a corresponding consumption, the flow of goods begins to stop” (147-48).

There are two weighty arguments against this theory: 1. Funds one desires to save are not hoarded—even in an economy without cash—but are “invested” (for instance, in stocks), because of the higher rate of interest, so that respending takes place automatically. Consequently, there is no lack, but merely displacement of demand. 2. Hahn himself keeps emphasizing that banks “regularly grant more credit than flows to them in the form of savings” (e.g., p. 63). Nevertheless, from his viewpoint he is right in wanting to fight economic crises by the vigorous creation of credit, ultimately for the account of the government (155).

However, it is entirely inconceivable how Hahn can maintain that inflationary credit spurs savings activity, that “savings increase not only pro rata with the credit granted but overproportionately” (153). Would a credit expansion which, according to Hahn, first raises prices, and secondly reduces the supply of current goods, induce people to limit consumption voluntarily still more than they are forced to already by higher prices, and to undergo willingly the inflation losses by not spending the depreciating currency?

4 All italics are Haberler’s. Numbers in parentheses after quotations refer to pages in Hahn’s book.

5 The reader must believe us when we say that the passages are quoted word for word, and have not been taken out of their context in order to distort the author’s views.

6 This condition must be interpreted restrictively according to the sense of the sentence.

• 1* Appeared first in The Banking and Law Journal, July 1943.
• 2Tübingen, 1st ed., 1920; 2d ed., 1924; 3d ed., 1930.
• 3Berlin, 1930; Tübingen, 1931. These articles, as well as those mentioned above, are available in the New York Public Library.
• 4  2. Should a Government Debt, Internally Held, Be Called a Debt at All?*
• 5I 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.
• 6When 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.