Prices and Production

CHAPTER 4

The Fundamental Cause of Cyclical Fluctuations

I

So far we have not answered, or have only hinted at an answer to the question why, under the existing organization of the economic system, we constantly find those deviations of the money rate of interest from the equilibrium rate76 which, as we have seen, must be regarded as the cause of the periodically recurring disproportionalities in the structure of production. The problem is, then, to discover the gap in the reaction mechanism of the modern economic system that is responsible for the fact that certain changes of data, so far from being followed by a prompt readjustment (i.e., the formation of a new equilibrium) are, actually, the cause of recurrent shifts in economic activity that subsequently have to be reversed before a new equilibrium can be established.

The analysis of the foregoing chapters has shown that when it is possible to detect, in the organization of our economy, a dislocation in the reaction mechanism described by equilibrium theory, it should be possible (and should, indeed, be the object of a fully developed trade cycle theory) to describe deductively, as a necessary effect of the disturbance—quite apart from their observed occurrence—all the deviations in the course of economic events conditioned by this dislocation. It has been shown, in addition, that the primary cause of cyclical fluctuations must be sought in changes in the volume of money, which are undoubtedly always recurring and which, by their occurrence, always bring about a falsification of the pricing process, and thus a misdirection of production. The new element we are seeking is, therefore, to be found in the “elasticity” of the volume of money at the disposal of the economic system. It is this element whose presence forms the “necessary and sufficient” condition for the emergence of the trade cycle.77

The question we now have to examine is whether this elasticity in the volume of money is an immanent characteristic of our present money and credit system; whether, given certain conditions, changes in the volume of money and the resulting differences between the natural and the monetary rate of interest must necessarily occur, or whether they represent, so to speak, casual phenomena arising from arbitrary interferences by the authorities responsible for the regulation of the volume of currency media. Is it an inherent necessity of the existing monetary and credit system that its reaction to certain changes in data is different from what we should expect on the basis of economic equilibrium theory; or are these discrepancies to be explained by special assumptions regarding the nature of the monetary administration, i.e., by a series of what might be called “political” assumptions? The question whether the recurrence of credit cycles is, or is not, due to an unavoidable characteristic of the existing economic organization, depends on whether the existing monetary and credit organization in itself necessitates changes in the currency media, or whether these are brought about only by the special interference of external agencies. The answer to this question will also decide into which of the most commonly accepted categories a given trade cycle theory is to be placed. We must deal briefly with this point because a false classification, which is largely the fault of the exponents of the monetary theories, has contributed much to make them misunderstood.

II

If we are to understand the present status of monetary theories of the trade cycle, we must pay special attention to the assumptions upon which they are based. At the present day, monetary theories are generally regarded as falling within the class of so-called “exogenous” theories, i.e., theories that look for the cause of the cycle not in the interconnections of economic phenomena themselves but in external interferences. Now it is, no doubt, often a waste of time to discuss the merits of classifying a theory in a given category. But the question of classification becomes important when the inclusion of a theory in one class or another implies, at the same time, a judgment as to the sphere of validity of the theory in question. This is undoubtedly the case with the distinction, very general today, between endogenous and exogenous theories—a distinction introduced into economic literature some twenty years ago by Bouniatian.78 Endogenous theories, in the course of their proof, avoid making use of assumptions that cannot either be decided by purely economic considerations, or regarded as general characteristics of our economic system—and hence capable of general proof. Exogenous theories, on the other hand, are based on concrete assertions whose correctness has to be proved separately in each individual case. As compared with an endogenous theory, which, if logically sound, can in a sense lay claim to general validity, an exogenous theory is at some disadvantage, inasmuch as it has, in each case, to justify the assumptions on which its conclusions are based.

Now as far as most contemporary monetary theories of the cycle are concerned, their opponents are undoubtedly right in classifying them, as does Professor Lowe79 in his discussion of the theories of Professors Mises and Hahn, among the exogenous theories; for they begin with arbitrary interferences on the part of the banks. This is, perhaps, one of the main reasons for the prevailing skepticism concerning the value of such theories. A theory that has to call upon the deus ex machina80 of a false step by bankers, in order to reach its conclusions is, perhaps, inevitably suspect. Yet Professor Mises himself—who is certainly to be regarded as the most respected and consistent exponent of the monetary theory of the trade cycle in Germany—has, in his latest work, afforded ample justification for this view of his theory by attributing the periodic recurrence of the trade cycle to the general tendency of central banks to depress the money rate of interest below the natural rate.81 Both the protagonists and the opponents of the monetary theory of the trade cycle thus agree in regarding these explanations as falling ultimately within the exogenous and not the endogenous group. The fact that this is not an inherent necessity of the monetary starting point is, however, shown by the undoubtedly endogenous nature of the various older trade cycle theories, such as that of Wicksell. But since this suffers from other deficiencies, which have already been indicated, the question of whether the exogenous character of modern theories is or is not an inherent necessity of their nature remains an open one.82 It seems to me that this classification of monetary trade cycle theory depends exclusively on the fact that a single especially striking case is treated as the normal, while in fact it is quite unnecessary to adduce interference on the part of the banks in order to bring about a situation of alternating boom and crisis. By disregarding those divergencies between the natural and money rate of interest that arise automatically in the course of economic development, and by emphasizing those caused by an artificial lowering of the money rate, the monetary theory of the trade cycle deprives itself of one of its strongest arguments; namely, the fact that the process it describes must always recur under the existing credit organization, and that it thus represents a tendency inherent in the economic system, and is in the fullest sense of the word an endogenous theory.

It is an apparently unimportant difference in exposition that leads one to this view that the monetary theory can lay claim to an endogenous position. The situation in which the money rate of interest is below the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the “natural rate” (at which the demand for, and the supply of, savings are equal) above its previous level; while the banks refrain from raising their rate of interest to a proportionate extent, but continue to lend at the previous rate, and thus enable a greater demand for loans to be satisfied than would be possible by the exclusive use of the available supply of savings. The decisive significance of the case quoted is not, in my view, due to the fact that it is probably the commonest in practice, but to the fact that it must inevitably recur under the existing credit organization.

III

The notion that the increase in circulation is due to arbitrary interference by the banks owes its origin to the widespread view that banks of issue are the exclusive or predominant agencies that can change the volume of the circulation; and that they do so of their own free will. But the central banks are by no means the only factor capable of bringing about a change in the volume of circulating media;83 they are, in their turn, largely dependent upon other factors, although they can influence or compensate for these to a great extent. Altogether, there are three elements that regulate the volume of circulating media within a country—changes in the volume of cash, caused by inflows and outflows of gold; changes in the note circulation of the central banks: and last, and in many ways most important, the often-disputed “creation” of deposits by other banks. The interrelations of these are, naturally, complicated.

As regards original changes in the first two factors—that is, changes that are not set in motion by changes in one of the other factors—there is comparatively little to say. It has already been pointed out that, in principle, an increase in the volume of cash, occasioned by an increase in the volume of trade, also implies a lowering of the money rate of interest—which gives rise to shifts in the structure of production that seem, though only temporarily, to be advantageous. It must certainly appear very problematical whether the deviations in the money rate of interest thus occasioned would, as a rule, be large enough to cause fluctuations of an empirically ascertainable magnitude. Central banks, on the other hand, are by law or custom bound to preserve such a close connection between note issues and cash holdings that we have no reason to assume that they, and they alone, provide the original impetus. Of course, it is possible to assume, with Professor Mises, that the central banks, under the pressure of an inflationist ideology, are always trying to expand credit and thus provide the impetus for a new upward swing of the trade cycle; and this assumption may be correct in many cases. The credit expansion is then conditioned by special circumstances, which need not always be present; and the cyclical fluctuations caused by it are, therefore, not the necessary consequence of an inherent tendency of our credit system, for the removal of the special circumstances would eliminate them. But before deciding in favor of this special assumption—which requires a proof of its own, to be given separately in the case of each cycle—we have to ask whether, in some other part of our credit system, such extensions may not take place automatically under certain conditions—without the necessity for any special assumption of the inadequate functioning of any part of the system. To me this certainly appears to be true as regards the third factor of money expansion—the “credit creation” of the commercial banks.

There are few questions upon which scientific literature, especially in Germany, is so lacking in clarity as on the possibility and importance of an increase in circulating media due to the granting of additional credit by the banks of deposit. To give an answer to the question of whether credit creation is a regular consequence of the existing organization of banking, we shall have to attempt to clear up our conception of the methods and extent of such credit creation by deposit banks. Besides dealing with the fundamental question of the possibility of credit creation and the limits to which it can extend, we shall have to discuss two special questions that are important for our further investigations: namely, whether the practical importance of credit creation depends upon certain practices of banking technique, as is often assumed; and second, whether it is, in fact, possible to determine whether a given issue of credit represents credit freshly created or not.

If in the course of our investigation, it is possible to prove that the rate of interest charged by the banks to their borrowers is not promptly adjusted to all changes in the economic data (as it would be if the volume of money in circulation were constant)—either because the supply of bank credit is, within certain limits, fundamentally independent of changes in the supply of savings, or because the banks have no particular interest in keeping the supply of bank credit in equilibrium with the supply of savings and because it is, in any case, impossible for them to do so—then we shall have proved that, under the existing credit organization, monetary fluctuations must inevitably occur and must represent an immanent feature of our economic system—a feature deserving of the closest examination.

IV

The main reason for the existing confusion with regard to the creation of deposits is to be found in the lack of any distinction between the possibilities open to a single bank and those open to the banking system as a whole.84 This is connected with the fact that, in Germany, the whole theory has been taken over bodily from England, where, owing to differences in banking technique, the limits imposed on any individual bank are, perhaps, somewhat less narrow, so that the general possibilities open to the banking system as a whole have not been indicated with the degree of emphasis that their importance deserves. In Germany, following the popular exposition of Mr. Hartley Withers, the most generally accepted view starts from English banking practice, which (except in the case of “overdrafts”) credits the account of the customer with the amount borrowed before the latter is actually utilized. Granted this assumption, the process leading to an increase of circulating media is comparatively easy to survey and therefore hardly ever disputed. So long and insofar as the credit a bank is able to grant, considering its cash position, remains on current account—and in the United States, for example, it is a regular condition for the granting of a loan that the current account of the borrower shall never fall below a certain relatively high percentage of the sum borrowed85—every new grant of credit must, of course, bring about an equivalent increase of deposits and a proportionately smaller diminution of cash reserves. Against these “deduced deposits” (Phillips), which regularly occur in the normal course of business, the banks naturally have to keep only a certain percentage of cash reserve; and thus it is clear that every bank can, on the basis of a given increase of deposits resulting from public payments, grant new credit to an amount exceeding this increase in deposits.

Against this method of proof it can rightly be objected that, while banking practices of this kind may well lead to the possibility of credit creation, the conditions this argument assumes are not present on the Continent. It has been justifiably and repeatedly emphasized that there is no reason why the borrower, so long as he is not forced to do so, should borrow money at a higher rate of interest merely to leave that money on deposit at a lower rate.86

If the possibility of creating credit depended only on the fact that borrowers leave part of their loans on current account for a time, then credit creation would be practically impossible on the Continent;87 while even in England and the United States it would have only a very secondary importance. It should be noted that this applies to the case in which the borrower pays the sum borrowed into another account in the same bank, so that it is transferred from one to the other without diminishing the total volume of deposits in the bank concerned. We need not, therefore, go separately into this case.

But, in adopting this line of argument, by far the most important process by which deposits are created in the course of current banking business, even in Anglo-Saxon countries, is neglected, and the sole way in which they are created on the Continent is left entirely out of consideration. The latter could easily be overlooked, since the ability of individual banks to make an increase in their deposits the basis of a far greater amount of new credit can only be accounted for by means of the assumptions used above, while in the banking system as a whole the same process occurs independently. In the following pages, therefore, we shall examine how an increase in deposits, paid in in cash, influences the lending capacity of the whole banking system; starting from the assumption, more appropriate to Continental conditions, that the sums granted will be credited to the account of the borrower only at the time when, and to the extent that, he makes use of them.

V

We may start as before by examining the procedure of a single bank. At this bank a certain amount of cash is newly deposited; a sum, let us say, equal to 5 percent of its previous total deposits. If the policy of the bank was to keep a reserve of 10 percent against deposits, that ratio has now been increased, by the new deposit, to 14.3 percent, and the bank is therefore in a position, in accordance with its policy, to grant new credit. If we assume further that it re-lends 90 percent of the newly deposited money and that the whole of this is immediately utilized by the borrower (in order, let us say, to increase his purchases of raw materials), then the ratio of cash to deposits has again sunk to 10 percent. Insofar as the bank does not change its policy, its individual lending capacity is exhausted, in these circumstances, before it has even re-lent the whole of the amount newly deposited.

The effect of the sums newly deposited at one bank on the lending capacity of the whole banking system is, however, not exhausted by this transaction. If the borrower does not use the credit in a way that leads quickly to the market for consumers’ goods, such as wage payments, but devotes it instead to the purchase of raw materials or half-finished products, then it is to be assumed that payment will be made by check and that the seller will hand over the sum received to his own bank for encashment, the amount being credited to his own account. The next consequence must be that the clearinghouse position of this bank improves by exactly the amount transferred, and it therefore obtains an equivalent amount of cash from the bank that originally granted the credit.

For the second bank, therefore, the sum originating in the granting of credit and paid into its accounts (representing, as we remember, 90 percent of the original deposit) is just as much an original deposit, based on cash payments, as it was to the bank we originally considered. It will, therefore, be regarded as a basis for additional lending and used in just the same way as any other new deposit. If the second bank also keeps 10 percent of its deposits as cash reserves, it too will be in a position to lend 90 percent of the new deposit, and the same process will be continued as long as the amounts are merely transferred from bank to bank and are not taken out in cash. As every bank re-lends 90 percent of the amount paid into it and thus causes an equivalent increase in deposits for some other bank, the original deposit will give rise to credit representing 0.9+0.92+0.93+0.94... times the original amount. As the sum of this converging infinite series is 9, the banks will be enabled, in an extreme case, to create, against an amount of cash flowing in from an outside source, credit equal to nine times that amount. This becomes clear when we consider that the process can only stop when the last part of this cash is required for the 10 percent reserve of the deposits.

For simplicity’s sake we have made use of an assumption that is undoubtedly incorrect, but which affects our conclusion only insofar as it reduces the actual amount of new credit the banks can create with a reserve ratio of 10 percent. Its omission leaves our fundamental conclusion intact; i.e., that they can grant credit to an amount several times greater than the sum originally deposited. In fact some part of the credit at least, if not on the first, then on subsequent occasions, will always be withdrawn in cash and not deposited with other banks. For example, if 70 percent is always redeposited instead of the full 90 percent, this amount being re-lent by every bank and the remainder being used in cash transactions, then the increase in deposits will give rise to additional credit equal to only 0.7+0.72+0.73... times (i.e., two and one-third times) the original. So long as any part of the credit granted is not withdrawn in cash but re-deposited with the banks, the latter will be able to create additional credit, of a larger or smaller amount, as a consequence of every increase in their cash holdings.88 The lifetime of this pyramid of credit is limited to that of the first credit granted, save in the case (which can be assumed as long as there are no withdrawals from deposits) where it is immediately replaced by a fresh credit. If, however, deposits unexpectedly diminish at any part of the banking system, the process will be reversed, and the original diminution of deposits will occasion a contraction of credit correspondingly exceeding the amount withdrawn.89

In this connection we must note for further emphasis later the fact that the proportion in which the credit granted is transferred to other accounts—and not paid out in cash—must be regarded as subject to very wide fluctuations as between different individuals at a given moment, as well as between various periods of time for the economic system as a whole. We return later to the significance of this fact.

What has been said above should be sufficient to show that the possibility of creating credit over and above the sums deposited—which, under Continental banking conditions, is not open to any individual bank—is, however, open to the whole banking system of the country to a considerable extent. The fact that a single bank cannot do what is automatically done by the banking system as a whole also explains another circumstance, which might otherwise easily be cited as a proof of the impossibility of additional credit creation. If every bank could re-lend several times the amount deposited, there would be no reason against its offering a much higher rate of interest on deposits than it actually does, or, in particular, under the existing discount rates of the central banks, against its procuring cash in unlimited quantities by way of rediscount; for it would only have to charge its customers a small part of the rate of interest charged by the banks in order to make the business pay. This apparent contradiction between theory and practice is cleared up as soon as one realizes that an increase of deposits by a single bank only offers possibilities for credit creation to the banking system as a whole. But the importance of this circumstance transcends the mere clearing up of this difficulty.

VI

As credit created on the basis of additional deposits does not normally appear in the accounts of the same bank that granted the credit, it is fundamentally impossible to distinguish, in individual cases, between “those deposits which arose through cash payment and those which find their origin in credit.”90 But this consideration rules out, a priori, the possibility of bankers limiting the amount of credit granted by them to the amount of “real” accumulated deposits—that is, those arising from the accommodation of temporarily unused money. The same fact enables us to understand why it is generally just those economic writers who are also practical bankers who are most unwilling to admit in any circumstances that they are in a position to create credit.91 “The banker simply does not notice that through this process there is an increase in the amount of money in circulation.”92 Once the impetus has been given to any part of the banking system, mere adherence to the routine of banking technique will lead to the creation of additional deposits without the possibility arising, at any point, of determining whether any particular credit should properly be regarded as “additional.” Every time money that has been deposited is re-lent—provided that the depositor is not prevented from using his deposits for making payments—this process is to be regarded as the creation of additional purchasing power; and it is merely this comparatively simple operation that is at the root of the banks’ ability to create purchasing power—although the process appears so mysterious to many people. It is thus by no means necessary that the banks should grant this credit, as Dr. Dernburg seems to assume, in an “improper or wanton” way.

It is of course quite another question whether bankers can or do create additional credit of their own free will. The objections to this theory of additional credit, which are leveled against the statement that the banks create credit “as they please,” although holding good at a given rate of interest, do not in the least affect that part of the theory we need for our analysis. If Professor Reisch, for example, emphasizes that bank deposits generally increase only “according to the needs of business,”93 or if Professor Bouniatian objects that “it does not depend on the banks, but on the demands made by commerce and industry, how far banks expand credit,”94 then these assertions, coming as they do from opponents of the theory of bank credit, already contain all that is needed for a deductive proof of the necessity for the recurrence of credit cycles. What interests us is precisely the question of whether the banks are able to satisfy the increased demands of businessmen for credit without being obliged immediately to raise their interest charges—as would be the case if the supply of savings and the demand for credit were to be in direct contact, without the agency of the banks (as, for example, in the hypothetical “savings market” of theory); or whether it is even possible for the banks to raise their interest charges immediately the demand for credit increases. Even the bitterest opponents of this theory of bank credit are forced to admit that “there can be no doubt that, with the upward swing of the trade cycle, a certain expansion of bank credit takes place.”95

We must not, however, be satisfied with registering the general agreement of opinion on this point. Before passing on to analyze the consequences of this phenomenon, we must ask whether the causes which bring it about—that banks increase their deposits through additional credit in periods of boom and thus postpone, at any rate temporarily, the rise in the rate of interest that would otherwise necessarily take place—are inherent in the nature of the system or not.

VII

So far, the starting point of our argument concerning the origin of additional credit has been the assumption that the banks receive an increased inflow of cash, which they then use as a basis for new credit on a much larger scale. We must now inquire how banks behave when an increased demand for credit makes itself felt.

Assuming, as is preferable, that this increased demand was not caused by a lowering of their own interest rates, this additional demand is always a sign that the natural rate of interest has risen—that is, that a given amount of money can now find more profitable employment than hitherto. The reasons for this can be of very different kinds:96 new inventions or discoveries, the opening up of new markets, or even bad harvests,97 the appearance of entrepreneurs of genius who originate “new combinations” (Schumpeter), a fall in wage rates due to heavy immigration, the destruction of great blocks of capital by a natural catastrophe, or many others. We have already seen that none of these reasons is in itself sufficient to account for an excessive increase of investing activity, which necessarily engenders a subsequent crisis; but that they can lead to this result only through the increase in the means of credit they inaugurate.

But how is it possible for the banks to extend credit, as they undoubtedly do, following an increase in demand, when no additional cash is flowing into their vaults? There is no reason to assume that the same cause that has led to an increased demand for credit will also influence another factor, the cash position of the banks—which as we know is the only factor determining the extent to which credit can be granted.98 So long as the banks maintain a constant proportion between their cash reserves and their deposits it would be impossible to satisfy the new demand for credit. The fact that in reality deposits always do expand relatively to cash reserves, in the course of the boom, so that the liquidity of the banks is always impaired in such periods, does not of course constitute a sufficient starting point for an argument in which the increase in credit is regarded as the decisive factor determining the course and extent of the cyclical movement. We must attempt to understand fully the causes and nature of this credit expansion and in particular its limits.

The key to this problem can only be found in the fact that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable. But we shall achieve a satisfactory solution only by showing that the reason for this variability in the reserve is not based on the arbitrary decisions of the bankers, but is itself conditioned by the general economic situation. Such an examination of the causes determining the size of the reserve ratio desired by the banks is all the more important since we had no theoretical warrant for our previous assumption that it always tends to be constant.

It is best to begin our investigation by considering once again the situation of a single bank, and asking how the manager will react when the credit requirements of the customers increase in consequence of an all-around improvement in the business situation.99 For reasons that will shortly become clear, we must assume that the bank under consideration is the first to feel the new credit requirements of industry, because, let us say, its customers are drawn from just those industries that first feel the effects of the new recovery. Among the factors that determine the volume of loans granted by the bank, only one has changed; whereas previously, at the same rate of interest and with the same security, no new borrowers came forward, now, under the same conditions of borrowing, more loans can be placed. On the other hand, the cash holdings of the bank remain unchanged. This does not mean, however, that the considerations of liquidity that dictate the amount of loans to be granted will lead to the same result now as when fresh loans could only have been placed at a lower rate of interest or with inferior security than was the case with loans already granted. In this connection, finally, we must mention that the sums we have, for simplicity’s sake, hitherto called cash balances, which form the bank’s liquid reserve, are by no means exclusively composed of cash—and are not even of a constant magnitude, unrelated to the size of the profits they make possible. The danger that, in case of need, the reserves may have to be replenished by rediscounting bills through the central bank,100 or that, in order to correct an unfavorable clearing-house balance, day-money may have to be borrowed at a given rate of interest, is far less abhorrent when it is possible to extend credit at an undiminished rate of interest than when such an extension would involve a lowering of that rate. But even disregarding this possibility and assuming that the bank recognizes that it can satisfy its eventual need for cash only at correspondingly higher rates, we can see that the greater loss of profit entailed by keeping the cash reserve intact will, as a rule, lead the bank to a policy that involves diminishing the size of this non-earning asset. Besides this, we have the consideration that, in the upward phase of the cycle, the risks of borrowing are less; and therefore a smaller cash reserve may suffice to provide the same degree of security. But it is above all for reasons of competition that the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks that had not yet experienced a similarly increased demand for credit. There can be little doubt, therefore, that the bank or banks that are the first to feel the effects of new credit requirements will be forced to satisfy these even at the cost of reducing their liquidity.

VIII

But once one bank or group of banks has started the expansion, then all the other banks receive, as already described, a flow of cash that at first enables them to expand credit on their own account without impairing their liquidity. They make use of this possibility the more readily since they, in turn, soon feel the increased demand for credit. Once the process of expansion has become general, however, the banks soon realize that, for the moment at any rate, they can safely modify their ideas of liquidity. While expansion by a single bank will soon confront it with a clearinghouse deficit of practically the same magnitude as the original new credit, a general expansion carried on at about the same rate by all banks will give rise to clearinghouse claims which, although larger, mainly compensate one another and so induce only a relatively unimportant cash drain. If a bank does not at first keep pace with the expansion it will, sooner or later, be induced to do so, since it will continue to receive cash at the clearinghouse as long as it does not adjust itself to the new standard of liquidity.

So long as this process goes on, it is practically impossible for any single bank, acting alone, to apply the only control by which the demand for credit can, in the long run, be successfully kept within bounds; that is, an increase in its interest charges. Concerted action in this direction, which for competitive reasons is the only action possible, will ensue only when the increased cash requirements of business compel the banks to protect their cash balances by checking further credit expansion, or when the central bank has preceded them by raising its discount rate. This, again, will only happen, as a rule, when the banks have been induced by the growing drain on their cash to increase their rediscount. Experience shows, moreover, that the relation between check payments and cash payments alters in favor of the latter as the boom proceeds, so that an increased proportion of the cash is finally withdrawn from the banks.101

This phenomenon is easily explained in theory by the fact that a low rate of interest first raises the prices of capital goods and only subsequently those of consumption goods, so that the first increases occur in the kind of payments that are effected in large blocks.102 It may lead to the consequence that banks are not only prevented from granting new credit, but even forced to diminish credit already granted. This fact may well aggravate the crisis, but it is by no means necessary in order to bring it about. For this it is quite enough that the banks should cease to extend the volume of credit; and sooner or later this must happen. Only so long as the volume of circulating media is increasing can the money rate of interest be kept below the equilibrium rate; once it has ceased to increase, the money rate must, despite the increased total volume in circulation, rise again to its natural level and thus render unprofitable (temporarily, at least) those investments which were created with the aid of additional credit.103

IX

The assertion that forms the starting point of the “Additional Credit Theory of the Trade Cycle,” and whose proof has been attempted in the preceding pages, has never in fact been seriously questioned; but hardly any attempts have been made to follow up all the unpleasant consequences of the state of affairs it indicates. Yet what is implied when the beneficial effects of bank credit are praised but, thanks to the activities of banks, an increased demand for credit is followed by a greater increase in its supply than would be warranted by the supply of contemporary saving? Wherein lie the often-praised effects of credit, if not in the fact that it provides means for enterprises for which no provision could be found if the choices of the different economic subjects were strictly followed? By creating additional credit in response to an increased demand, and thus opening up new possibilities of improving and extending production, the banks ensure that impulses toward expansion of the productive apparatus shall not be so immediately and insuperably balked by a rise of interest rates as they would be if progress were limited by the slow increase in the flow of savings. But this same policy stultifies the automatic mechanism of adjustment that keeps the various parts of the system in equilibrium and makes possible disproportionate developments that must, sooner or later, bring about a reaction.

Elasticity in the credit supply of an economic system is not only universally demanded but also—as the result of an organization of the credit system which has adapted itself to this requirement—an undeniable fact, whose necessity or advantages are not discussed here.104 But we must be quite clear on one point. An economic system with an elastic currency must, in many instances, react to external influences quite differently from an economy in which economic forces impinge on goods in their full force—without any intermediary; and we must, a priori, expect any process started by an outside impulse to run an entirely different course in such an economy from that described by a theory that only takes into account changes originating on the side of goods. Once, owing to the disturbing influence of money, even a single price has been fixed at a different level from that which it would have formed in a barter economy, a shift in the whole structure of production is inevitable; and this shift, so long as we make use of static theory and the methods proper to it, can only be explained as an exclusive consequence of the peculiar influence of money. The immediate consequence of an adjustment of the volume of money to the “requirements” of industry is the failure of the “interest brake” to operate as promptly as it would in an economy operating without credit. This means, however, that new adjustments are undertaken on a larger scale than can be completed; a boom is thus made possible, with the inevitably recurring “crisis.” The determining cause of the cyclical fluctuation is, therefore, the fact that on account of the elasticity of the volume of currency media the rate of interest demanded by the banks is not necessarily always equal to the equilibrium rate, but is, in the short run, determined by considerations of banking liquidity.105

The main question set by this inquiry is thus answered. A deductive explanation embracing all the phenomena of the trade cycle would require far-reaching logical investigations entirely transcending the scope of this work, which aims merely at an exposition of the monetary basis of trade cycle theory. For the present, we must content ourselves with a reference to existing literature on the subject.106 In the present work we shall only draw a few conclusions that follow from our previous arguments, some with regard to practical policy, some with regard to further scientific research. Before going on to this, however, we shall venture a few remarks on the question of whether the result of our investigations unequivocally settles the controversy between the protagonists and opponents of the monetary trade cycle theory in favor of the former.

X

It must be emphasized first and foremost that there is no necessary reason why the initiating change, the original disturbance eliciting a cyclical fluctuation in a stationary economy, should be of monetary origin. Nor, in practice, is this even generally the case. The initial change need have no specific character at all; it may be any one among a thousand different factors that may at any time increase the profitability of any group of enterprises. For it is not the occurrence of a “change of data” that is significant, but the fact that the economic system, instead of reacting to this change with an immediate “adjustment” (Schumpeter)—i.e., the formation of a new equilibrium—begins a particular movement of “boom” that contains within itself the seeds of an inevitable reaction. This phenomenon, as we have seen, should undoubtedly be ascribed to monetary factors, and in particular to “additional credit” that also necessarily determine the extent and duration of the cyclical fluctuation. Once this point is agreed upon, it naturally becomes quite irrelevant whether we label this explanation of the trade cycle as a monetary theory or not. What is important is to recognize that it is to monetary causes that we must ascribe the divergences of the pricing process, during the trade cycle, from the course deduced in static theory.

From the particular point of view from which we started, our theory must be regarded most decisively as a monetary one. As to the incorporation of trade cycle theory into the general framework of static equilibrium theory (for the clear formulation of which we are indebted to Professor A. Lowe, one of the strongest opponents of monetary trade cycle theory), we must maintain, in opposition to his view, not only that our own theory is undoubtedly a monetary one but that a theory other than monetary is hardly conceivable.107 It must be conceded that the monetary theory as we have presented it—whether one prefers to call it a monetary theory or not, and whether or not one finds it a sufficient explanation of the empirically determined fluctuations—has this definite advantage: it deals with problems that must, in any case, be dealt with, for they are necessarily given when the central apparatus of economic analysis is applied to the explanation of the existing organization of exchange. Even if we had never noticed cyclical fluctuations, even if all the actual fluctuations of history were accepted as the consequences of natural events, a consequential analysis of the effects that follow from the peculiar workings of our existing credit organization would be bound to demonstrate that fluctuations caused by monetary factors are unavoidable.

It is, of course, an entirely different question whether these monetary fluctuations would, if not reinforced by other factors, attain the extent and duration we observe in the historical cycles, or whether in the absence of these supplementary factors they would not be much weaker and less acute than they actually are. Perhaps the empirically observed strength of the cyclical fluctuations is really only due to periodic changes in external circumstances, such as short-period variations of climate, or changes in subjective data (as, e.g., the sudden appearance of entrepreneurs of genius), or perhaps the interval between individual cyclical waves may be due to some natural law.108 Whatever further hypothetical causes are adduced to explain the empirically observed course of the fluctuations, there can be no doubt (and this is the important and indispensable contribution of monetary trade cycle theory) that the modern economic system cannot be conceived without fluctuations ascribable to monetary influences; and therefore any other factors that may be found necessary to explain the empirically observed phenomena will have to be regarded as causes additional to the monetary cause. In other words, any non-monetary trade cycle theory must superimpose its system of explanation on that of the monetarily determined fluctuations; it cannot start simply from the static system as presented by pure equilibrium theory.

Once this is admitted, however, the question of whether the monetary theory of the trade cycle is correct or not must, at any rate, be presented in a different form. For if the correctness of the interconnections described by monetary theory is unquestioned, there still remains the problem of whether it is also sufficient to explain all those phenomena that are observed empirically in the course of the trade cycle; it may perhaps need supplementing in order to make it an instrument suitable to explain the working of the modern economic system. It seems to me, however, that before we can successfully tackle this problem we ought to know exactly how much of the empirically observed fluctuations are due to the monetary factor, which is actually always at work; and therefore we shall have to work out in the fullest detail the theory of monetary fluctuations. It is hardly permissible, methodologically speaking, to go in search of other causes whose existence we may conjecture, before ascertaining exactly how far and to what extent the monetary factors are operative. It is our duty to work out in detail the necessary consequences of those causes of disturbance that we know, and to make this train of thought a definite part of our logical system, before attempting to incorporate any other factors that may come into play.

XI

The fact, simple and indisputable as it is, that the “elasticity” of the supply of currency media, resulting from the existing monetary organization, offers a sufficient reason for the genesis and recurrence of fluctuations in the whole economy is of the utmost importance—for it implies that no measure that can be conceived in practice would be able entirely to suppress these fluctuations.

It follows particularly from the point of view of the monetary theory of the trade cycle that it is by no means justifiable to expect the total disappearance of cyclical fluctuations to accompany a stable price level—a belief Professor Lowe109 seems to regard as the necessary consequence of the monetary theory of the trade cycle. Professor Röpke is undoubtedly right when he emphasizes the fact that “even if a stable price level could be successfully imposed on the capitalist economy the causes making for cyclical fluctuations would not be removed.”110 But to realize this, as the preceding argument shows, is by no means “equivalent to a rejection of a 100 percent monetary Trade Cycle theory.”111 On the contrary, on this view, we must regard Professor Röpke’s theory, which coincides in the more important points with our own,112 as itself constituting such a 100 percent monetary trade cycle theory.

Once this is realized, we can also see how nonsensical it is to formulate the question of the causation of cyclical fluctuations in terms of “guilt,” and to single out, e.g., the banks as those “guilty” of causing fluctuations in economic development.113 Nobody has ever asked them to pursue a policy other than that which, as we have seen, gives rise to cyclical fluctuations; and it is not within their power to do away with such fluctuations, seeing that the latter originate not from their policy but from the very nature of the modern organization of credit. So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles. They are, in a sense, the price we pay for a speed of development exceeding that which people would voluntarily make possible through their savings, and which therefore has to be extorted from them. And even if it is a mistake—as the recurrence of crises would demonstrate—to suppose that we can, in this way, overcome all obstacles standing in the way of progress, it is at least conceivable that the non-economic factors of progress, such as technical and commercial knowledge, are thereby benefited in a way we should be reluctant to forgo.

If it were possible, as has been repeatedly asserted in recent English literature,114 to keep the total amount of bank deposits entirely stable, that would constitute the only means of getting rid of cyclical fluctuations. This seems to us purely utopian. It would necessitate the complete abolition of all bank money—i.e., notes and checks—and the reduction of the banks to the role of brokers, trading in savings. But even if we assume the fundamental possibility of this state of things, it remains very questionable whether many would wish to put it into effect if they were clear about its consequences. The stability of the economic system would be obtained at the price of curbing economic progress. The rate of interest would be constantly above the level maintained under the existing system (for, generally speaking, even in times of depression some extension of credit takes place).115 The utilization of new inventions and the “realization of new combinations” would be made more difficult, and thus there would disappear a psychological incentive toward progress, whose importance cannot be judged on purely economic grounds. It is no exaggeration to say that not only would it be impossible to put such a scheme into practice in the present state of economic enlightenment of the public, but even its theoretical justification would be doubtful.

As regards the practical bearing of our analysis on the trade-cycle policy of the banks, all that can be deduced from it is that bankers will have to weigh carefully the relative advantages and disadvantages of granting credit on an increasing scale, and to take into account the demand, now fairly widespread, for the early application of a check to credit expansion. But the utmost that can be achieved on these lines is only a mitigation, never the abolition, of the trade cycle. Apart from this, the only way of minimizing damage is through a far-reaching adjustment of the economic system to the recognized existence of cyclical movements; and for this purpose the most important condition is an increased insight into the nature of the trade cycle and a knowledge of its actual phase at any particular moment.116