Prosperity and Depression

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§ 1.    THE EXPLANATION OF THE BUSINESS CYCLE

Before we begin the exposition of the various theories of the business cycle, some remarks may be advisable on the general logical nature of any explanation of the cycle, and on the mutual relation between various possible explanations (theories). The implications of these observations will be fully realised only in the light of subsequent pages where these formal principles are, so to speak, put to work. Nevertheless, it seems useful to touch upon these things at the beginning in order to avoid misunderstandings. The study of the various theories will be more fruitful if the following general remarks are kept in mind.

Plurality of causes.

Such a complex phenomenon as the business cycle, which embraces almost all parts of the economic system, does not easily lend itself to explanation by any one factor. Even if we assume from the beginning that the same explanation of the business cycle holds good in the highly industrialised countries of Western Europe and America as well as in industrially less developed countries such as New Zealand or Roumania, and in the twentieth century as well as at the beginning of the nineteenth—neither of which assumptions is by any means self-evident—it is not easy to speak of the cause of the business cycle. Few writers have ventured to proclaim just one single factor as the cause of the business cycle or of depression in particular. In fact, explanations which run in terms of one single cause have been more and more discredited and should be regarded with suspicion. The majority of modern writers on the subject are careful to point out that a whole set of factors, and perhaps not always the same combination of factors, contribute towards producing an alternation of prosperity and depression. Frequently, the difference between various theorists is rather a difference in the emphasis laid upon the different factors than a difference in the enumeration of contributing causes and conditions.

Even those writers whose theory centres round one single factor which they make responsible for the business cycle—e.g., crop variations, or inventions, or the acceleration of derived demand, or changes in demand, or waves of optimism and pessimism—are forced to admit that what they call the cause of the business cycle can produce its effect only in a certain economic institutional environment. They assume, explicitly or implicitly, a certain structure of the exchange economy, a certain rigidity of wages and contracts, a certain behaviour of investors, the presence or absence of a certain amount of knowledge and foresight amongst entrepreneurs, a certain monetary organisation, etc. The business cycle might well not appear (a) if those “active” forces (crop changes, inventions, changes in demand, etc.) were absent, or (b) if one or several of the significant features in the economic institutional framework were changed; if, for example, wages and contracts were perfectly plastic, if entrepreneurs behaved in a different way, if they possessed perfect foresight or if the monetary organisation were different and monetary authorities took steps to prevent repercussions: in a word, if they were to behave differently from what they actually do.

It might therefore just as well be maintained that the rigidity of our economic system, or its financial or monetary organisation, or particular features of the latter, are the causes of the cycle as that inventions or crop changes or changes in demand arc responsible.

Theories differ mainly as to emphasis.

Normally, a complex phenomenon such as the business cycle is caused and conditioned by a large number of factors and circumstances. Even if the same theory holds good for all cycles, there is still room for a multitude of “different” explanations which need not all be logically exclusive and contradictory. Each of them stresses one or other of the relevant factors and conditions and calls it the “dominant” or “causally relevant” one. The other factors are neglected, or it is assumed that they do not change or cannot be changed, or that it is for some reason not desirable to change or eliminate them (e.g., inventions) or that their changes cannot be further explained (at least not by the economist) and that they must therefore be taken for granted. In particular, monetary and non-monetary explanations of the business cycle seem to be frequently reconcilable. The non-monetary theorist (who stresses, e.g., the impact of inventions, or changes in demand with intensified changes in derived demand) often tacitly assumes—or ought logically to assume—the willingness and ability of the banking system to expand credit on existing terms, whereas the monetary theorist takes such disturbing events as inventions or changes in demand for granted and blames the monetary authorities for not adjusting the terms of credit.

Classification of causal factors.

These considerations suggest that it is useful to distinguish certain types of causal factors. One may draw a distinction, for instance, between active and passive factors or, in other words, between causes and conditions or between conditions per quam and conditions sine qua non. Inventions, crop changes, changes in demand are active factors, while institutional circumstances such as are mentioned above should be classified as passive conditions. Sometimes this distinction may be useful; but frequently it is difficult or impossible to draw a sharp line between the two types of factors. How is it possible to decide whether any given action on the part of the banks, such as lowering the discount rate when reserves are running high or failure to raise the rate when the demand for credit rises (i.e., when the “natural rate” has risen), is an “active” or a “passive” factor? This is obviously a terminological question and it is fruitless to press for an answer in every single case.

The real distinction—in some cases—is between controllable and uncontrollable factors.1 The weather, e.g., is uncontrollable, while institutional factors are at least in theory controllable. Among factors, furthermore, which can in principle be controlled, there are those which one does not find it desirable, for one reason or another, to control or to eliminate altogether—e.g., inventions, or the liberty of the recipient of income to spend his income or to save it, or to exercise freedom of choice in regard to his consumption or occupation. Needless to say, opinion as to what it is possible and desirable to control or influence varies from time to time and from person to person.

A more usual if less pragmatic classification is that of causes which originate within and causes which originate outside the economic system. Wars, inventions, crop changes (so far as they depend on the weather and are not economic adjustments to changes in demand, prices or cost), spontaneous changes in demand (so far as they are due to changes in taste and are not simply a reaction to changed supply conditions) are examples of outside causes. Changes in production due to changed demand conditions, price changes due to rise in cost, intensified demand for producers’ goods due to changes in demand for consumers’ goods are examples of economic causes. But what is to be called an economic and what a non-economic factor or circumstance is frequently rather a matter of convention than of argument.

Exogenous and endogenous theories.

Closely connected with the distinction between economic and non-economic factors and causes is the distinction between “exogenous” and “endogenous” theories of the business cycle. Exogenous theories are those which assume external disturbances—e.g., crop changes or inventions—in order to explain the business cycle. Endogenous theories rely exclusively on movements which can be explained economically. This distinction, too, is not always definite. Is the monetary theory, which explains the business cycle in the light of certain actions or a certain policy on the part of the banking authorities, to be regarded as exogenous or endogenous? If the banks lower the rate of interest, thereby inducing a credit inflation, their action will presumably be regarded as an exogenous factor: but suppose they do not raise the rate sufficiently in face of a rising demand for credit (due, e.g., to inventions) with the same result in the shape of a credit inflation—is that the operation of an exogenous factor?

It has been attempted to give more precision to the distinction between exogenous and endogenous theories by saying that the former assume movements in the data, while the latter suppose the data to remain constant.2 This distinction is precise enough once the general theoretical system on which a writer builds his theory of the business cycle has been determined and accepted; but it is not possible to lay down beforehand once and for all what phenomena are to be regarded as accepted data and what are magnitudes to be explained and determined in the light of those data. What the theory of yesterday accepted as data, we try to explain to-day; and the independent variables (data) on which we build to-day may become dependent variables to-morrow. All attempts to make a definite distinction between data and results lead back to the earlier conception which regards forces or movements of a “non-economic” nature or “external” to the economic system as the “data” of economic theory. But this distinction between “economic” and “non-economic” phenomena is a purely conventional one. There is no reason why forces or movements not to be classified as economic should not become “dependent” or “explained” variables of a general—as distinct from an economic—theory.

With very few exceptions, all serious explanations are neither purely exogenous nor purely endogenous. In almost all theories, both the “originating factors” and the “responses of the business system” (to use the expression of J. M. CLARK3) play a rôle. On the one hand, a purely exogenous theory is impossible. Even if one assumes a weather cycle, the peculiar response of the business system, which converts harvest variations into a general alternation of prosperity and depression, has still to be explained. On the other hand, a purely endogenous theory is hardly satisfactory. It is not likely that, without outside shocks, a cyclical movement would go on for ever: and, even if it did go on, its course would certainly be profoundly influenced by outside shocks—that is, by changes in the data (however these may be defined and delimited by economically explained variables).

The interaction of exogenous and endogenous forces is intricate, and the logical possibilities of their mutual impacts are numerous. We shall not, however, discuss these problems in the abstract here at the beginning. They will find their solution as we proceed in our theoretical enquiry, especially in Part II of the present report.

Inherent instability in the economic system.

One methodological rule of thumb may be suggested at this point, however, although it will find its full justification only later. For various reasons, it seems desirable, in the explanation of the business cycle, to attach as little importance as possible to the influence of external disturbances. In the first place, large swings in the direction of prosperity and depression as we find them in real life are difficult to explain solely by exogenous forces; and this difficulty becomes an impossibility when the alleged “disturbances” do not themselves show a wavelike movement. Even if a periodic character is assumed (e.g., in the case of crops or inventions), the hypothesis is full of difficulty. The responses of the business system seem prima facie more important in shaping the business cycle than external shocks. Secondly, historical experience seems to demonstrate that the cyclical movement has a strong tendency to persist, even where there are no outstanding extraneous influences at work which can plausibly be held responsible.4 This suggests that there is an inherent instability in our economic system, a tendency to move in one direction or the other. If it is possible (as we believe) to demonstrate that such a tendency exists and to indicate the conditions under which it works, it will be comparatively easy to fit all kinds of external perturbations, including all State interventions, into the scheme. Exogenous forces will then figure as the originators or disturbers of endogenous processes, with power to accelerate, retard, interrupt or reverse the endogenous movement of the economic system.5

Mechanical analog.

A frequently used analogy may be adduced, not to prove anything, but to make the meaning of what has been said clearer. We can compare the economic system with a pendulum or with a rocking-chair. A rocking-chair may be made to perform fairly regular swings by quite irregular impulses (shocks) from the outside. (Besides it may conceivably have a mechanism installed which makes it swing without outside forces operating on it.) In the explanation of the movement of the chair we must now distinguish two factors: the structure of the chair and the impulses from the outside—endogenous and exogenous factors. The structure of the chair is responsible for the fact that irregular shocks are transformed into fairly regular swings. An ordinary chair would ordinarily respond quite differently, although some particular kinds of impulses are thinkable (regular pushes and pulls) which would make it move in regular swings.

Naturally, the structure of the rocking-chair—and hence the nature of the swings produced by external shocks—may be very different in detail. The system might be so constructed that incessant regular swings are produced if, after having been pushed, the system is left to itself. Or else the swings may gradually disappear—that would be the case with an ordinary rocking-chair; we speak in that case of “damped oscillations” and may distinguish various degrees of dampening. The opposite may be true, the swings may become more and more violent; the fluctuations are then said to be “explosive” or “antidamped”, or the system is in an unstable equilibrium.

The methodological suggestion made above then comes to this. We tentatively assume that, for the explanation of the fairly regular swings of the economic system (just as for those, of the rocking-chair), it is more important to study the peculiar structure of the system and hence its responses to outside shocks than to look for regularities in the occurrence of these shocks. This hypothesis is, of course, subject to subsequent confirmation or rejection.

If, therefore, in many of the following sections, not much is said about such external influences (and in particular about the various forms of intervention in the economic process by the State or other public bodies, which figure so prominently in the daily comments of economists, politicians and economic journals on contemporary events), this must not be taken to imply that, in our opinion, or in the opinion of the writers whose theories are reviewed, these factors do not influence the economic situation. Our object is in the first instance to isolate the responses of the economic system, in order to stage the scene and to describe the environment in which the external influences have play.

§ 2.    METHOD OF THE FOLLOWING ANALYSIS

Principles of selection.

The scope of the following analysis of theories has been defined in the Introduction (page I).6 The method followed in the exposition is thereby largely determined. No attempt has been made to present the various theories in chronological order or to picture the theoretical and sociological background of the various writers (except in so far as it may have been necessary in order to elucidate their doctrines). It has been preferred to present the theories in a systematic order, beginning (so far as possible) with the less complicated and proceeding thereafter to the more complicated. Frequently it happens that the latter cover all the factors on which the former lay stress, while drawing attention to others which the former have overlooked or treated as irrelevant or put aside by means of a convenient simplifying assumption (e.g., by a ceteris paribus clause).

It has been necessary to select certain authors or certain works as illustrative of the various lines of thought. Preference has been given, where there was no reason to the contrary, to the more recent and more accessible works. No attempt has been made to trace every thought or hypothesis back to its origin in the history of economic doctrines.

Naturally, the work of those writers who have themselves attempted a synthesis of theories—such as MITCHELL, PIGOU, ROBERTSON—had to be mentioned at several points in connection with the various lines of thought which they have incorporated in their systems. Mention is not made, however, at every point of all the writers who have made useful contributions to the problem in hand. The method followed has been dictated by the purpose of the present enquiry: it does not pretend to do justice to the originality and importance of different writers’ contributions. It is not intended to be an appraisal of the merits of various writers, but a review and analysis of explanatory hypotheses.

Heads of analysis.

The various theories under review have been examined, as far as possible, under the following heads:

General characteristics.

Explanation of the upswing (prosperity).

      „      „      „      upper turning-point (crisis).

      „      „      „      downswing (depression).

      „      „      „      lower turning-point (revival).

Reasons given for recurrence, periodicity, etc.

International complications.

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7 Cf. J. M. Clark, Strategic Factors in Business Cycles, New York, 1935. pages 4-5 and passim.

8 See especially Tinbergen: “Suggestions on Quantitative Business Cycle Theory” in Econometrica, Vol. Ill, No. 3, July 1935, page 241.

9 See his book: Strategic Factors in the Business Cycle, passim.

10 What is to be regarded as “outstanding” and “plausible” is, of course, a matter of dispute. As there is always something happening somewhere, it is always possible to find some external events which can be made the basis of a tentative explanation.

11 For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.

12 This special purpose explains the difference between the following exposition and the classification of theories and theorists given in such works as A. H. Hansen: Business Cycle Theories, Boston, 1927; W. M. Persons: “Theories of Business Fluctuations” (Quarterly Journal of Economics, Vol. 41, reprinted in Forecasting Business Cycles, New York, 1931); F. A. Hayek: Monetary Theory and the Trade Cycle, London, 1933; Macfie: Theories of the Trade Cycle, London, 1934.

• 1Cf. J. M. Clark, Strategic Factors in Business Cycles, New York, 1935. pages 4-5 and passim.
• 2See especially Tinbergen: “Suggestions on Quantitative Business Cycle Theory” in Econometrica, Vol. Ill, No. 3, July 1935, page 241.
• 3See his book: Strategic Factors in the Business Cycle, passim.
• 4What is to be regarded as “outstanding” and “plausible” is, of course, a matter of dispute. As there is always something happening somewhere, it is always possible to find some external events which can be made the basis of a tentative explanation.
• 5For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
• 6This special purpose explains the difference between the following exposition and the classification of theories and theorists given in such works as A. H. Hansen: Business Cycle Theories, Boston, 1927; W. M. Persons: “Theories of Business Fluctuations” (Quarterly Journal of Economics, Vol. 41, reprinted in Forecasting Business Cycles, New York, 1931); F. A. Hayek: Monetary Theory and the Trade Cycle, London, 1933; Macfie: Theories of the Trade Cycle, London, 1934.
• 7The real distinction—in some cases—is between controllable and uncontrollable factors. The weather, e.g., is uncontrollable, while institutional factors are at least in theory controllable. Among factors, furthermore, which can in principle be controlled, there are those which one does not find it desirable, for one reason or another, to control or to eliminate altogether—e.g., inventions, or the liberty of the recipient of income to spend his income or to save it, or to exercise freedom of choice in regard to his consumption or occupation. Needless to say, opinion as to what it is possible and desirable to control or influence varies from time to time and from person to person.
• 8It has been attempted to give more precision to the distinction between exogenous and endogenous theories by saying that the former assume movements in the data, while the latter suppose the data to remain constant. This distinction is precise enough once the general theoretical system on which a writer builds his theory of the business cycle has been determined and accepted; but it is not possible to lay down beforehand once and for all what phenomena are to be regarded as accepted data and what are magnitudes to be explained and determined in the light of those data. What the theory of yesterday accepted as data, we try to explain to-day; and the independent variables (data) on which we build to-day may become dependent variables to-morrow. All attempts to make a definite distinction between data and results lead back to the earlier conception which regards forces or movements of a “non-economic” nature or “external” to the economic system as the “data” of economic theory. But this distinction between “economic” and “non-economic” phenomena is a purely conventional one. There is no reason why forces or movements not to be classified as economic should not become “dependent” or “explained” variables of a general—as distinct from an economic—theory.
• 9With very few exceptions, all serious explanations are neither purely exogenous nor purely endogenous. In almost all theories, both the “originating factors” and the “responses of the business system” (to use the expression of J. M. CLARK) play a rôle. On the one hand, a purely exogenous theory is impossible. Even if one assumes a weather cycle, the peculiar response of the business system, which converts harvest variations into a general alternation of prosperity and depression, has still to be explained. On the other hand, a purely endogenous theory is hardly satisfactory. It is not likely that, without outside shocks, a cyclical movement would go on for ever: and, even if it did go on, its course would certainly be profoundly influenced by outside shocks—that is, by changes in the data (however these may be defined and delimited by economically explained variables).
• 10One methodological rule of thumb may be suggested at this point, however, although it will find its full justification only later. For various reasons, it seems desirable, in the explanation of the business cycle, to attach as little importance as possible to the influence of external disturbances. In the first place, large swings in the direction of prosperity and depression as we find them in real life are difficult to explain solely by exogenous forces; and this difficulty becomes an impossibility when the alleged “disturbances” do not themselves show a wavelike movement. Even if a periodic character is assumed (e.g., in the case of crops or inventions), the hypothesis is full of difficulty. The responses of the business system seem prima facie more important in shaping the business cycle than external shocks. Secondly, historical experience seems to demonstrate that the cyclical movement has a strong tendency to persist, even where there are no outstanding extraneous influences at work which can plausibly be held responsible. This suggests that there is an inherent instability in our economic system, a tendency to move in one direction or the other. If it is possible (as we believe) to demonstrate that such a tendency exists and to indicate the conditions under which it works, it will be comparatively easy to fit all kinds of external perturbations, including all State interventions, into the scheme. Exogenous forces will then figure as the originators or disturbers of endogenous processes, with power to accelerate, retard, interrupt or reverse the endogenous movement of the economic system.
• 11One methodological rule of thumb may be suggested at this point, however, although it will find its full justification only later. For various reasons, it seems desirable, in the explanation of the business cycle, to attach as little importance as possible to the influence of external disturbances. In the first place, large swings in the direction of prosperity and depression as we find them in real life are difficult to explain solely by exogenous forces; and this difficulty becomes an impossibility when the alleged “disturbances” do not themselves show a wavelike movement. Even if a periodic character is assumed (e.g., in the case of crops or inventions), the hypothesis is full of difficulty. The responses of the business system seem prima facie more important in shaping the business cycle than external shocks. Secondly, historical experience seems to demonstrate that the cyclical movement has a strong tendency to persist, even where there are no outstanding extraneous influences at work which can plausibly be held responsible. This suggests that there is an inherent instability in our economic system, a tendency to move in one direction or the other. If it is possible (as we believe) to demonstrate that such a tendency exists and to indicate the conditions under which it works, it will be comparatively easy to fit all kinds of external perturbations, including all State interventions, into the scheme. Exogenous forces will then figure as the originators or disturbers of endogenous processes, with power to accelerate, retard, interrupt or reverse the endogenous movement of the economic system.
• 12The scope of the following analysis of theories has been defined in the Introduction (page I). The method followed in the exposition is thereby largely determined. No attempt has been made to present the various theories in chronological order or to picture the theoretical and sociological background of the various writers (except in so far as it may have been necessary in order to elucidate their doctrines). It has been preferred to present the theories in a systematic order, beginning (so far as possible) with the less complicated and proceeding thereafter to the more complicated. Frequently it happens that the latter cover all the factors on which the former lay stress, while drawing attention to others which the former have overlooked or treated as irrelevant or put aside by means of a convenient simplifying assumption (e.g., by a ceteris paribus clause).