Prosperity and Depression

CHAPTER 10 THE PROCESS OF EXPANSION AND CONTRACTION

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§ 1. INTRODUCTION

The problem stated.

In this chapter, the mechanism of the expansion and contraction processes will be analysed. We assume that the process of expansion (or contraction) has been started in one manner or another and we investigate what is meant by saying that the process is cumulative and self-reinforcing, and on what factors this cumulative quality depends. How such a process can be started, how in fact it is normally started, whether it can or cannot go on indefinitely, how it can be, and how it is in fact, interrupted, whether it is automatically brought to an end—all these questions will be taken up in extenso in the next chapter, although it will be impossible to avoid all reference to them in the present chapter, if only by way of implication or illustration.

On the whole, it may be said that the problems considered in this chapter are less controversial than those which form the subject of Chapter 11. If there is anything like common ground in modern business cycle theory, we are likely to find it here.

A. The Expansion Process

§ 2. GENERAL DESCRIPTION OF THE MECHANISM UNDER THE ASSUMPTION THAT THERE ARE UNEMPLOYED PRODUCTIVE RESOURCES

Elasticity of supply.

We begin our analysis of the process of expansion at its starting-point—viz., at the bottom of the depression. This means in effect that we start with a situation where there are unemployed productive resources. The analysis of an expansion which has started with, or has advanced to the attainment of, a state of full employment is more difficult:it will be attempted in § 3.1

If there is much unemployment, the supply of labour is completely or almost completely elastic in the upward direction—that is to say, an increasing demand can be satisfied at the same or only a slightly higher wage. The supply of other means of production is also elastic, since there are stocks of raw materials, under-employed capital equipment, etc. In such a situation, there are no technical reasons why production should not be increased at short notice all along the line in almost all stages and branches of industry.

Suppose, now, expansion has been started for any reason whatsoever—e.g., because new investment opportunities have been opened up and large sums are being invested over a considerable period of time at some point in the economic system (to build, say, a new railway line).

Reciprocal stimulation of investment and consumption.

Assume that the necessary sums are raised in such a way as to bring about an increase in the effective circulation of money. The funds for the investment are not withdrawn from other uses, but consist of money newly created by the banking system, or come out of hoards of unused purchasing power. The monetary details will be discussed in § 4. Here it is enough to assume that, in one way or another, the aggregate demand for goods in terms of money increases. Workers are hired; raw materials, semi-finished goods and implements, etc., are bought or ordered. Note that there is no sort of guarantee that all the money thus injected will remain in circulation. On the contrary, there will be numerous leakages (which need not be discussed here in detail)2 through which a smaller or larger proportion of the new purchasing power will be withdrawn from the active circulation and so sterilised. Assume, however, that a part of the new money goes on circulating—that is to say, is spent by the successive recipients. It is easy to see how it will stimulate other branches of industry and spread the expansion to all parts of the economic system.

The producers of materials and implements will increase their production.3 They may draw on idle funds at their disposal, or borrow from the banks, or float a new issue in the market, in order to hire workers and buy the material or equipment they need. The additional earnings of the workers will be at least in part spent immediately. The demand for consumers’ goods will go up and production of consumers’ goods will be stimulated. This reacts favourably on the higher stages of production. Idle monetary funds are set in motion; and the demand for all kinds of goods is further increased, which generates income. The process is likely to proceed slowly at the beginning and then to gather momentum. At first, it may easily be interrupted by adverse influences. Later on, when demand for many goods has grown for some time and the expansionary movement has spread to many parts of the system, the increase in the total demand for goods in terms of money per unit of time becomes greater. Adverse influences which tend to decrease the flow of money against goods will now only be able to decrease the rate of increase in the flow of money and to slow down the general expansion, whereas in the early stage of the upswing they would have nipped the expansion in the bud. This is what is meant by saying that “the process has gathered momentum”; it has become strong enough to overcome obstacles of lesser magnitude.

Rise in prices, costs and profits.

There are other factors which are likely to come into play after a while and to reinforce expansion. A sustained and rapid increase in output due to, or accompanied by, an increase in the flow of money will certainly lead to a rise in production costs and commodity prices at various points, even if the labour supply is, for the time being, perfectly elastic. (See Chapter 4, § 2, above for a detailed description.) Profits will also rise all along the line, owing to the fact that rigid overhead costs can be spread over a larger output and wages lag behind prices.

Investment in fixed capital stimulated.

A continued rise in demand, coupled with rising prices and profits, is bound to create in the business world a more optimistic outlook in general and in particular an expectation—no matter whether justified or not—of a further rise of prices. This will induce entrepreneurs to embark on more ambitious schemes of investment in fixed capital and either borrow more freely from the money or capital market or use idle funds at their disposal for the purpose. There will always be technological improvements waiting to be made, especially at the end of a depression during which investment has been at a standstill—improvements which necessitate the installation of additional machinery (fixed capital) and are profitable only at a certain ratio between price and cost. Given the profitability at the existing price-cost ratio, the investment will be undertaken only if the profitable price-cost ratio is expected to last long enough to permit the amortisation of the invested capital, and there are no other disturbing factors such as State interventions, revolutions, currency inflation, etc., to prevent the reaping of the expected profit. Naturally, the more durable the investment projected the more important the expectation factor.

Thus the expansion proceeds in a progressive and cumulative fashion. As it advances, restraining forces come more and more into play. These will be analysed in the section on the upper turning-point.

The above analysis of the expansion process can be put in more technical language. If we describe the initial expansion as being due to a divergence between the natural or equilibrium rate of interest, on the one hand, and the money or market rate of interest, on the other, the cumulative continuation of the expansion has to be ascribed to the fact that the price rise (and profit rise) induced by the initial divergence forces the equilibrium rate up, with the result that the gap between the two rates is widened—which in turn intensifies the rise in prices and profits, etc.

There are other terminological alternatives,4 and terminological as well as analytical niceties, which need not detain us here: the non-technical description of the expansion process as given above is for the time being clear and precise enough. We shall come back to the monetary details in § 4.

§ 3. THE MECHANISM OF EXPANSION UNDER THE ASSUMPTION OF FULL OR ALMOST FULL EMPLOYMENT

Can full employment be attained?

In what sense can the expansion continue beyond the point of full employment? How can it start from a situation of full employment of all factors of production? These questions are not intended to suggest that the upswing is always, or generally, carried to the point of full employment. On the contrary, it will be shown that the economic system becomes increasingly vulnerable when it approaches full employment, and that there is a consequent possibility that the full employment level will not be fully attained or, if attained, will not long persist. But for completeness’ sake the question must be considered.

Obviously, after full employment has been reached, output can no longer expand at the same pace as before, since there are no idle factors which can be drawn into employment. But it can still expand in so far as improved methods of production are introduced, the working population grows, and additions are made to the capital stock.

Monetary expansion can of course go on, just as before; but the consequences will not be the same.

From rise in output to rise in prices.

As more and more unemployed factors of production are drawn into employment, the supply of factors of production and of goods in general becomes more and more inelastic, and a constant expansion in terms of money will lead to a smaller and smaller increase in output and to a larger and larger rise in factor and commodity prices. In other words, at the beginning of the expansion, a large part of the increase in monetary circulation will have been absorbed by a rise in the output and turnover of goods, and a smaller part by increasing prices. When full employment is being gradually approached, this necessarily changes.

So long as the supply of factors of production is plentiful and elastic, output can be increased all along the line at the same time. For reasons which will be discussed in § 5, the output of producers’ goods and durable goods rises much faster than the output of consumers’ goods. When one category of factors after the other is becoming scarce—the transition to full employment is of course gradual and not sudden—it becomes more and more difficult to expand at various points at the same time. If one industry increases its demand for means of production and succeeds in attracting labourers by offering higher wages, it lures them away from other industries. The same holds true of raw materials and semi-finished products. The expansion of the industry is possible only at the expense of a contraction somewhere else.

If the monetary expansion through the creation of new money by the banks for productive purposes goes on, there will be a tendency for producers’ goods industries to expand at the expense of consumers’ goods industries, the former drawing away factors of production from the latter. We shall see that this process is not very likely to continue for long—if it has a chance to start at all ! But for some time it may continue; and thus the expansion may go beyond, or start from, the level of full employment.

Having sketched the process of expansion in general, we may go on to consider various points in detail. This will be done in §§ 4-6.

§ 4. THE MONETARY ANALYSIS OF THE PROCESS OF EXPANSION

Importance of total demand.

An expansion of the monetary circulation, in the sense that the money value of the volume of production and total demand for goods in terms of money per unit of time increases, is (as we have seen) a regular feature and, we may add, an indispensable condition for a rapid expansion of production after a slump. If the monetary circulation could not somehow be expanded, prices of goods and productive services, especially money wages, would have to fall pari passu with the rise of employment and production. We need not pause to explain why in that case re-employment and recovery would come very slowly, if they came at all. Certainly such a fall in prices is the contrary to what actually happens during a recovery after a slump.

The market for investible funds.

We have seen (Chapters 2 and 3 above) that the expansion may be described in technical language as being due to a discrepancy between the money or market rate of interest, on the one hand, and the natural or equilibrium rate of interest, on the other. If the former is below the latter, a cumulative process of expansion (a “Wicksellian process” as it is called) sets in. Since it is difficult to define the natural or equilibrium rate,5 it seems advisable to adopt a slightly different approach to the problem, more in accordance with the modern method of marginal analysis.

We may conceive a market for investible funds which is divided into a demand side and a supply side. This is not quite the same thing as those sections of the demand and supply which actually appear in the market for loans or credit, because abstraction is made of the contractual element in the debtor-creditor relationship. Entrepreneurs or corporations, for example, who invest their own money appear both on the demand and on the supply side of the market: they advance investible funds to themselves.6

Investible funds are supplied, and demanded, at a price which we shall call the interest rate. For the moment, we may ignore differences in the type and quality of investible funds, and speak as if there was only one, instead of a whole range, of interest rates. We may suppose both the supply and the demand for investible funds to be expressed in the form of curves or schedules in the familiar Marshallian manner. Along the horizontal axis of a system of rectangular co-ordinates we measure amounts of investible funds, and along the vertical axis the price of investible funds—i.e., the rate of interest. For each amount we suppose the demand price—that is, the rate of interest at which this amount would be taken up by entrepreneurs for investment purposes—to be determined. If we join these points together, we get the demand curve for investible funds. We shall have occasion to make various hypotheses about the elasticity of this curve. In general, we may assume that it slopes downward from the left to the right, to represent the fact that at lower interest rates larger quantities are demanded and invested for productive purposes. Similarly, for each amount the supply price is determined; and by joining these points together the supply curve of investible funds is obtained. It may be horizontal for a certain range—in which case the supply is said to be perfectly elastic over that range; that is frequently Mr. KEYNES’ assumption. It may be vertical—in which case the supply is said to be perfectly inelastic. We may assume that, generally, it slopes upward from the left to the right—that is to say, that investors exact higher rates of interest when they are called upon to provide larger amounts of investible funds.

It should be remembered that a system of these curves refers always to a point of time or a short period of time. We shall soon have to speak of shifts of these curves in time—that is, between successive points or short periods of time.

Let us now enquire about the factors which determine the shape of these curves.

The demand curve for investible funds.

The demand curve for investible funds bears a close relationship to the curve of the marginal profit rate. By profit rate we understand the rate of profit in terms of money which an entrepreneur expects to derive from a concrete piece of investment. We may conceive the various investment opportunities existing at a given moment of time as being arranged in order of decreasing profitability, and construct a schedule or curve sloping down from left to right. If, now, we suppose that all the risks of investment are borne by the suppliers of investible funds—and it is convenient to allocate all risks to one or the other side of the market—this schedule is identical with the demand schedule for investible funds and the lowest or marginal profit rate for a given amount of investment is identical with the demand-interest rate for that amount of investible funds.7

The reader will have noticed that this description of the capital market is substantially the same as Professor OHLIN’S and Professor ROBERTSON’S market for credit or loans which was discussed in Chapter 8, § 2, above (pages 177 et seq.). The only difference between Professor OHLIN’S scheme (as represented by the graph on page 185) and ours is that we choose to take on the demand side only demand for purposes of real investment. Demand for credit (loans) for other purposes—e.g., for the purpose of strengthening cash resources (for hoarding purposes)—we prefer to deduct from the supply curve instead of adding it to the demand curve.8 But the reader can easily make the slight adjustment, if he prefers Professor OHLIN’S scheme.

It may furthermore be observed that we need not exclude short time-lags between the floating of a loan in the market for investible funds and the actual expenditure for the purchase of material, equipment, labour, etc., of the money raised.9

“Net” investment and “gross” investment.

There is another point to be cleared up. Do we count as investment only “net” (or “new”) investment or “total” (or “gross”) investment? The difference between the two is reinvestment or replacement requirement. Gross investment = net investment + reinvestment. Gross investment is roughly the same as production of producers’ goods, the only difference being production of consumers’ goods which are not consumed, but stored up in the shape of stocks, or of durable consumers’ goods (motor-cars, houses): but the latter are better regarded as producers’ goods producing consumable services. If we define investment as net investment, we must consider the possibility of its becoming negative (although this contingency will not arise so long as we deal with the expansion process). If, namely, gross investment does not cover replacement requirements, the difference between the two is negative investment: disinvestment, capital consumption. Since we are concerned with what actually happens in the market and “negative demand” for investible funds is a difficult concept, we had better refrain at this point from using the concept “negative investment”.

Hence, in some contexts, we may elect to interpret investment as gross investment.10 There are other reasons which would justify this decision. First, the definition of the concept “net investment” presents great difficulties, because it implies definition of what is meant by “keeping the capital stock intact”.11 Secondly, since we assume that people act rationally, it should really make no difference whether a certain sum which is spent by an entrepreneur for productive purposes represents new investment or reinvestment. In the latter case, too, the prospective yield of this investment should be compared with what can be obtained from the same sum if lent out in the market for investible funds or if kept in liquid form (hoarded).12

In thus defining investment on the demand side as including reinvestment, we must be careful to apply a correspondingly broad definition on the supply side, to the discussion of which we now turn.

Supply of investible funds.

The supply of investible funds may be said to flow from three sources—from amortisation quotas, from new savings and from “inflation” in the broad sense (including, not only newly printed notes and newly created bank money, but also withdrawals from existing hoards of money). The first two items, which we may lump together as “gross saving”, leave the total demand for goods (MV) constant. Inflation implies an increase in total demand for goods, a rise in M and/or in V.

This statement requires elucidation in various respects.13 First, a word of justification must be said about the inclusion of amortisation quotas. This corresponds to the inclusion of replacement under investment on the demand side. For the individual firm, the setting-aside of amortisation quotas out of total receipts and their expenditure for replacement of outworn equipment do not always coincide in time. Amortisation will usually—though not necessarily—be a continuous process, whereas the replacement of durable means of production is usually discontinuous. For the economy as a whole, both processes are more continuous and run parallel. During any period of time, a number of firms use their amortisation quotas to accumulate balances or to repay loans, thus adding to the supply of investible funds in the market, while others draw on their balances or borrow from the market in order to replace their equipment. The reason why it seems advisable to include replacement on the demand side and amortisation quotas on the supply side has been given above. Since, however, during the process of expansion with which we are now concerned net additions to the capital stock are supposed to be made (whatever the exact definition of this magnitude may be), we may deduct amortisation from the one side and replacement from the other without running the risk of obtaining a negative figure for investment and consequently for demand for investible funds. Therefore, so long as we are dealing with the expansion, investment may be interpreted as net investment.14 If we adopt this procedure in order to simplify the further discussion, we have to distinguish only two sources of supply—viz., saving and inflation.

Savings and inflation.

The statement that the supply of investible funds which would be forthcoming at a given point of time or during a short period of time at various hypothetical rates of interest may be made up partly by current saving and partly by inflation implies that actual investment need not be equal to saving. During an expansion process, the volume of investment is normally larger than the volume of savings, the excess being financed by inflation. In other words, demand for investible funds is so large that it cannot be satisfied by current saving, so that inflationary sources of supply are tapped.

As we have seen in Chapter 8, § 2, this convenient language, which has been used by many writers, has given rise to intricate terminological difficulties. We need not again go over the controversies discussed there. Suffice it to say that the definition of saving to be given presently is identical with that of Professor ROBERTSON.15 The reader who has read Chapter 8 will have no difficulties in translating, if he so desires, what will be said in the following pages into other terminologies—e.g., the Keynesian, which avoids speaking of differences between saving and investment.

Supply of saving.

By saving we understand—as everybody does—income minus expenditure for consumption. But it is necessary to introduce the time factor. We must distinguish between currently earned income, which Is simply the money value of the net output of the economic community, and income currently available for consumption. This distinction rests upon the fact that, in the real world, income earned is distributed, not continuously, but periodically. Wages are paid weekly, salaries monthly, dividends quarterly, half-yearly or yearly: rents are paid at similar intervals; while farmers’ incomes also come in to a considerable extent annually. There are, of course, exceptions to this rule, particularly in small-scale trade and handicraft where entrepreneurial withdrawals may take place practically continuously; but the exceptions are of so little practical significance that they may be neglected in consideration of the immense analytical advantage of such a simplification.

The fact that incomes are earned continuously, expended continuously, and distributed periodically has the consequence of creating a time-lag between the moment when a given sum is earned and the moment when it becomes available for expenditure on consumption. On the average, wages are available for expenditure half a week after the moment of earning, salaries half a month later, dividends (assuming six-monthly payments) a few weeks to almost a year later, and so on. Of all the income earned at a given moment, part will become available for expenditure almost immediately, and other parts at various intervals up to (say) a year.

This distinction between earned income and available income is of considerable importance in the description of the process of change in investment and in total demand, through time.

Supply from inflationary sources.

If in any short period chosen as a unit of time the income currently earned (that is, the sum of consumption expenditure and investment) exceeds the income available for expenditure, the excess must be financed out of inflationary sources. That is to say, the hoards of individuals and the reserve proportions of banks must—in the absence of State inflation—be diminished in comparison with the previous period.

Thus the money invested to-day is financed partly by savings out of income earned yesterday and becoming available to-day, and partly by inflation. But all that is invested to-day, inclusive of the part financed by inflation, becomes to-day’s earned income16 and to-morrow’s available income. If, then, a part of the latter is saved to-morrow, it constitutes again current saving, although it is historically of inflationary origin. (The influence which changes in the rate of saving are likely to have on the development of the expansion process will be discussed below in § 6.)

Having discussed savings and inflation as two separate sources of the supply of investible funds and the implied inequality of saving and investment, we have now a few observations to make in regard to the shape of the supply curve at a given point or during a short period of time.

The shape of the supply curve.

We shall have to make further assumptions as follows. The supply of investible funds is sometimes very elastic, so that a higher demand can be satisfied at slightly higher interest rates. At other times it is inelastic, so that a rise in demand is calculated to lead tp a rise in interest rates rather than to evoke a greater supply. Any hypothesis of this sort about the behaviour of supply as a whole must be supported by an analysis of the behaviour of the constituent parts of the total supply.

Let us first take that part which is furnished by saving from current income. It is very probable that, ceteris paribus, the amount of saving becoming available for investment does not react strongly to changes in the interest rate. If there is a reaction at all, its direction is not clear. When the rate of interest rises, people may just as well save more and spend less on consumption or save less and spend more of their income.

On the other hand, the elasticity of saving in respect to magnitudes and factors other than the rate of interest is probably great. It is, e.g., generally assumed that the rate of saving rises with rising income. It is not unlikely that it varies, not only with the level of income, but also with the rate of change of income. There are yet other factors which make it probable that the rate of saving exhibits a systematic movement during the course of the cycle. We shall come back to this point later.17 Here, where we are concerned with the shape of the supply curve at a given point or during a short period of time, we may in all probability regard the supply of savings as a constant magnitude, insensitive to changes in the interest rate. In technical parlance, the supply of saving is, at least in the short run, inelastic in respect to changes in the interest rate. Hence the asserted elasticity in the total supply must depend on the elasticity of that part of the total which is furnished by “inflation”.

We shall have to discuss the factors which determine the degree of elasticity of supply of investible funds from inflationary sources at various points in our analysis. Here a few introductory remarks will suffice. There are various inflationary sources of supply—the central bank, the commercial banks and, last but not least, liquid reserves of purchasing power (hoards) in the hands of business firms and individuals.

The concept of elasticity of supply from the first two sources does not present analytical difficulties, and we know approximately what the factors are on which it depends, how far the banks are willing at any given moment to vary the supply of investible funds in the face of variations in demand and in the rate of interest which they can obtain.

In the case of the third source—hoards of firms and individuals—the situation is more involved. All the considerations which have been put forward in recent times under the head of “liquidity preferences”, “liquidity motives” and “propensity to hoard or dishoard” and the like are relevant here. In a general way, we may assume that, ceteris paribus, the higher the rate of interest the greater the temptation to dishoard—that is, the larger the supply of investible funds coming on the market from this source.

Movements along, and movements of, the curves.

The clause ceteris paribus calls to mind the limitations of our elasticity concept. If we say that the supply has a certain elasticity, this refers to a point or short period of time. But what we want is an analysis in time; we have to compare what happens in successive periods of time. This we can accomplish with our apparatus of demand and supply curves by introducing movements of these curves in time. We substitute, so to say, a ciné-camera for a simple snapshot camera: that is, we take pictures of our demand and supply schedule at successive points of time and watch the movements of the curves. This will become clearer when we proceed to put our simple analytical instrument to work. It is hoped that it will enable us to describe more precisely and simply the processes and relationships which have been analysed in the literature in terms of differences between the money or market rate of interest on the one hand and the natural or equilibrium rate on the other. It is hoped, furthermore, that it will be possible with the help of our method to clear up a number of difficulties and paradoxes which have not been adequately explained so far.

Subdivisions of the capital market.

It should, however, be kept in mind that there are other difficulties which are not removed by our treatment of the matter. We speak of the rate of interest for investible funds, whereas there are in reality a multitude of rates with complicated inter-relations—short-term and long-term rates with intermediate rates and a great variety of gradation according to the standing of the borrower, the nature of his business, the possibilities of furnishing security, the risk involved, etc. The assumption of a homogeneous capital market is a drastic simplification. For the time being, we try to overcome this difficulty by interpreting the market rate of which we speak as somehow a properly weighted average or composite of the existing rates. If we say the rate has risen or fallen, we mean the complex of the rates which we find in the market.18

Let us now put our apparatus to work and try to analyse the monetary side of the expansion process which was indicated in outline in §§ 2 and 3.

Cumulative expansion process.

It has been assumed that, in one way or another, the expansion has been started. The various initiating forces or “starters” will be discussed in detail in the section on the revival. Here we assume by way of illustration that new investment opportunities have appeared and that a certain number of people are prepared accordingly to borrow new money, or to utilise their own reserves hitherto lying idle, on a larger scale. This can be expressed by saying that the demand curve for money has shifted to the right to such a degree that more than the current flow of savings is taken up and inflationary sources are being tapped. The total demand for goods in terms of money increases, and the cumulative continuation of the process may be described, in terms of our analytical scheme, by the statement that this increase of the demand for goods causes the demand curve for investible funds to shift further to the right. If the flow of current savings does not suddenly rise to an extent sufficient to satisfy the growing demand—which would seem very unlikely—and if the supply of investible funds from inflationary sources is not inelastic, the result will be a further inflow of new money, which in turn will tend to force the demand curve further to the right, and so on.

Repercussions m supply of funds.

The force of the expansion is usually further intensified by a change on the supply side which is, in itself, a consequence of the expansion. The supply is likely to become more plentiful—that is to say, the supply curve is likely to shift to the right—because of a tendency to dishoard on the part of the public and the banks. When production increases and prices rise, not only the entrepreneurs—i.e., the borrowers—but also the lenders, banks and investing public are likely to take a more optimistic view. During the contraction, a series of bankruptcies and failures will have made them more and more reluctant to lend. Now, with the progress of expansion, many bad debtors unexpectedly begin to pay interest on their debts or even to repay them. Frozen credits begin to thaw, and fear of compulsory conversions and currency instability recedes. All this tends to make lenders willing to lend at lower interest rates funds which they had kept in cash or other liquid forms.

Time sequence.

It is impossible to generalise as to the time sequence of these various changes. The change on the supply side may precede the revival in demand and, once the process has started, one factor tends to stimulate the others. If, with a rising demand, people are induced to disgorge the content of their hoards on the capital markets, it may very well happen that for a considerable time the rising demand for credit and rising prices and production go parallel with falling interest rates—a development which, superficially regarded, might seem to contradict all accepted principles of economic theory.19 The situation in the gold- and sterling-bloc countries in 1933 to 1936 seems to offer a good illustration. In the sterling bloc, continued recovery, rising transactions and demand have been coupled with comparatively low or even falling interest rates. In the gold countries, contraction and liquidation have been accompanied by comparatively high interest rates and a tight capital market.20

Volatility of demand for funds.

It is extremely important to realise from the beginning that both the demand curve and the supply curve for investible funds are subject to frequent and rapid shifts. They are influenced, not only by technological factors—e.g., by a new invention or the destruction of instruments by wear and tear or fire tending to move the demand curve to the right, which is tantamount (loosely speaking) to increasing the demand for funds—but also by “psychological” factors (optimism and pessimism), changes in demand for particular goods, etc. Much theorising in this field has been vitiated by the tacit assumption that the demand curve for funds is more or less fixed by technological circumstances (viz., the superior productivity of longer roundabout ways of production). If the demand curve is considered as relatively fixed, changes in the flow of investible funds must be explained by shifts in the supply (in the other terminology, by changes in the money rate of interest rather than the equilibrium rate). This assumption cannot be reconciled with the facts, and hence the conclusion is unavoidable that the demand for funds is highly variable and sensitive to all kinds of influence.

An important corollary of this proposition is that MV, the flow of money or total demand for goods in terms of money, is also highly changeable. Static economic theory for the most part assumes a constant MV. It is very important to recognise in principle that this need not be, and rarely is, the case. In the investigation of concrete cases such as the probable influence of some measure of economic policy (e.g., imposition of a tariff, devaluation of a currency, public works, etc.), or of spontaneous changes such as changes in the demand for particular commodities, many perplexing consequences which are quite inexplicable on a rigid static analysis, which assumes MV constant, can be cleared up by taking into consideration changes in MV produced or induced by the measure or event studied. We shall have many occasions to recognise the fruitfulness of this principle.21

Forms of monetary expansion.

An expansion in the monetary circulation, in the broad sense in which the term is here employed, may originate in different ways. It remains to investigate the ways in which it can, and the ways in which it will usually or normally, be brought about.22 As a first step, we may say that a change in the money stream may be due either to a change in M or in V, in the quantity of money outstanding or in its velocity of circulation. This does not, however, help very much, since neither M nor V is statistically ascertainable (except by way of complicated indirect estimates which are not very reliable). We shall do better to start with those magnitudes which are statistically measurable, viz.:

(a) Legal tender money, notes, coins;

(b) Bank deposits subject to cheque;

(c) Velocity of circulation of (b).

These three items constitute, of course, only a fraction of the total in which we are interested. We cannot readily measure the velocity of (a). Furthermore, credit instruments (bills) frequently function like money, and a number of transactions are settled by direct offsetting without the use of money. (It is immaterial whether one construes such cases as implying changes in the velocity of circulation of money proper or in the quantity of money. In any case—and this is the important thing—an increase or decrease in the total demand for goods in terms of money can be effected by such practices.)

§ 5. WHY DOES THE PRODUCTION OF PRODUCERS’ GOODS AND DURABLE GOODS RISE FASTER THAN THE PRODUCTION OF PERISHABLE CONSUMERS’ GOODS?

The essence of the “acceleration principle”.

Many writers have pointed out that, for technical reasons, changes in the demand for, and production of, finished goods give rise to much more violent changes in the demand for, and production of, producers’ goods. This is one of the most important applications of the so-called principle of the acceleration and magnification of derived demand which we have stated and discussed, with all necessary qualifications, in an earlier part of this study (see Part I, pages 85 et seq.). It remains to determine its place and function within the mechanism of expansion.

The essence of the acceleration principle can, as we have seen, be summed up in the statement that, to enable the output to be expanded, it may be necessary to make heavy immediate investments which will continue to bear fruit for some time into the future. The fact that capitalistic production utilises durable instruments means that services or goods of a given sort currently produced are in joint supply with services or goods of the same sort at various future dates. Thus, if demand is expected to rise over a certain future period, the supply will be provided In a lump at the beginning and (as it were) stored up in the shape of stocks and durable instruments.

Repercussions on demand for finished goods.

Since consumers’ demand can be profoundly affected by changes in capital construction, it is illegitimate to presuppose a cyclical fluctuation of consumers’ demand, and then to use the acceleration principle to explain the larger fluctuations in the production of capital goods.

The principle therefore—quite apart from the necessary qualifications previously discussed—must be given its proper place within the framework of a more elaborate theory of investment, in connection with which it expresses the one-way causal relationship from the demand for consumers’ goods to the production of producers’ goods. The volume of production of producers’ goods (which, in order to avoid double reckoning, should be measured as the sum of the value added to the product in successive stages) is equal to the sum of new investment and replacement or reinvestment. As has already been pointed out, it may be convenient to speak of “total” or “gross” investment in distinction to “new” or “net” investment (which may also be negative). Gross investment is then another way of saying production of producers’ goods plus changes in the stock of consumables.

As we have seen, it is very difficult to give an exact definition of new investment for the economy as a whole, since it involves defining what is meant by maintaining the capital stock of society intact. It is still more difficult to measure it statistically—that is, to distinguish during a given period between replacement of worn-out capital and additions to the capital stock. Fortunately we do not need for many purposes to make the distinction. It suffices to speak of production of producers’ goods. But, roughly speaking, the fact that production of producers’ goods fluctuates more violently than the production of consumers’ goods—which is taken as an index for consumption23—indicates that there is net investment during the upswing and a drastic reduction of net investment, or probably even net disinvestment, during the downswing of the cycle.

Rôle of expectations.

The acceleration principle deals with one of the factors which determine the volume of investment—namely, changes in demand for the finished product. Obviously, demand must not be defined in too narrow a fashion as actual demand. What matters is, strictly speaking, anticipated demand. The investor expects that demand for his product will be forthcoming. But actual demand is certainly one of the most powerful factors in shaping the expectations of business-men as to future demand. If actual demand rises, and if the new level has been sustained for some time, or if the rise has continued for a certain period of time, there is a good chance that a continuation of the higher level or a further rise will be anticipated. There is, however, no absolute certainty that this will in every case be so; many special reasons are conceivable which might prevent these optimistic expectations from being induced in the mind of the producers.24

Ratio of capital to labour.

Supposing, however, that a producer of a certain commodity has formed his conclusions as to the probable volume of the future demand and is resolved to act on his anticipation, and increase production accordingly, then the acceleration principle postulates a rigid relationship between the volume of production of the finished product per unit of time and the volume of investment. The relationship is determined by the durability of the equipment and machines which are required for the production of the commodity in question and by the importance of the machine services relative to other input items (working capital and labour) in the production process—which is as much as to say, roughly speaking, by the degree of mechanisation.

Here an important qualification is called for. This relationship is not rigid for various reasons. In the first place, surplus capacity may—and at the beginning of the expansion after a more or less severe depression usually does—exist. If there is unused or under-employed machinery or equipment, production can be increased by simply applying more labour and raw material to the existing equipment. The acceleration principle will then come into play only after production has been increased by so much that new machinery is thought to be desirable. But the point where it becomes desirable is not determined exactly by purely technological considerations. Usually the existing plant can be worked more or less intensively, although at rising cost. The decision to increase the plant is influenced—apart from the anticipations about future demand—by the rate of interest and certain other factors which will be discussed presently.

Importance of rate of interest.

Supposing, now, it has been decided in principle to extend the fixed equipment, it is then necessary to determine how it should be done. As a rule there is a choice between different methods of production. More or less durable equipment can be installed, the more durable varieties involving as a rule higher cost. In other words, methods of varying degrees of “round-aboutness”, involving investments of different magnitude, are usually available. The magnification of derived demand—that is, the increase in investment induced by a given increase in the demand for, and production of, a finished product—depends accordingly on the choice between these available methods, on the durability of the instruments (or, in other words, the “roundaboutness” of the process chosen). And this choice, in turn, depends: (a) on the rate of interest, that is the terms on which the necessary funds can be raised, (b) on the estimation of the risk25 involved and on the general outlook. The lower the rate of interest, the more durable the instrument, the longer the roundabout way of production, the heavier the investment and the larger the magnification of derived demand. Furthermore, in an atmosphere of optimism and confidence in an undisturbed development of economic life, people will be more inclined to undertake heavy investment by which they are committed for a long period than in a state of uncertainty and apprehension.

Contribution of the acceleration principle.

We are now in a position to formulate the contribution of the acceleration principle to the explanation of the mechanism of expansion, and especially of its cumulative nature. The technical fact that, in order to produce certain finished goods or services, one must construct durable instruments, because the finished goods cannot be produced otherwise or only at much higher cost or in inferior quality, operates as a powerful intensifier of the cumulative force of the expansion. If demand for such goods and services rises, investment becomes profitable. The profit rate rises or, to formulate it correctly in terms of our demand and supply schema, the demand curve for investible funds is pushed to the right. If the supply of funds is elastic, more money is drawn into circulation, with the result that demand for the finished product is further augmented and the expansion proceeds with accumulated force.

Application to durable consumers’ goods.

It should be noted that our argument applies also to durable consumers’ goods. In their case, the finished product consists of the services which flow from the durable goods. If the demand for apartments rises (or is expected to rise), the demand for investible funds for the purpose of constructing houses will rise. The construction of the houses is usually under-taken by entrepreneurs, not by the prospective dwellers. Thus an increase in the annual demand for apartments may give rise to investment many times the amount of the annual rent. The service is being provided, so to speak, en bloc for many years to come.

In the case of semi-durable consumers’ goods such as motor-cars, furniture, radio sets and the like, there is the institutional difference that these goods are usually bought by the consumer out of his own resources. But an installment selling scheme may enable consumers to extend their current purchases beyond their current income. Thus slight increases in current income may bring about a much larger increase in demand in general.

Inelastic supply.

We have here a factor which accelerates the expansion of the total demand for goods in terms of money, and (if supply is still elastic in all branches and stages of industry) of production and employment as well. The restraining forces which gradually make their appearance when full employment is being approached will be discussed in the section on the upper turning-point. It suffices here to point out that the acceleration principle cannot work unobstructed when supply becomes less elastic. Production cannot then be expanded all along the line. It remains true, however, that an increase in the demand for a commodity, the production of which necessitates the installation of durable instruments, may still, by increasing the price of these instruments, increase the amount of money required to purchase them. The physical quantity of investment may remain unchanged, but its money value increases, and the demand for funds rises likewise.26

Methods of financing.

The question now arises how the increased production of producers’ goods is financed. The workers who are engaged in producing these durable and non-durable means of production, and the owners of other factors of production which contribute thereto, must be paid. The answer has in fact already been given. The necessary funds come partly from inflationary sources, partly out of current savings.

We have seen that the cumulative nature of expansion hinges on the growth in the total monetary demand—i.e., on the increase in the flow of money. Therefore, the larger the proportion of new investment financed by way of inflation (newly created bank money or more intensive utilization of existing funds) in preference to voluntary saving, the more rapid the expansion—viz., the expansion primarily of the circulating medium and in addition (so long as the supply of factors of production of various kinds is elastic) of employment and production.27

But this raises the very important question of the rôle of saving in, and the influence of changes in the rate of saving on, the mechanism of expansion. This question, which has received much attention in the recent literature on the trade cycle, we must now discuss systematically.

§ 6.    SAVING AND THE EXPANSION PROCESS

Importance of savings.

Allusion has been made more than once in the course of the preceding argument to the actions of income-receivers with respect to spending and saving. On page 285, it was noted as an essential link in the expansion process that the increased earnings of the workers due to increased investment would in part be spent immediately. Later (page 296) saving was mentioned as one of the two sources of the supply of investible funds, the other being inflation in the wider sense of the term. It is therefore of importance to enquire, in the first place, what are the probable consequences on the expansion of a change in the proportion of income saved by the public as a whole and, secondly, what are the factors which, at the stage of the business cycle with which we are now concerned, determine whether the proportion saved will be great or small, whether it will rise or decline?

Income not at once disposable.

By the proportion of income saved is meant the average proportion of income not spent on consumers’ goods in the income period in which it becomes available. The distinction between the period in which income is earned and that in which it is available to be spent or saved must be kept in mind. Even if no saving whatever takes place, this does not mean that the incomes are spent as soon as they are earned. Allowance must be made for the fact previously mentioned that incomes are paid out periodically and spent in the course of the ensuing period. Thus, even apart from saving in the sense here employed, income earned at a given moment of time will be spent about a week later, if it takes the form of wages, a month later in the case of salaries, and a few weeks to a year later in the case of dividends.

Expansion with zero saving.

Suppose, now, that an impulse (“starter”) is given to the recovery by some act of credit-expansion on the part of the banks, or dishoarding on the part of individuals or the State, whereby goods and services are bought and additional money income created. How should we expect the expansion to proceed in the absence of saving? After a distributed time-lag, determined (as explained above) by habits of payment and expenditure, the entire additional income is spent on consumption goods.28 This increase in demand for consumption goods does not evoke an immediate and equivalent increase in their production. Time has to be given for the merchants to order new stocks and for the manufacturers to produce the goods. In the meantime, the merchants’ stocks are reduced and the extra money receipts are kept in easily available form. They may be added to the merchants’ bank balances, or used to repay a part of their debts to banks or to their own suppliers. It is here assumed that any effect this may have in increasing the supply of investment funds, and so affecting investment, is negligible. Ultimately, if we assume that merchants and manufacturers in the consumption-goods section of industry desire at least to maintain their stocks and working capital, the increased expenditure on consumption goods evokes an equivalent rise in income, which, after a further lapse of time, is again spent, and so on indefinitely. Thus, in the supposed circumstances of zero-saving, extra income, once created, will never disappear.

Income velocity of money.

While these time-lags between the earning and receiving of incomes, and again between the receiving and spending of them, are highly relevant to the determination of the proportion of money which the economic community will hold relative to its money income, it is not possible to deduce the “average lag” between the primary and the secondary increases of income directly from the magnitude of the average “income-” or “circuit-velocity” of the total stock of money, or vice versa. In part, this is because a certain portion of the community’s cash holding is primarily a reserve store of value in no close connection with the routine receipts and disbursements of firms and of individuals. Only a part rises and falls regularly as receipts exceed and fall short of disbursements as determined by the lags which have been mentioned. But even if we proceed to exclude from consideration that money which is locked up in hoards, a distinction must be drawn between what may be called average and marginal time-lags between receipts and disbursements. Our assumption that no part of the income is saved excluded the possibility of a divergence between average and marginal time-lags in the case of income-receivers. But it is quite likely in the case of business firms that extra receipts will take a longer or shorter time to be disbursed than the average lag between all receipts and all disbursements.29 In a very interesting passage in his Economics of Planning Public Works30 Professor J. M. CLARK estimates that the marginal period of flow of purchasing power from ultimate income recipient to ultimate income recipient (the length of the “cycle of secondary effects”) in the United States of America is very much shorter than the average period expressed in the “income-velocity of money”.

After some time, the “braking” influence of some of these time-lags will tend to disappear. Capitalists, at any rate, will probably begin to anticipate the payment of their increased incomes. Merchants and producers of consumption goods will anticipate the rise in demand, and will create new incomes in advance of demand. Even apart from further investment than is involved in an increase in working capital corresponding to the increase in output, the rise in incomes will soon gather a terrific momentum. Moreover, investment in fixed capital will not in fact stand still: on the contrary, it will expand in the manner analysed above to a much greater extent even than the production of consumers’ goods. The movement will gather momentum continuously until checked by the appearance of a shortage of factors of production and/or of investible funds from inflationary sources.

Immediate effect of saving.

What difference now will saving make to this process? An act of saving is necessarily two-sided. It means a fall in demand for consumers’ goods in terms of money and a rise in the supply of investible funds. If we look at saving only in its aspect of a reduction of expenditure—for example, if we suppose that money saved is simply destroyed or hoarded—it is obvious that, even in the absence of money-scarcity, credit restrictions and a rise in the rate of interest, a habit on the part of the public of saving a certain proportion of its income will tend to damp down, and finally extinguish, this increase in money income. At each revolution of the money stream, each time income is spent, it will undergo a reduction. Obviously, continual additions by way of investment will have to be made to the income stream in order to counteract the deflationary pressure of saving. The question then arises whether an act of saving in itself tends to produce an act of investment. Answers to this question are usually of an extreme nature. Some economists, of whom Mr. J. M. KEYNES is not the least eminent, reply that saving has no immediate effect on investment and that its ultimate effect, owing to the deflation which it induces, is to diminish the incentive to invest.31 Others32 assume that in normal conditions saving will give rise to an equivalent amount of investment.

The truth probably lies somewhere between these extremes. The supply of investible funds from dishoarding, credit expansion, etc., even where it is not completely elastic, is probably always to some degree sensitive to the price of borrowing (i.e., the interest rate).

Saving and boarding

This is true at any rate for the stage of the trade cycle which we are now considering, though it may cease to be true at a later point in the boom. The lower the interest rates, the more money will be withdrawn from entrepreneurs and hoarded in some form. Anything which lowers or even prevents a rise in the interest rate will increase the quantity of money withheld from entrepreneurs and hoarded, or reduce the quantity of money which would otherwise have been dishoarded and offered to entrepreneurs. It is probable that the effect of savings will be to bring about a reduction or prevent a rise in the interest rate. If this does not happen, there can only be two possible explanations. Either the savings have been completely hoarded in the first instance, or the entrepreneurial demand for investible funds is perfectly elastic over a range equal to the amount of savings which is offered for investment. As for the first alternative, if even a part of the savings is hoarded, it is obvious that they cannot give rise to an increase in demand for producers’ goods equivalent to the reduction of demand for consumers’ goods which they occasion. In order to produce this compensating increase in investment, all the savings must be invested. But, even if the savers should in the first instance seek to invest all their savings, this will not increase actual investment to an equivalent extent unless the demand for investible funds is such that entrepreneurs can absorb the supply as increased by the full amount of the savings, at the same rate of interest as that at which they might have absorbed the same supply minus the savings. If they are unable to do this, the saving will be in part sterilised by hoarding, or a reduction in dishoarding, due to reduction of the rate of interest, or to its failure to rise; and the net effect will be deflationary.

We may suppose that, in the case of an increment of saving which is not expected and which entrepreneurs have made no plans to meet,33 the demand for investment funds will show very little elasticity and investment will scarcely increase at all. On the other hand, where investment projects, which (consciously or otherwise) rely on such an increase in saving, have been conceived in advance, the fall in the interest rate will be much slighter and the relative deflation less severe. But always and in all circumstances—short of a complete insensitiveness of banks and capitalists to the rate of interest in their decisions to hoard and dishoard—saving must tend to reduce the total demand for goods in terms of money. The comparison, it must be noted, lies not between the state of affairs after the saving and before it, but between the state of affairs at a given time with the saving, and what it would have been had there been no saving. It may well be that the extra saving is fully counteracted by an increase in investment; but, unless this investment would not have taken place in the absence of such saving, it remains true to say that the saving has a relatively deflationary effect.

Consequences of continued saving.

An increase of saving, we have found, normally exercises a deflationary effect at the moment of its appearance. The amount of dishoarding is diminished, and the community’s currently-earned income rises less fast than it otherwise would have done. If we pursue the consequences of this saving in subsequent periods, we find the deflationary effect is, as it were, cumulated. A relative fall in demand now leads to a relative fall in investment later, this to a further fall in demand and so on.

If the increase in saving is repeated in subsequent periods, it may not merely slow down the expansion but even prevent it from reaching the height it would otherwise attain, and finally turn it into a decline. This can be easily demonstrated on somewhat abstract assumptions. The higher the proportion of income saved, the less will the income level require to rise in order that a given rate of saving may be attained. On the other hand, according to the acceleration principle, the rate of investment will be greater or less according as incomes are rising more or less fast, and, since the greater the proportion of income saved the slower will be the expansion of incomes, it follows that the higher the proportion of income saved the less will be the rate of investment at any given income level. But the expansion will cease when saving catches up with investment, and the higher the proportion of income saved the lower will be the income level at which the expansion will cease.34

The general conclusion of the foregoing argument is that saving which is in progress during an expansion process tends to slow down the expansion. Ceteris paribus, the more people save the slower the expansion, and the less they save the more rapid the expansion.

Qualifications.

It must, however, be kept in mind, if serious misunderstanding is to be avoided, that our analysis is limited at this point to the peculiar economic circumstances which are supposed to prevail during a typical upswing. We assume that a credit expansion is under way and that the supply of investible funds from inflationary sources is to some degree elastic. If that is so, then an increase in the rate of saving leads to a slowing-down of the inflow of new money (inflation), and a decrease in the rate of saving to an acceleration of the inflow of new money. If the money supply is completely inelastic, the situation is different; for in that case we cannot assume that a deficiency in the supply of investible funds caused by a decrease in the rate of saving will be automatically made up, wholly or partly, by inflation. This is, however, not the typical situation during the upswing, which is, on the contrary, characterised by an elastic money supply from inflationary sources. But, since (as will be shown in detail at a later point) this elasticity in the money supply is likely to diminish with the progress of the boom, the deflationary effect of saving is likely to become less and less pronounced.

Institutional complications.

Furthermore, exceptions to our rule are conceivable in special institutional circumstances. Take, for instance, the following situation. Hitherto we have assumed a homogenous capital market with a homogeneous object of transactions—viz., investible funds. In reality, however, there are subdivisions in this market, and the different types of investible funds which are marketed in these subdivisions are not perfect substitutes. We are thinking here primarily of the distinction between long- and short-term credit—that is, between the capital and money market. Now, it may be that the inflationary sources of supply (e.g., bank credit) serve mainly the money market, while the capital market is fed chiefly by saving. It is true that in the real world this separation is not complete. The sources from which the demand for long-term credit is satisfied include inflationary sources. Banks, for example, invest, not only in commercial paper, but also in securities; money hoards of individuals and corporations go into long-term investment and play a large rôle during the first phase of the upswing. On the other hand, to a certain extent, short- and long-term credit are also substitutable on the demand side. Investment in fixed capital may be financed by means of short-term credits which are continuously renewed.35 But the substitutability is certainly not perfect either on the demand or on the supply side. If that is the case to a considerable extent, if (that is to say) the money market and the capital market are separated in the sense indicated above and short- and long-term credit are not substitutable for the entrepreneur, then the progress of the expansion may be seriously hampered, and not accelerated, by a low rate or a fall in the rate of saving. The capital market may become tight; the rate of interest there may be driven up and the volume of investment, so far as it requires long-term financing, will be reduced. To the extent that different kinds of investment are complementary so that long- and short-term funds are in joint demand, the inflow of new money through inflationary faucets into the money market will be impeded. In order to appraise this possibility correctly, it should be remembered that money flowing from an inflationary source, after it has become income and is saved, has to be counted as saving. It has been assumed by many writers—e.g., by Mr. HAWTREY—that profits which have been brought about by an inflationary rise in demand are the most important source of supply of investible funds during the upswing of the cycle.

But, even if such exceptions are deemed unimportant and our rule that savings during the expansion slow down the latter remains substantially unimpaired, it does not by any means follow that, for the purpose of obtaining the maximum long-run Productivity, a low rate of saving during the upswing of the cycle is desirable. We are not yet in a position to give a definite answer to this question. There can, however, be no doubt that good reasons can be adduced for the proposition that an expansion which develops slowly will last longer and give rise to less serious maladjustment than one which progresses very rapidly.

Saving during the early expansion.

We turn now to the second problem presented at the beginning of this section. What proportions of available incomes are likely to be saved as the expansion develops? Are there any reasons for believing that the proportion of income saved by the economic community varies at different points in the cycle?

Unfortunately, for lack of statistical data, there is no possibility of measuring directly how savings behave during different phases of the cycle.36 We have to rely on very general considerations which cannot provide a precise answer to the above questions.

So far as the wage-earning section of the community is concerned, there are various considerations which do not all point in the same direction. The real incomes of those who were employed during the slump probably fall during at least the first part of the upswing. The proportion of income saved by such people will probably tend to diminish, particularly as the danger of unemployment recedes. On the other hand, as the unemployed of the slump are re-employed, they obtain a saveable surplus, and in some cases may have a strong incentive to save for the purpose of repaying debts to tradesmen which they have contracted. Since the real income of the working-class as a whole probably rises during an upswing—especially in post-war cycles—it is possible that the tendencies to increased saving prevail, but it seems unlikely that the increase in saving from this source can be of much importance.

Among the propertied classes, the fluctuations in the proportion of income saved are probably much more important, because their incomes fluctuate more widely. They skim the cream off the boom and bear the brunt of the depression. Considering that their standard of living is much less flexible than their incomes, it appears plausible that they should even dissave during the slump and save considerably during the upswing and boom. This is likely to be accentuated by the fact that they are, to some extent at least, cycle-conscious. During good times, they save not only for old age, children’s education and inheritance, calamity, etc., but also to some extent against the eventuality of a slump. Business corporations pursue a policy of “dividend-stabilisation” by accumulating reserves out of net revenue in good times to disburse them in bad.

It is true that the bond-holding section of the propertied class is to some extent in a position analogous to that of wage-earners who find their real incomes diminishing during the upswing. This, however, is not likely to be important in the earlier stages of an expansion; and if we take capitalist-entrepreneurs, holders of equity shares and holders of industrial bonds in the mass, there can be no doubt that their real incomes greatly increase during the expansion. Where there is a big national debt, the situation is a little different. Here it is conceivable that the transference of real income from taxpayers (poor and rich) to rentiers (mainly rich) will be considerably diminished during the upswing, and this will counteract the redistribution of income in favour of the rich which will otherwise take place at that time, and to some extent limit saving.

Consideration of public finance in a wide sense (including social insurance institutions), however, brings in a further element which decisively tips the balance in favour of increased saving. During the slump—largely as a consequence of the increased real weight of social services, maintenance of unemployed and national debt—Governments are normally forced into budget deficits which we may regard as dissaving. During the upswing, these deficits disappear and may even be succeeded by budget surpluses.

Saving during the later expansion.

The considerations set forth above are applicable to the expansion in its beginnings and in its heyday: but, as the boom reaches its height, they may lose some of their force. There are reasons for the view that, in the later stages of an expansion, people begin to spend once again a larger proportion of their available incomes.

Workers, farmers, and business-men alike will probably have accumulated a certain amount of debt during the depression, which represents a psychological burden and a threat to their security out of proportion to the actual money burden of interest. Any additional income coming their way during the expansion will be used to a considerable extent to repay these debts. Once this is accomplished, however, it is very unlikely that the same rate of saving will be maintained merely with the object of adding to capital. A larger proportion of incomes received will tend to be spent; and the consumers’ goods trades will receive a fillip thereby, which will transmit itself, if there is still a sufficiency of unemployed funds and physical resources, to the investment-goods trades. The new élan which will thus be given to the expansion will provoke a further fall in the proportion of income saved, because the business world will be aware that bigger profits are being made and bigger dividends will in due course be distributed, so that a spirit of confidence will spread, which is very favourable to spending.

Another influence may make its appearance which will have more or less effect according to the social and economic structure of the country concerned. Rising business profits, and the anticipation of a continuance of rising profits, will bring about a recovery of equity values on the stock exchange. As time goes on, this boom may interest a larger and larger number of people in a speculative capacity. They may be disposed to utilise gains on the stock exchange as additional income, or they may feel that, since the value of their shares is so high, the future is well provided for and they can afford to do less saving out of current available income.

Saving at the peak.

When the boom arrives at the stage where shortage of materials and men develops and prices rise rather than production, it is probable that the tendency to greater spending is increased. Wages in the latter stages of a boom no longer show the same “stickiness”, workers’ organisations become more and more active, and wages rise as fast as profits. Further, it is probable that the farmers and other producers of raw materials succeed in getting a bigger share than before in the total income: and, since they are on the average much poorer than the industrial population, they will probably spend a larger proportion of their incomes.

In this way, the position envisaged by the monetary over-investment theorists at the end of the boom may possibly arise. The proportion of spending to saving tends to increase. The consumption-goods trades may draw labour away from the investment-goods trades and so create difficulties for them. Suppose now that, before the shortage of material means of production becomes a factor of much importance, the liquidity of the monetary system declines to such an extent that banks are unwilling to expand credit or individuals to dishoard to any considerable degree, even though interest rates rise very high. In such circumstances, increased saving will only be slightly deflationary, and a fall in saving only slightly inflationary. If, as has been asserted, the proportion of expenditure to income tends to increase at the later stages of the boom, the stimulating effect will be reduced to a minimum by the inelasticity of the supply of credit. The money added to the demand for consumers’ goods will in large part be abstracted from the demand for producers’ goods and the dislocation caused thereby may precipitate a deflation.

B.    The Contraction Process

§ 7.    GENERAL DESCRIPTION OF THE MECHANISM

Rôle of deflation.

The process of contraction, like the process of expansion, is cumulative and self-reinforcing. Once started, no matter how, there is a tendency for it to go on, even if the force by which it was provoked has in the meantime ceased to operate.

The contraction may start from a state of full employment or partial employment; and the mechanism is, in principle, the same in both cases.

Deflation in the sense of a gradual decrease in the total demand for goods in terms of money plays an essential rôle in the contraction process. Deflation must not, however, be interpreted in the narrow sense of a deliberate act or policy on the part of the monetary authorities or commercial banks. A deflation in this narrow sense may, of course, act as a starter to the process, and it usually comes in sooner or later as an intensifying element; but, when the process has once got under way, a sort of automatic deflation or self-deflation of the economic system (in contradistinction to a deflation imposed on it by the monetary authorities) is just as much an effect as a cause.37

In many respects, the contraction is the exact counterpart of the expansion, so that large parts of the analysis of the latter can be adapted to explain the former.

Spread of deflation.

Suppose contraction has been started for any reason whatsoever (e.g., because a large construction scheme which was under way has had to be interrupted owing to inability to raise the necessary funds for financing it). Demand for construction materials and implements falls off, and production in the industries which provide those things is curtailed. We might equally well take the case where an act of deliberate deflation by the monetary authorities (which again may be due. to a great variety of reasons or motives) starts the ball rolling. In the section on the down-turn (crisis), the question of the possible or usual starters will be taken up. Here we simply assume that a net contraction has been produced, and that the total demand for goods in terms of money has shrunk by a considerable amount.

When demand flags at various points, merchants will give lower orders to producers, production will be curtailed and workers will be dismissed. This reduces income. When incomes fall, the demand for all kinds of goods is further reduced and depression spreads to other parts of the system.

Like the expansion process, the contraction process will probably proceed slowly at the beginning and then gather momentum.38 At first, when demand has fallen off in the case of only a few commodities, the contraction may easily be stopped or reversed by favourable influences elsewhere. Later on, when the demand for a greater number of goods has fallen for some time and contraction has spread to many parts of the system, expansionary influences, which in the early stage of the process would have been strong enough to outweigh the forces of contraction, will no longer be sufficient to reverse the downward movement, but will merely slow it down. This is what is meant when we say that “the process has gathered momentum”.

Intensifying factors.

After the process has continued for a while, intensifying factors are likely to come into play. Prices will soon begin to fall, and losses will be made everywhere, because wages and other cost items cannot readily be reduced. There will be a strong tendency to reduce stocks and to curtail orders and purchases by more than the amount by which sales have gone down. A sustained fall in demand and prices is bound to create in the business world a more pessimistic outlook in general and an expectation, whether justified or not, of a further fall in prices, The profit rate will be reduced all along the line, and new investment or reinvestment of amortisation quotas will be curtailed. Nobody dares to embark on ambitious schemes of investment; and this will intensify the tendency to reduce commodity stocks and to increase money stocks, that is to hoard—the counterpart of the tendency to dishoard during expansion.

It is important to note that such a contraction process can happen even in a pure cash economy with constant quantity of money (M). In a modern banking and credit economy, powerful intensifying factors come in. If a large part of the circulating medium consists of bank money (demand deposits subject to cheque) and if the banking system as a whole or a number of individual banks get into difficulties, the banks will restrict credit. They will call in outstanding loans and be reluctant to grant new ones, and as a consequence M will shrink. If a run on the banks occurs—if, that is to say, depositors want to change their deposits into notes—the deflation becomes still more serious. The same may happen in the international sphere. There may be a run on the central bank in order to exchange notes for coins and foreign moneys—that is to say, gold hoarding may develop or a flight of capital may intensify the deflation.

Owing to the rigidity of a number of cost items, each decrease in the total demand for goods in terms of money is followed by a certain shrinkage in production, and any reduction in the production of finished goods tends to be transmitted with increasing violence to the preceding stages of production, which again tends to reduce the demand for finished goods, and so on in a long and painful process.

This general description of the contraction process may probably be taken as a correct description of the common opinion on the matter. The most important thing to remember is that the depth to which the contraction develops depends on a number of circumstances, partly of an institutional nature, of which many are—or, at any rate, may be—quite independent of the factor which first initiated the contraction or even of the intensity of the preceding boom. The circumstances which are responsible for the cumulative nature of the contraction process we must now analyse in detail.

§ 8.    MONETARY ANALYSIS OF THE CONTRACTION PROCESS

Fall in total demand.

The monetary manifestation of the cumulative process of contraction is the prolonged fall in MV—i.e., in the total demand39 for goods in terms of money. If MV did not fall, there would be no such rapid deterioration of the economic situation, no such swift fall in production and employment, as is in fact exhibited in the course of cyclical depressions.40 In this sense, one may call the contraction a monetary phenomenon. But the description is wrong, if it is taken (as it frequently is) to imply that the responsible factor for the shrinkage in MV is always a deflationary policy pursued by the banking system, or that the monetary authorities can always effectively prevent a fall in MV if they refrain from contracting credit, or if they expand credit, by the ordinary measures of credit policy. Within the limits set by existing monetary organisation and banking practice, the monetary authorities can regulate the supply of money. But, in order to arrest a fall in MV during a contraction, it will frequently be necessary to regulate and stimulate demand as well as supply; and this may require very drastic interventions, which are hardly possible without far-reaching changes in the present institutional framework.

Cumulative fall in investment.

We shall now analyse the contraction process broadly in terms of our demand-and-supply schedules of investible funds. It may be that not much is gained thereby; but, as the analysis recapitulates the essence of the theories which explain the slump by an excess of the market rate of interest over the equilibrium or profit rate, it may serve as an introduction to a more realistic treatment of the matter.

When the demand for goods in general falls and production shrinks, the demand for investible funds falls too—i.e., the demand curve shifts to the left. Assuming that the supply curve is unchanged, and is fairly elastic over the given range, the new point of intersection will be to the left of the old one—i.e., the amount of investment is reduced. But we cannot assume that the supply of savings is as elastic as the supply of investible funds. This means that part of the supply of investible funds which is not taken up by the demand will be diverted, not into expenditure on consumption goods, but into hoards—i.e., it will be withdrawn from circulation. Hence the total demand for goods in terms of money falls further, prices fall still lower and production and employment are reduced. This provides a further discouragement to the demand for investible funds, and the demand curve is shifted further to the left.

Drying-up of supply of funds.

On the other hand, the contraction process is bound to give rise to unfavourable reactions on the supply side. Losses are made everywhere: defaults and bankruptcies threaten or actually occur. The effect is to make the banks and the investing public cautious and pessimistic. The risk of lending rises and the supply of investible funds decreases. In technical parlance, the supply curve, too, shifts to the left. The interest rates are thereby pushed up or are prevented from falling, in spite of the falling demand, which intensifies the deflation. As Mr. KEYNES and Mr. M. BREIT have both pointed out, the same risk factor may be counted twice over, on the demand and the supply side, by the lender and the borrower, thus widening the gap between demand and supply.41

For a more detailed study of the monetary aspects of the contraction process, especially a study which lends itself to statistical verification, it will be useful to start with the following considerations. MV the total demand for goods in terms of money, shrinks: this may be due to a shrinkage in the quantity of money and/or to a decrease in its velocity of circulation. It must be possible to demonstrate that (1) a part of the monetary circulation is destroyed or leaves the country, and/or (2) money does not change hands so frequently against goods, because it is hoarded or used for other purposes. (3) In addition to the factors mentioned here as effecting a reduction in MV, or the flow of money against goods, it is conceivable that a deflationary influence may be exerted by another development which does not affect the flow of money, but adds to the work which money has to do—and that is an increase in the turnover of goods. Goods in general will in this case change hands for money more frequently in the course of their journey from the primary producer to the consumer. There is, however, no reason to believe that this disintegration of the structure of production is a characteristic or necessary feature of the downswing.42 (4) Financial transactions may immobilise a larger part of the circulating medium, and demand for goods falls.

Forms of deflationary pressure.

We have now to answer the questions: At what point does the money leak out of the circulation? Where is it held up? Who hoards it? In what shape is the money hoarded? How is it destroyed? It is possible to enumerate a number of forms in which the monetary contraction may appear, beginning with the more extreme and conspicuous cases and proceeding to the less conspicuous and more subtle ones. Not all of these forms of monetary contraction are regular or unavoidable features of every cyclical depression. The attempt is here made to arrange them approximately in decreasing order of regularity and conspicuousness.

Outright deflation by the central bank.

Deflation by the central bank is a straightforward case which does not require much comment. A restriction by the central monetary authorities of the circulation of gold coins, notes and short-term liabilities (central-bank money) means a decrease in the flow of purchasing power—unless counteracted by other forces: e.g., the substitution of bank credit for centralbank money or an increase in the velocity of circulation which will take place if the money flowing into the central bank comes out of hoards. This happens sometimes on a large scale after a period of panic which has led to a great drain of cash out of the banking system—e.g., in the United States after the bank suspension in 1933.

Active deflation on the part of the central bank is nowadays almost always the consequence of a disequilibrium in the international balance of payments of a country, which may be due to the withdrawal of foreign credits, the cessation of the inflow of capital, a flight of domestic capital or a deficit in the balance of payments on current account because of a relatively high price and income structure (over-valuation of the currency).

An outright reduction of central-bank money is, however, not an invariable feature of every depression: at least, it is usually not pursued right through the whole course of the depression. It is a common experience at the beginning of the depression, or during the financial crisis which usually marks the turning-point, or in some later financial crisis in the course of the depression, to observe a sharp increase in the note circulation accompanied by a decrease in the total demand for goods. This is proof that, at some other point in the economic system, money is being hoarded, and that the central bank is providing the cash in order to avoid a collapse of private banks and firms and to mitigate the drain on the industrial circulation.

Hoarding of gold and bank notes by private individuals.

This again is a clear case of deflation. In the first case, gold is sought from the banks by the public in exchange for notes so long as the latter are redeemable in gold. The circulation is thereby reduced and pressure is brought upon the bank of issue to contract further in order to improve the reserve ratio. In the second case, rotes which otherwise would have been spent on goods are hoarded, or bank deposits are turned into notes; and so pressure is brought to bear on the commercial banks to contract credit in order to preserve their cash reserves. It should be noted that the amount of money an individual can hoard is not limited to the magnitude of his current money income. He may sell other assets such as securities, real estate and commodities of all sorts against cash, and hoard the proceeds of the sales. This has a double effect. On the one hand, money is withdrawn from circulation (except in so far as the buyer of the assets manages to pay without decreasing his other expenditure—e.g., if securities are taken up by banks which create deposits against them), and the demand for goods falls off at some point. On the other hand, the price of the assets in question is depressed, which may have serious repercussions. To this extremely important aspect we shall return later.

Clearly, hoarding of gold and bank notes by the public is not a feature of every cyclical depression. It happens only in exceptionally severe depressions and under special circumstances—e.g., when the banking system is in bad shape, as in the United States of America in 1933, or when a flight into foreign currencies takes place, as in many European States during recent years. If money hoarding by the public develops, naturally it brings with it a severe intensification of the deflation.

Contraction of credit by the commercial banks.

This probably has been, until now, an invariable feature of any contraction in an economy with a fairly developed banking system. It is one of the best known and most fully analysed aspects of the depression and need not long detain us.

Since bank deposits are, under modern banking organisation, a means of payment (bank money), a liquidation of bank loans and deposits is a clear case of deflation. This process may proceed in a slow and orderly fashion without spectacular bank failures, or rapidly to the accompaniment of bankruptcies. It may be hastened by pressure from above and below, from the central bank and from a public that demands cash for its deposits. Whether such complications arise or not and whether in consequence the contraction of credit goes a long way or not depends, not merely on the seriousness of the disturbance by which the contraction process was first set afoot, but also—and presumably in many cases to a larger extent—on institutional and psychological circumstances, on the policy pursued by the monetary authorities, on the international complications, on the methods of financing production (short-term or long-term credit, equities or fixed-interest-bearing bonds), etc. By way of example, the habit of indirect investment through the banks may be mentioned as a factor which tends to accentuate the deflationary possibilities of the economic system. The public, instead of holding securities directly, holds bank deposits (savings deposits or time-deposits) and the banks in turn hold securities, or loans backed by securities.43 If and when—possibly as a result of a fall in security values which weakens the position of the banks—the public loses confidence in the bank deposits and desires to turn them into cash, the banks are forced to sell securities in order to find the money. This precipitates a further headlong fall in security values, which of course raises the real rate of interest at which business can raise long-term capital. It may be objected that, if the public which converts its deposits into cash does not use the money to buy up securities as fast as the banks unload them on the market, this shows that it prefers holding money to holding securities at the current price, the effect of which—even in the absence of indirect investment through banks—must be to force the price of securities down to the same extent. This objection probably assumes too much “rationality” on the part of investors. It is likely that people who have bought securities at a high price will hold on to them when the market is low, even where they would no longer be willing to buy the same securities at the same price. Moreover, the very fact that the banks hold securities may lead—as a result of the doubts which it engenders as to their ability to meet their obligations and the “runs” which it provokes—to a contraction of commercial credit which will be even more deflationary than the effect on security prices.

Even though an active policy of credit contraction on the part of the commercial banks is in practice—though not of logical necessity—an almost invariable feature in one phase or another of every depression, it does not follow that it always continues to the very end of the depression as the sole or principal deflationary factor. On the contrary, the contraction of credit may persist even after the banks have stopped pressing for the repayment of loans, the reason being that there are other, more subtle, forms of deflation than those so far discussed. To these we now turn.

Hoarding by industrial and commercial firms.

Industrial and commercial enterprises tend, like the banks, during a general contraction to increase their liquidity: that is, they endeavour to strengthen their cash reserves and to reduce their debts with the banks. (The liquidation of other than bank debts, which is not so closely connected with the extinction of purchasing power as the liquidation of bank debts, will be discussed below in connection with certain aspects of the liquidation of debts in general.)

There is a twofold motive behind this attempt to increase liquidity. There is, first, the uncertainty as to the possibility of raising funds when they are needed to meet liabilities falling due. During a period of contraction, especially in its initial phase, it is difficult to get credit from the banks or from the suppliers of raw material and other means of production. There is the danger that such credits may be difficult to renew. In addition, one is not sure of being paid punctually by one’s own debtors. All this makes increased liquidity seem advisable. Secondly, there is the fact that, when prices fall and losses are made and further losses are expected, the replacement of fixed and working capital (reinvestment), as well as new investment which may have been contemplated before the situation became too bad, is postponed or suspended for the time being. It does not pay to invest or reinvest; and, instead, idle balances are accumulated, or bank loans repaid even when the banks are no longer pressing for repayment. (In extreme cases, of course, the hoarding may be effected in the form of bank notes or gold rather than through the accumulation of idle bank balances and the repayment of bank loans.)

The immediate effect is in all cases the same, whatever may be the motives for, and the form of, the pursuit of liquidity. Demand for goods shrinks, prices fall, production is curtailed and the general situation is aggravated. So the initial achievement of greater liquidity creates a need for further steps to maintain liquidity, and makes things worse than they were. Gradually, however, with the fall in prices and wages and the curtailment of production, funds are liberated and—it may be, not till after a succession of setbacks and relapses—liquidity increases all round.

Needless to say, the policy of the central and commercial banks is a decisive factor. By supplying or withholding additional funds, they can intensify or mitigate the consequences of private hoarding. Both factors—viz., banking and monetary policy on the one hand and the liquidity policy of industrial and commercial firms on the other hand—interact in a complicated way. But it is nevertheless important to realise that the policy of the latter—i.e., the hoarding by private business firms—is an independent factor which may make itself felt and provoke a general contraction, even in a pure cash economy with no bank money at all.

Liquidation of non-bank debts.

Quite apart from bank debts, a strong deflationary effect is probably exercised, at least in the first stages of the cyclical contraction, by the liquidation of inter-personal and inter-business debts. But the connection between the liquidation of debt in general and the decrease in the flow of money against goods is more complicated and indirect than in the case of bank debts.

The debts of a bank to its customers (that is, its deposits) are normally used as money. The owner treats them as cash: they constitute purchasing power and have a Velocity of circulation. Hence the extinction of such debts through bank failures or through a contraction of bank credit diminishes purchasing power and demand for goods. Other debts may, of course, perform the same function. A bill may circulate as money; and its settlement has then the same effect as the liquidation of a deposit. These cases, however, we may safely regard as quantitatively unimportant under our present monetary and banking arrangements (although economic history can show instances where they have been important). Usually it is in a less direct way that the liquidation of debts—or, if we prefer to take it from the opposite angle, credits—exerts its deflationary influence.

But, even if debts (credits) other than bank debts (credits) do not circulate as money, they may be highly liquid assets—the degree of liquidity depending on the standing of the debtor and the situation of the market. Therefore, such debts are used as liquidity reserves; and when during a process of general contraction they diminish in quantity or lose their saleability, they can no longer adequately fulfil this function and must be replaced by money, bank deposits or central bank money. The demand for money increases, its velocity of circulation tends to fall, and total demand shrinks according to the process previously described.

Forced sales of assets to repay debts.

The liquidation of debts in general has, however, yet another aspect, which is of great significance. When a debtor is pressed to repay a loan, he is not always in a position to meet his obligation out of his current receipts. Ordinarily, he will be forced to sell assets in order to raise the fund for the discharge of his debt. He may sell securities, real estate, or commodities of different descriptions. These forced sales must have a depressing influence on the price of the assets, with deflationary consequences.

It is important to realise clearly why it is that such forced sales and the consequent price-falls produce or intensify deflation. It might be argued that these transactions themselves (i.e., the sales and purchases of such assets) absorb money, temporarily at least, and withdraw it from other uses. Purchasing power which otherwise would have been spent for new investment or for consumption is now spent for old securities and other assets which are thrown on the market by harassed debtors. In the terminology of Mr. KEYNES’ Treatise on Money, we may say that “the financial circulation is stealing money from the industrial circulation”. It would seem, however, that this temporary absorption of purchasing power in the actual transference of assets is a comparatively unimportant factor in the general scheme. A much more important factor is the indirect influence of the fall in the prices of the assets in question. If the price of securities falls, this is equivalent to a rise in the interest rate; and this must obstruct the financing of new investment through the issue of securities (bonds or shares). Bank loans are frequently granted on securities; and, if the latter fall in price, this will certainly not promote the willingness and ability of the banks to lend. If the price of real goods —e.g., houses—falls, the production of these goods loses its profitability and will be curtailed

We must not, however, forget the other side of the medal. What does the creditor do with the money? If he buys the assets which the debtor sells, it is difficult to see why their prices should fall at all. Since, however, we are dealing with what happens during a general contraction, we may assume that the creditor will not promptly invest the money, but will keep it, at least temporarily, in liquid form. If that happens, then of course the whole procedure is highly deflationary. But the villains of the piece are in such case the hoarders who try to accumulate cash by calling in loans, and not the debtors who are forced to sell assets. Given the decision of the creditor to hoard (in other words, to increase his liquidity by turning debts into cash), the effect is deflationary, even if the debtor is able to retrain from selling assets and to meet his obligations by cutting down his expenditure on consumption or, if he is a producer, on producers’ goods (investment and reinvestment).

Before leaving the question of debts, we may pause to point out that the indirectly deflationary effects of default on debts are probably much more serious than the directly deflationary effects which may follow from their payment, since defaults are bound to spread apprehension and to stimulate the liquidation of debts and the hoarding of cash.

Sales of securities, etc., to cover losses.

A special variety of this case has been discussed by Mr. KEYNES and Mr. DURBIN.44 They assume that somebody saves, that the demand for consumers’ goods decreases, and that the producers of these consumers’ goods make losses and cover them by selling “old” securities in their possession (as distinguished from new issues) in exchange for the savings which have brought about the losses. We need not pause to discuss the likelihood of this rather artificial case. We may consider instead the more general case where losses, however brought about, are covered by the sales of assets.

This case is very similar to the previous one but rather more general. The idea is that a producer who is making losses does not cut down his expenditure (whether the expenditure for his personal consumption or his disbursements for labour, raw materials, semi-finished products, etc.) to a corresponding extent, but keeps them up by selling assets to somebody else. His sales in such case will certainly have an indirect deflationary influence (as was pointed out in connection with the previous case) by depressing the price of the assets in question. But it is difficult to see how any more direct deflationary effect is produced.45 Money is transferred from a saver to the entrepreneur who ex hypothesi spends it in various ways. Hence the demand for goods does not fall (except in so far as these transactions themselves absorb money temporarily). We may describe the process by saying that the savings of a part of the public are compensated by dissaving on the part of entrepreneurs. Savings are wasted to cover losses. The situation is one which cannot of course continue for long; but at any rate the procedure is not directly deflationary.46 It is even conceivable that the direct effect is rather inflationary than deflationary. If the assets sold to cover losses are taken up by the banks and new deposits are created against them, or if somebody else is tempted to dishoard in order to buy them, the flow of money may be increased rather than decreased.

We are left with the conclusion that we have here no new form of deflation. It is the losses which tend to bring about deflation and not the fact that losses are covered by the sale of assets. On the contrary, the effect may even be to mitigate the force of the deflation. The alternative method of coping with losses—viz., retrenchment of expenditure—is certainly in its immediate effect in a higher degree deflationary.

Sales of securities, etc., for fear of a fall in their price.

If the sales of securities and other assets are induced, not by the necessity for repaying debts or covering losses, but by the speculative motive—that is, by the expectation that prices will fall, or in other words that the value of money will rise—we have a deflationary move pure and simple. It is, however, important to note that what makes for deflation is not the demand for money for the purpose of these transactions, but the tendency to hoard—i.e., to change less liquid assets into more liquid assets and to keep the latter unspent. It does not matter much whether the seller performs the act of hoarding after having disposed of the assets at a low price or whether the price of the assets falls without any transaction’s having taken place. When everybody is equally pessimistic about the future trend of security prices, prices will quickly fall all round without any securities changing hand at all. On the stock exchange, this is a well-known phenomenon. Prices are “talked down” on a bear market, if there is a consensus of opinion. If there are actual transactions, that is because the consensus of opinion is not complete, those who buy being less pessimistic than those who sell. To be sure, the degree of pessimism will never be uniform; but the deflationary effect in no way depends on there being differences of opinion and therefore actual transactions. (If the pessimistic expectations of one part of the public are offset by the optimistic expectations of another part, the situation is of course different. Our present case is, however, only one of differences in the degree of pessimism.)

Scales of liquidity.

Some writers have tried to devise a general formula for the motives which lie behind the various forms of hoarding that take place during a cyclical depression. They say that “liquidity preferences” in general rise.47 Banks, business enterprises and private individuals tend to increase their liquidity—that is, they wish to hold a larger part of their wealth in cash or in more liquid forms than before. The attempt has sometimes been made to set up typical “scales of liquidity”—i.e., to arrange the various types of assets in the order of their liquidity. If we start from the most liquid assets and proceed to less and less liquid ones, we arrive approximately at the following scheme: gold, bank-notes, bank deposits, short-term credits, long-term credits, bonds, shares, real goods.48 It is, however, impossible to regard such a scheme as invariable. The order will differ in different circumstances, and all kinds of anomalies may arise. In a state of high inflation, for instance, shares will rank above bonds, real property above bank deposits, and so on.49

It does not seem that such generalisations can add much to what is revealed by a detailed analysis such as has been attempted in the previous pages.

§ 9.    WHY DOES THE PRODUCTION OF PRODUCERS’ GOODS AND DURABLE GOODS FALL FASTER THAN THE PRODUCTION OF CONSUMERS’ GOODS AND PERISHABLE GOODS?

The operation of the acceleration principle in the contraction.

Assuming the ratio of durable means of production (machines) to labour and raw material (working capital) required for the production of a unit of output to be rigidly fixed (within a certain range of output) by technological considerations—an assumption which would seem to be a good approximation in the short run—the acceleration principle50 readily explains why demand for, and consequently production of, durable producers’ goods and the various materials required for their production falls more rapidly than the demand for, and production of, the finished product.

When in the upward phase of the cycle all branches of the economic system are expanding and production and employment are increasing in all industries, the producers’ goods industries and especially the durable-goods industries experience a particularly rapid growth. When the system stops expanding or even curtails output, people naturally stop adding to their fixed equipment. It is not at all paradoxical that no new investments should be made when the existing equipment is insufficiently employed owing to the fall in the demand for the product. The production of durable means of production is reduced to the replacement required for the maintenance of capacity and, in many lines of industry, virtually no replacement may be needed for some time in view of the fact that, during the preceding boom, the equipment has to a large extent been renewed, presumably on the most up-to-date lines. If the depression is particularly severe and long-drawn-out, it is possible that even replacement will be neglected and capacity allowed to shrink.

We may put the matter in a different way. Suppose consumers’ demand falls to a certain level and production is curtailed so as to bring the output down to the level strictly required by the new (lower) level of “consumer-taking” (to use an expression coined by Professor FRISCH). Then the production of those goods and services of which there are excessive stocks (excessive in view of the new level of output) will be discontinued altogether until these stocks have been reduced to the level required by the new level of output. Now, as has been pointed out, durable goods—consumers’ goods as well as producers’ goods51—can be conceived of as a stock or bundle of services available at successive points of time. Such “stocks” are usually more considerable than the actual stocks of perishable goods.52

The possibility of postponing the acquisition of durable goods.

For these reasons, we should expect a sharper decline in the production of producers’ and durable goods than of consumers’ and perishable goods—and that, even where the decline in consumers’ expenditure is quite evenly distributed over all types of finished goods and services. But this need not and probably will not be the case. Consumers will cut down expenditure for different goods to a varying degree, and changes in income distribution will lead to different reductions in demand for different types of finished output. It is difficult, however, to generalise about the nature of the “marginal” expenditure, whether of the individual or the community. One may characterise those goods which are the first to be sacrificed when income shrinks as “luxuries”. But it is not clear why durable means of production should enter into the production of luxuries to a particularly large extent. This has, however, frequently been implied by those who say that the production of durable goods falls more rapidly, because it is easier to “do without them”, to postpone their purchase (or the purchase of their services), than it is in the case of perishable goods. It is easier to go without a new motor-car or any car at all than to go without food. To a certain extent, it may be true that durable goods and their services are at the margin of consumers’ expenditure and will therefore be especially severely hit by any fall in consumers’ outlay: but this reason for the comparatively rapid fall in the production of durable goods would seem to be less important and less inherent in the nature of the case than the reason given previously.53

The rôle of expectations.

This description of the place and operation of the acceleration principle in the mechanism of contraction must be supplemented and modified much as was the description of the operation of the principle in the expansion process.54 Strictly speaking, it is not actual but expected future demand for the product which gives rise to the demand for equipment. The present level or recent movement (that is, in our present case, the recently experienced fall) of demand (and/or prices) may be extrapolated in different ways into the future. We may arrange a whole scale of possible expectations, ranging from the more “optimistic” down to more and more “pessimistic” varieties. It may be assumed that the recent fall in demand is only temporary and will be followed by a rise, or that the new low level will persist or that the downward movement will continue at the same, or at an accelerated, rate. If we say, for instance, that a gloomy outlook is bound to be created by a prolonged contraction, what we mean is that people become more and more inclined to expect that a fall in demand which they have experienced in the recent past will continue (at the same or at an accelerated rate).55

Thus, logically speaking, the door is open for all kinds of reactions; and it is only a question of fact which one is the most frequent and typical. The supposition which underlies the rigid application of the acceleration principle is that the present level of demand is assumed to rule in the future also. Now, it is very doubtful whether it is possible to generalise as to the exact behaviour of producers in this respect. Fortunately for the broad result, however, it is sufficient to indicate a certain range of expectations as probable and to eliminate others as highly unlikely. Obviously, the cumulative process of contraction will go on—not necessarily indefinitely, but for a while—if the low level of demand reached at any point of time during the downswing is expected to persist, or if more pessimistic expectations prevail, the more optimistic ones being regarded as on the whole unlikely.56 This would seem to be a fairly plausible assumption and perhaps it may even be somewhat relaxed without any fundamental change in the result.

The result is the cumulative process of contraction through the interaction of consumers’ and producers’ spending, through the operation of the acceleration principle and the dependence of consumers’ purchasing power on gross investment (production of producers’ goods).57 Expenditure on consumers’ goods falls off. This in turn reacts violently on the production of producers’ goods (acceleration principle). Demand for investible funds shrinks. MV is reduced in one way or the other as described in § 8 above. Income and expenditure on consumption are further curtailed, and so on.58

 

 

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59 It has often been argued—e.g., by Professor Hayek—that an analysis of the cycle must start from an equilibrium with full employment. One cannot assume unemployment from the beginning, it is said, because it is the thing which has to be explained. But surely it must be possible and legitimate to investigate what happens when business has begun to expand after a depression which has created much unemployment and over-capacity, without first explaining how the depression has been brought about. This latter question we shall take up later. The order in which the various problems connected with the cycle are considered is a matter of exposition rather than of logical necessity. Furthermore, the question whether an expansion can start from a situation of full employment, and what it looks like and how it develops when it does, is not neglected, but only postponed.

It should be noted that the equilibrium concept of theoretical economics by no means implies full employment of all the factors of production. There are, first, apparent exceptions which really turn on the proper definition of unemployment. (Cf. A. C. Pigou, The Theory of Unemployment, London, 1933. Part I, Chapter 1.) In any economy, there are means of production which could be used but are not used because it does not pay—submarginal land, unemployable workers, etc. Secondly, voluntary unemployment does not count. If, at the prevailing wage-rate, certain people do not care to work, they are not to be counted as unemployed. Thirdly, if the prices of some factors of production (e.g., wages) are kept too high by a trade union, by State intervention, by tradition or for any other reason, there may be some unemployment (unused factors) consistently with perfect equilibrium. In a sense, this kind of unemployment, too, may be called “voluntary”. (On this concept of “involuntary unemployment” compare Chapter 8, § 5.)

60 The point has been discussed at length by Mr. Kahn, Professors Arthur D. Gayer, J. M. Clark, etc., in connection with the probable effects of public works.

61 Additional supplies may be available, even of those raw materials which are of agricultural origin, if quantities have been held in store during the depression. Whether the production of fixed capital rises at once or with a lag will depend on the existence of excess capacity at the moment when revival starts, on the “accumulation of investment opportunities” during the preceding depression, and a number of other factors which will be discussed at various points in the following pages.

62 The reader will observe that the reactions so far analysed have to be described in Mr. Keynes’ terminology as a shift to the right of the schedule of marginal efficiency of capital coupled with an elastic liquidity-preference schedule.

63 Different interpretations have been given of the term “natural” rate. By some it has been defined as that rate (in terms of goods) which would obtain in a barter economy where capital is lent out in natura. This definition raises a host of difficulties which need not be discussed here. By others the “natural” rate is defined as the equilibrium rate. But what are we to understand by “equilibrium”? Four or five different possible interpretations at once suggest themselves. Which one is best calculated to preserve stability of output and employment? The rate which, in given circumstances, tends to keep the price level—in one or the other sense of this ambiguous term—stable? The rate which tends to stabilise aggregate income, income per head, the price level of the factors of production, MV, etc.? Every one of these alternatives has been, at one time or another, proposed as the right criterion. Our discussion has, however, already made—and will make it abundantly clear that it is very doubtful whether—is possible at all, by mere manipulation of the interest rate, to iron out short-term fluctuations in any one of these magnitudes. In any case, it would require drastic and rapid changes of the rate which in themselves would probably become a de-stabilising factor.

These difficulties need not—fortunately—be discussed here. It will be sufficient to say that it is premature and inadvisable at the beginning of the analysis to come to a decision as to what interest rate is best calculated to preserve the economic equilibrium. It is not proposed, therefore, in the present study to make any use of the terms “natural” or “equilibrium” rate; and it is hoped that the theoretical terminology which is developed in the text will make it possible to express clearly and correctly all that is indicated by these terms in trade-cycle literature.

64 Since we assume as a first approximation a perfectly smoothly working market for investible funds with only a single rate of interest, the problem of self-financing does not present special difficulties. It is assumed that it makes no difference whether the money invested is borrowed or not. The opportunity cost is in all cases the market rate of interest. In other words, the entrepreneur who invests his own money must put on the debit side of his account the interest which he could earn if he lent out the money in the market for investible funds.

This assumption is of course regarded by many writers as incorrect. It is alleged that self-financing leads easily to “over-investment”, because people are not so careful when investing their own money in their own enterprise. In other eases there may be a separation of ownership and disposition. It is frequently the director of the corporation who decides how much of the corporate income is to be “ploughed back” into the business, and not the owner—viz., the shareholder. These complications have been discussed to some extent in Chapters 3 and 5 above in connection with the theories of F. Vito (page 44) and E. Preiser (page 141). It may be added that the rationale of such measures as an “undistributed-profit tax” is closely connected with the problem on hand.

65 It will be seen that we do not speak of the profit rate obtaining in a country. Naturally, for different investment plans different profit rates are expected. We speak of the marginal profit rate and we do not say that there is a difference (or equality) between the interest rate and the profit rate, but we say that the interest rate is equal to the marginal profit rate.

An alternative way of dealing with the risk factor would be to define the profit rate so as to include the risk. There are further complications about the risk. The same risk may be counted twice over, by the borrower and lender, or it may not be counted at all. These complications we ignore for the time being. Compare, however, footnote on page 328 below.

66 Hence our demand for investible funds is more nearly equivalent to Mr. Keynes’ schedule of marginal efficiency of capital than Professor Ohlin’s demand for credit.

67 That would seem to be the most “natural” use of the terms, that is, the one which follows most closely their everyday meaning. But there are alternative constructions (terminologies) available and it should be noted that the one proposed in the text implies that a current excess of satisfied demand for investible funds—in short, of investment—over saving (see below) will lead to an increasing income only with a short time-lag. Hence there is a slight deviation from Professor Robertson’s definitions.

68 We may put the matter also this way: Gross investment is what actually is invested. It is always a positive figure. Replacement requirement is a calculated magnitude—viz., that amount which will have to be invested if the existing capital stock is to be maintained.

69 Compare on the subject of these difficult points: Hayek, “Maintenance of Capital”, in Economica, August 1935, pages 247 et seq.; Pigou, Economics of Welfare, Part I, Chapter V (“What is meant by maintaining Capital intact”), and Economic Journal, June 1935, page 225; Keynes, The General Theory of Employment, Interest and Money, pages 38 et seq.

70 There may be psychological, and (in the case of corporations) institutional, differences between new investment and reinvestment, similar to those mentioned above in connection with self-financing. But we shall ignore them for the moment.

71 Compare also Chapter 8, § 2. V must not be interpreted for our purposes as “transaction velocity”. I have not outrightly defined it as income velocity, because of the difficulties connected with the definition (not to speak of those connected with the measurement) of net income. As Mr. Hawtrey points out (see his review of the first edition of this book, Economica, Vol. V (New Series), February 1938, page 94), the use of the concept of “trade velocity” also presents certain difficulties for our purposes, because “MV so defined includes all purchases of goods by one trader from another. But such purchases, whether for the purpose of use as materials in manufacture or for simple resale, do not take the goods off the market. The goods continue to be offered for sale”. Mr. Hawtrey would prefer a “final-purchases velocity”, and would include the purchase of new investment goods (e.g., of a machine) in the volume of final purchases. But what is the relevant difference between the purchase of raw material (say coal) for manufacture which will eventually be sold in the shape of output as, say, pig-iron and the purchase of a not very durable machine which will also be sold in the shape of its services which enter the output? Mr. Hawtrey seems to have overlooked that a qualification has been made about the degree of “integration” of industry (Chapter 3, § 6), which seems to exclude from MV precisely those changes in the volume of purchases which Mr. Hawtrey wishes to exclude.

72 This we may do, even if we refrain from giving a perfectly exact definition of net investment.

73See, however, the slight qualification alluded to in footnote 1 on page 293 above.

74 A reservation must be made as to that part of the invested money which does not at once become income, but becomes amortisation quota. If we work with gross investment on the one hand and gross saving on the other (as, strictly speaking, we should), this qualification becomes superfluous. In this case, income which is a “net quantity” is replaced by the corresponding “gross quantity”—viz., net income plus amortisation for fixed and working capital.

75 Compare Chapter 8, § 3, and this chapter, § 6, below.

76 Compare especially R. M. Bissel: “The Interest Rate” in American Economic Review, Supplement to Vol. XXVIII, 1938, pages 23 et seq.

77 This can be expressed in Keynesian terms by saying that the liquidity-preference schedule shifts, or that the liquidity preference of the community as a whole becomes weaker. Thè transaction motive to hold money has become stronger; but this is over-compensated by an opposite change in the speculative motive; M1 increases; M2 decreases. For details see Chapter 4, § 3.

78 This explains also the fact that sometimes increased borrowing by the State for unproductive purposes (e.g., armaments) makes the money and capital market more rather than less liquid.

79 There is, of course, no intention to assert that this has been completely overlooked. It is only suggested that the variability of MV has not been sufficiently stressed and that one of the disparities between business-cycle theory and general equilibrium theory seems to have its root here.

80 Statistical explorations in this field have recently been made by Professor J. W. Angell. See his book, The Behavior of Money, New York, 1936.

81 A reservation must be made regarding the fluctuations in stocks of consumers’ goods. There is no consumption corresponding to that part of the production of consumers’ goods which goes to stocks.

82 Strictly speaking, a whole scale of more or less optimistic anticipations should be distinguished, ranging from the expectation that the increase in demand is only temporary, via the expectation that it will be maintained to the expectation that it will go on rising at a constant or increasing rate. In other words, there are various ways in which an actual increase can be extrapolated into the future.

83 Cf. M. Kalecki: “The Principle of Increasing Risk” in Economica, 1937, page 440, reprinted in Essays in the Theory of Economic Fluctuations, London, 1939.

84 Consequently, if the supply of investible funds is perfectly elastic—i.e., if the rate of interest does not change—the increase in demand for consumers’ goods, and the resulting price rise, will spread throughout the whole structure of production, replacement demand in terms of money rising parallel with or even faster than the demand for the product. If consumers’ demand starts to rise from a given level, this will speedily induce a proportionate or more than proportionate rise in the total demand for goods in terms of money (including demand for intermediate goods and replacement demand). Since consumers’ demand is only a fraction of total demand, a given increase in consumers’ demand gives rise to a greater increase in total demand. In this sense, the acceleration principle can still be said to be in operation.

85 A word must be said on the concept of “forced saving”, which has been much misunderstood. If investments are financed by inflationary means—if, that is to say, the flow of money against goods increases—those who spend the new money attract for their purposes goods which would otherwise have accrued to somebody else. These other people, whose purchasing power in real terms (real income) is now reduced, because of the new entrants to the reservoir of goods, are said to be forced to save. Forced saving is inflicted upon them. If total demand for goods in terms of money had not gone up, prices would not have risen, or they would have fallen; and those members of society whose money income has not been changed by the inflation could have consumed more—i.e., their real income would have been greater.

This sounds quite unambiguous if we assume that (a) the magnitude of the total flow of goods (output) is not changed by the inflation and that (b) there are no secondary influences (apart from the addition in question) on the flow of money. If the latter condition does not hold, and there are secondary increases or decreases in the flow of money induced by the primary injection, the problem becomes more complicated; but it is still possible to apply to these secondary additions or reductions the same reasoning as to the first.

If, however, the magnitude of the total flow of goods is changed, the situation becomes more involved. Suppose, e.g., that the increase in the flow of money calls for an equal increase in the flow of goods—in other words, that supply is perfectly elastic and, when the demand for goods rises, production and supply rise equally, so that prices remain on the average unchanged. In this case, it is difficult to speak of forced saving or a forced levy on particular persons. In practice, however, perfect elasticity of supply is almost unthinkable, even at the bottom of the depression. In other words, the flow of goods will increase in a smaller proportion than the flow of money: some prices will be higher than they would have been without the inflationary increase in demand—that is to say, some prices will rise or be prevented from falling; and therefore forced saving will be inflicted upon some persons to some extent, although not necessarily to the extent indicated by the increase in the money stream.

86 It will be remembered that this assumption is not equivalent to a marginal propensity to save of zero in Mr. Keynes’ terminology, because Mr. Keynes does not allow for time-lags. (See Chapter 9, § 4, above.) One may, of course, use Mr. Keynes’ concept just as well, but one should not forget that these little time-lags for “technical” reasons are absolutely essential for a money economy, and that, in everyday language, when one speaks of zero-saving one automatically takes these time-lags for granted. The assumption that there are no such lags—the assumption, in other words, that the money was spent and respent instantaneously—would imply an infinite velocity of circulation of money, which would be tantamount to assuming away the use of money altogether and assuming instead a barter economy with a numéraire but without a medium of exchange (money).

87 This may, of course, also be expressed by saying that the average time-lag or average income velocity is likely to be changed by new additions to the income stream. It is not safe, therefore, to regard it as a comparatively stable magnitude

88 Washington, 1935, pages 87 and 88.

89 See, however, Chapter 8, § 3, pages 217 et seq, above.

90 E.g., Professor Pigou, in his review of Mr. Keynes’ General Theory of Employment, Interest and Money in Economica, May 1936, page 125.

91 Cf. C. Bresciani-Turroni, “The Theory of Saving” in Economica, Vol. Ill (New Series), 1936.

92 Compare Mr. Harrod’s treatment of the interactions of the acceleration principle (which he calls “the relation”) and the propensity to save (or “the multiplier”) in The Trade Cycle, London, 1936, Chapter 2.

93 On this, compare M. Breit: “Ein Beitrag zur Theorie des Geld- und Kapitalmarktes” in Zeitschrift für Nationalökonomie, Band VI, Heft 5, 1935 pages 632 et seq.

94 Cf. America’s Capacity to Consume, passim.

95 Writers on the subject have frequently used the term “secondary” deflation. Their attention has been concentrated mainly on the maladjustment which, they maintain, is the cause of the crisis. They conceive of the depression, not as a cumulative self-reinforcing process, but as a period of adaptation during which the economic system reverts to equilibrium and eliminates the maladjustments which have developed during the preceding upswing and have been brought to light in the crisis. The deflation is regarded as an unfortunate accident.

More recent writers have, however, come to realise increasingly that the above view is a misconception, that what it treats as an accidental phenomenon is in fact the most important element in the depression, that the deflation may continue long after the maladjustment by which it was started has been removed, that it may be started by purely monetary forces without anything being wrong with the structure of production, and that it does not revert directly to equilibrium, but, on the contrary, carries the economic system a long way away from equilibrium.

96 The spectacular events in the financial sphere which usually mark the turn from prosperity to depression should not be allowed to obscure the fact that the downward movement of production and trade usually takes time to get under way. This was, e.g., the case after the crisis of 1929. Cf. Slichter in Review of Economic Statistics, February 1937, on the 1929 down-turn. In the autumn of 1937, the fall in production and employment was much more rapid than in 1929, although there were no spectacular breakdowns in the financial sphere.

97 “Demand” in the sense of “actual demand” or “expenditure”, not in the sense of “demand schedule”.

98 It should be noted that this is not a tautological statement following from the definition of depression. We have defined the latter, not in monetary terms, not in terms of MV, but in terms of volume of production and employment. Logically, a decrease in employment and production may be accompanied by a rise instead of a fall in MV. This will imply a rapid rise in wages and prices. Something like that seems to have happened during the last phase of the German post-war inflation. But this is surely not the typical picture of a cyclical depression.

99 See Keynes: The General Theory of Employment, Interest and Money, pages 144 and 145. Mr. Breit (“Ein Beitrag zur Theorie des Geld-und Kapitalmarktes”, in Zeitschrift für Nationalökonomie, Band VI, Heft 5, page 654, footnote) describes five possible ways in which lender and borrower may anticipate the sharing between them of the risk involved in a given investment. Each may believe that he will have to bear the weight of the possible losses—in this case there is a double reckoning of risks. Both may regard the risk as falling on the creditor alone, or on the debtor alone. In either case there is a single reckoning of the risk. Each may regard the other as the risk-bearer, and in this case no allowance for risk is made by either party. Lastly, extremes may be avoided and a single reckoning achieved where both estimate that the risk will be shared in a given way between the two parties. Mr. Breit, however, believes that the first possibility, that of the double reckoning, is less unrealistic than the other possibilities. It might perhaps be added that the question of the sharing of risk between lender and borrower cannot be considered without reference to the wealth of the borrower, and also to the probable distribution of returns expected from the investment. If the risk consists in a considerable possibility of a small loss, there is more likelihood that the creditor will ignore the risk factor than if it consists in a slight possibility of a very large loss, which the borrower could not possibly make good. In the course of a deflation, the money value of the wealth of the debtor is likely to diminish, the entire probability curve of returns is reduced, and, in consequence, the range of possible losses which the debtor could not make good increases. The debtor finds that a greater part of risk consists, not in the danger of having to sell part of his property in order to pay his debt, but in having to go through bankruptcy courts. The creditor finds that he stands in greater danger of not being able to recover his money. In those circumstances there is a greater likelihood of a double-counting of the risk. A particular application of this principle occurs where the debt is secured on specific assets. The deflation reduces the amount of cover that borrowers can offer, and in consequence increases the risk premium they have to pay on their borrowings.

100 See Hayek: Prices and Production, 2nd ed., pages 118 et seq.

101 For an indication of the importance of the movement towards indirect investment through the holding of bank deposits, especially in Central-European countries since the inflation and in the United States of America since the war, and for a discussion of the consequences involved, see Commercial Banks 1925-1933, League of Nations, Geneva, 1934. Cf also Röpke: Crises and Cycles, pages 126 and 127.

102 J. M. Keynes: A Treatise on Money, Vol. I, pages 173 and 174; Durbin: The Problem of Credit Policy, pages 95 et seq.

103 This was pointed out by Professor F. A. Hayek: “Reflections on the Pure Theory of Money of Mr. J. M. Keynes”. Part II in Economica, February 1932, page 29.

104 There may be in this respect a slight difference between the case envisaged by Mr. Keynes and Mr. Durbin (where an increase in the rate of saving is the cause of the losses) and the other case (where the losses nave other causes). In the former case, it might be argued that the path which the money has to travel from the moment when it becomes income in the hands of the saver until it constitutes demand for goods is lengthened, inasmuch as, before people decide to save, the money is spent by them directly for consumers’ goods. After they have decided to save, it goes first through the capital market buying old securities before it reaches the hands of the producers of consumption goods. Its arrival at the final stage may be delayed en route—which is equivalent to a hold-up in the flow of money against goods. In the other case, where the losses are independent from the fact that somebody saves who has not saved before, no turnover of money is interpolated, since the sums saved have in any case to pass through the capital market before being spent on real goods. Whether they buy old securities and cover losses or new securities and finance new investment, they reach the commodity market at the same time.

It is unlikely, however, that this difference is of much practical importance.

105 Cf. J. M. Keynes: The General Theory of Employment, Interest and Money and the various comments which this book has evoked, especially from Professor J. Viner, “Mr. Keynes on the Causes of Unemployment. A Review”, in Quarterly Journal of Economics, Vol. 51, October 1936, pages 147-168 passim.

106 Cf., e.g., Professor J. R. Hicks: “Gleichgewicht und Konjunktur” in Zeitschrift für Nationalökonomie, Vol. IV, 1933, page 441.

107 Cf. E. F. M. Durbin: The Problem of Credit Policy (1935), page 106.

108 Compare § 5 of this chapter and §§ 17-24 of Chapter 3.

109 Assuming some arbitrary line of separation so that, e.g., an apartment-house or an automobile is held to be a consumers’ good and an electrical power plant a producers’ good.

110 There is furthermore this difference. If there are large stocks of transient goods—say sugar or coal—they can be “forced” upon the consumers and into consumption and thus eliminated from the market by price-cutting. Nothing of this sort can be done with durable goods. A machine or a house cannot be made to give up all its services in a short time, even if its price (or the price of its services) is reduced to zero. Sales of machines or houses can, of course, be hastened by lowering their price. But that does not eliminate them; they are still there, and their very existence restricts the demand for similar goods. It is only by selling them and using them up for scrap that they can be eliminated outright. But this could only happen when their price had fallen so low that reproduction, not to speak of adding to capacity, was out of the question It is, of course, another question whether a general reduction in prices could not revive production and investment all around. We are, however, here concerned with another problem: Why is it that, given a decline in production and activity in general, the production of durable goods and producers’ goods declines more than the production of transient and consumers’ goods?

111 If applied to producers’ goods, the argument is more plausible and does not really differ from what has been already said. It is frequently possible within a certain range to vary the methods of production. In particular, more or less durable, and more or less up-to-date, machinery can be used. But as soon as it is durable, expectations as to the future development of, demand for, and prices of, the product become relevant; and, if these expectations are pessimistic, machinery will not be installed or replaced, even though it may be profitable on the basis of the present cost and output situation—that is, assuming that the present level of output and prices will persist. Producers will “do without”—that is to say, they will work existing equipment beyond the “optimum” point (optimum, of course, only from the longer-run point of view). It is obviously in most cases impossible to vary in this way the requirements for working capital, nor is there the same motive for doing so.

112 Cf. above, § 5 of this chapter.

113 Professor J. R. Hicks has tried to systematise the various possible reactions. He introduced the concept “elasticity of expectations” which he defines “as the ratio of the proportional rise in expected future prices . . . to the proportional rise in (the) current price”. Thus the elasticity of expectations is unity, if a change in current prices will change expected prices in the same direction and proportion. (Cf. Value and Capital, Oxford, 1939, page 205.) He also expresses the cumulative nature of processes of change in terms of elasticities of expectations. As was also shown at various points earlier in this chapter, changes give rise to cumulative processes, if expectations move in the same direction as the current price—that is to say, if the elasticity of expectation is at least unity. (Cf. Hicks, loc. ext., pages 251-252).

114 It is sufficient if this is the case in the majority of industries. Occasional exceptions would not alter the result.

115 This description of the dependence of consumers’ purchasing power, and through it of the activity in consumption industries, on investment is analytically somewhat different from the use of the “Multiplier” concept by Kahn, Keynes and Harrod. But, substantially, the same thing is referred to in both cases, and it can be said that the idea of the multiplier is more or less explicitly implied in any description of the “Wicksellian process”.

116 How long this process will last before it is finally brought to an end will be discussed below in Chapter 11, section B.

• 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.
• 5This 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.
• 6Trade and Credit, London, 1928, page 98.
• 7Currency and Credit, 3rd ed., London, 1928, page 153.
• 81913, page 186.
• 9For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
• 10Monetary Reconstruction, 2nd ed., London, 1926, page 135.
• 11Op. cit., page 171.
• 12The Lessons of Monetary Experience, page 131.
• 13See his paper “Money and Index-Numbers” in Journal of the Royal Statistical Society, 1930, reprinted in The Art of Central Banking, pages 303-332.
• 14It has been questioned whether this process of saving and investment runs smoothly. A great number of writers believe that the process of saving is likely to produce serious disturbances (a) because saving produces depression in the consumption industries which then spreads to the higher stages, (b) because money which is saved frequently disappears on the way and is not invested (deflation), (c) because increased investments eventually bring about an increase in the production of consumers’ goods, which cannot be sold at the prevailing prices unless the flow of money is increased. But it is not with these alleged frictions and disturbances that we are here concerned. They will have to be discussed at a later stage of our enquiry. The theorists now under review believe that ordinarily the process of saving and investment runs smoothly. According to them, troubles arise only if voluntary saving is supplemented from “inflationary sources”, that is, by new bank credit or by expenditure from money hoards (which is equivalent to by a rise in the velocity of circulation of money).
• 15Cf. his Trade Depression and the Way Out, 2nd ed., pages 29-31 and 133-135, Capital and Employment, pages 85-87, “A Credit Deadlock”; and his contribution to The Lessons of Monetary Experience (edited by A. D. Gayer), “The Credit Deadlock”, pages 129-145.
• 16The concept “forced saving” has a long history (cf. F. A. HAYEK, “A Note on the Development of the Doctrine of Forced Saving” in Quarterly Journal of Economics, Vol. 47, page 123). In addition to the writers of the present group, Professor Schumpeter has given it a prominent place in his account of the upward phase of the cycle. (See his Theory of Economic Development, English translation from the last German edition, 1934. First German edition, 1911.) Unlike the monetary over-investment theorists, however, he does not use the alleged peculiarities of forced saving to explain the crisis. This point will be taken up later (cf. Ch. 5, § 3). Recently the doctrine of forced saving has been attacked by Mr. Keynes (The General Theory of Employment, Interest and Money, pages 79-81, 183). But, as Professor Robertson has pointed out (cf. “Some Notes on Mr. Keynes’ General Theory of Employment” in Quarterly Journal of Economics, Vol. 51, 1936, page 178), Mr. Keynes’ objections are purely verbal. He banishes the word, but is forced to recognise the thing which the word denotes, though in another dress, when he says that, under the pressure of investment which is imperfectly foreseen, there may occur a “temporary reduction of the marginal propensity to consume” (loc. cit., pages 123 and 124).
• 17Kapital und Produktion, Vienna, 1934, page 195, and “Die Produktion unter dem Einfluss einer Kreditexpansion”, in Schriften des Vereins für Sozialpolitik, Vol. 173, 1928.
• 18Banking Policy and the Price Level, 1932 ed., page 48.
• 19See F. Vito: “Il Risparmio forzato e la teoria di cicli economici” in Revista internazionale di scienze sociali, 1934, and “Die Bedeutung des Zwang-sparens für die Konjunkturtheorie” in Beiträge zur Konjunkturlehre, 1936.
• 20Currency and Credit, 3rd ed., page 155.
• 21Since the appearance of the first edition of this book, a very lucid analysis, also in “real” terms but much more elaborate than the above, has come to the author’s notice: Autour de la crise américaine de 1907, ou Capitaux-réels et Capitaux-apparents, by Marcel Labordère (enlarged reprint from the Revue de Paris of February 1st, 1908), Paris, 1908. This important study has been entirely overlooked by the whole literature on the subject.
• 22See below Ch. 3, §§ 8,16, and Part II, Ch. 11.
• 23Such an over-narrow interpretation of the “Austrian” theory seems to be implied in Professor D. H. Robertson’s article: “Industrial Fluctuations and the Natural Rate of Interest” in Economic Journal, Vol. 44, 1934, Page 653.
• 24A. H. Hansen and H. Tout, in “Investment and Saving in Business Cycle Theory,” Econometrica, April 1933, have pointed out the underlying assumptions.
• 25This qualification is necessary, because there are other facts which influence the proportion mentioned in the text. If, for example, two or more successive stages of production are merged and run by a single firm instead of by two independent firms, the transfer of the intermediate goods from the former to the latter will from that time on be accomplished without the help of money. The amount of money required in the business sphere is reduced by such an act of integration.
• 26HAYEK: Prices and Production, 2nd ed., London, 1934, page 57.
• 27In so far as entrepreneurs repay loans to the banks, they find themselves in possession of a real surplus, since their obligations have remained unchanged, while their receipts, etc., have risen owing to the rise in prices. This surplus may, and probably will, to a certain extent be utilised for increased consumption. Professor Robertson has drawn attention to this consideration: see his Banking Policy and the Price Level, 2nd ed., London, 1932, page 73. A further factor which operates in the direction of increasing demand for consumers’ goods is the fact that, with rising prices, the consuming public is likely to dishoard and “to hurry on with the purchase of goods (such as clothes and motor-cars) of which the exact moment of purchase can be varied within pretty wide limits” (Robertson, op. cit., page 75).
• 28If competition in the labour market and the mobility of labour are imperfect, the condition of full employment can, of course, be relaxed.
• 29The durable means of production constructed during the upswing outlast, of course, the boom. But the contention is that they are lost economically. They are not used at all or axe used in such a way that their marginal product does not cover the cost of reproduction. It should, however, be noted that important qualifications are called for in respect of permanent goods or instruments where the cost of maintenance is negligible compared with production cost.
• 30The fact that the production of consumers’ goods can be expanded only at the expense of a reduction in the production of producers’ goods and vice versa does not, of course, hold if there are idle factors of production available. Furthermore, it does not preclude the possibility that, besides this physical connection between the production of the two categories of goods, there may be connections of another nature—e.g., an increase in the production of consumers’ goods may tend to stimulate the production of producers’ goods, as postulated by the “acceleration principle” (see below, § 17 et seq. of this chapter), or there may be a causal connection in the opposite direction as postulated by the so-called “multiplier” (see below, passim).
• 312nd ed., pages 55 et seq.
• 32Ibid., page 57.
• 33Hayek: “Capital and Industrial Fluctuations” in Econometrica, Vol. II, April 1934, page 161. Reprinted as Appendix to 2nd ed. of Prices and Production. See also E. F. M. Durbin: Purchasing Power and Trade Depression, London, 1933, pages 153-155. The latter concludes that the crisis is a purely monetary phenomenon, brought about by the refusal of the banks to continue the expansion of credit.
• 34Cf. C. Bresciani-Turroni, “The Theory of Saving” in Economica, 1936, pages 165 et seq.
• 35See especially L. Robbins: The Great Depression, London, 1934.
• 36See: Crises and Cycles, London, 1936 (translated from the German). “Geldtheorie und Weltkrise” in Deutscher Volkswirt of September 25th, 1931. “Praktische Konjunkturpolitik” in Weltwirtschaftliches Archiv, 34. Band, 1931. “Trends in German Business Cycle Policy” in Economic Journal, September 1933.
• 37Kapital und Produktion, Vienna, 1934, pages 208 et seq.
• 38See especially L. Robbins: The Great Depression, London, 1934.
• 39On this subject, compare M. W. Holtrop: De Omloopssnelheid van het geld, Amsterdam, 1928, and “Die Umlaufsgeschwindigkeit des Geldes” in Beiträge zur Geldtheorie, ed. by Hayek, Vienna, 1933, pages 115-211. Compare further J.Marschak: “Volksvermögen und Kassenbedarf” in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 68, 1932, pages 385-419, and “Vom Grössensystem der Geldwirtschaft,” loc. cit., Vol. 69, 1933, pages 492-504. H. Neisser: Der Tauschwert des Geldes, Jena, 1928. “Der Kreislauf des Geldes” in Weltwirtschaftliches Archiv, 1931, Vol. 33, pages 365-408. “Volksvermögen und Kassenbedarf “in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 69, 1933, pages 484-492. A. W. Marget: “A Further Note on Holtrop’s Formula for the ‘Coefficient of Differentiation’ and Related Concepts” in Journal of Political Economy, Vol. 41, pages 237-241 and “The Relation between the Velocity of Circulation of Money and the Velocity of Circulation of Goods”, loc. cit., Vol. 40, 1932, pages 289-313 and 477-512. J. Schumpeter: “Das Sozialprodukt und die Rechenpfennige” in Archiv für Sozialwissenschaft u. Sozialpolitik, Vol. 44, pages 627-715. The whole literature on this subject is well reviewed and summarised by Professor H. S. Ellis, German Monetary Theory 1905-1933 (Cambridge, Mass., 1934), Part II, and by A. W. Marget, The Theory of Prices. A Re-examination of the Central Problems of Monetary Theory, Vol. I, New York, 1938, passim.
• 40Hayek, op. cit., pages 160 and 161.
• 41Strigl, op. cit., Anhang I. It may be added that, owing to the existence of the various reserves which will have been accumulated during the depression, the expansion can go far with little or no help from the banks.
• 42See, however, Bresciani-Turroni, “The Theory of Saving” in Economica, May 1936, pages 172-174.
• 43Compare Professor H. Neisser’s criticism in his article: “Notenbankfreiheit?” in Weltwirtschaftliches Archiv, Vol. 32, pages 446-461, and Vera Smith, The Rationale of Central Banking, London, 1936.
• 44See his book, Börsenkredit Industriekredit und Kapitalbildung, Vienna, 1931, pages 161-178.
• 45Whilst there can be little doubt that we have here a possible source of inflation (whatever its quantitative importance), it is difficult to see in this factor any independent cyclical significance.
• 46The following statement of a prominent adherent of the monetary over-investment theory is significant: “This theory does not make the pretence of being the only explanation of all cycles and crises that have ever occurred, nor does it pretend that it states unconditional necessities” (F. Machlup, “Professor Knight and the ‘Period of Production’” in Journal of Political Economy, Vol. 43, October 1935, page 622.
• 47Therefore, the statement made in the text is perfectly compatible with the free-trade argument. The qualifications made should be sufficient to exclude protectionist measures from the arsenal of a rational depression policy.
• 48See, in particular: Keynes: A Treatise on Money, London, 1930. Robertson: Banking Policy and the Price Level, and the controversy in Economic Journal of the following dates: Robertson, “Mr. Keynes’ Theory of Money”, September 1931; Keynes, “A Rejoinder to Mr. Robertson”, September 1931; Robertson, ‘‘Saving and Hoarding”, September 1933, and three notes on “Saving and Hoarding”, by Keynes, Hawtrey and Robertson, December 1933.
• 49No attempt has been made to establish priorities or to trace the various lines of thought to their historical origins.
• 50See especially R. Nurkse: Internationale Kapitalbewegungen, Vienna, 1935. Ch. V, pages 187-211.
• 51Cf. Durbin: The Problem of Credit Policy, 1935; Bresciani-Turroni, “The Theory of Saving” in Economica, May 1936, pages 175 and 176.
• 52In the earlier versions of the theory, the assumption was made, more or less explicitly, that the discrepancy between the equilibrium rate and money rate of interest is always brought about by a lowering of the money rate—that is, from the supply side. It is now pretty generally accepted that the situation is more complex and that the equilibrium rate is likely to move upward under the influence of psychological forces, price changes, inventions and discoveries, etc.
• 53See “Vorbemerkungen zu einer Theorie der Ueberproduktion” in Jahrbuch für Gesetzgebung, Verwaltung und Volkswirtschaft, 1902. “Krisen” in Handwörterbuch der Staatswissenschaften, 1925.
• 54Professor Hayek in particular has laid down the methodological rule that the analysis of the cyclical movement should never start on the assumption of existing unemployment, because that would beg the question of why unemployment can exist at all. This postulate would seem to narrow down unduly and quite unnecessarily the scope of such analyses.
• 55See, e.g., The Downfall of the Gold Standard, Oxford, 1936. Like Mr. Hawtrey, he believes that “the economic development of post-war times has been so strikingly dominated by great monetary disturbances that trade cycles of the earlier kind are no longer applicable” (The Theory of Social Economy, Vol. II, page 538).
• 56Geldwertstabilisierung und Konjunkturpolitik, Jena, 1928, pages 56-61.
• 57G. Cassel: The Theory of Social Economy, revised ed., London, 1932, page 552.
• 58We need not go into the causes which give a country an advantage in the production of this or that type of goods. They range from climatic conditions and the quality of the soil to the structure of the tariff and social legislation. Cf. B. Ohlin, Interregional and International Trade, passim, Cambridge, Mass. (U.S.A.), 1933.
• 59The 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.
• 60It 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.
• 61With 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).
• 62One 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.
• 63The 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).
• 64“If the restriction of credit did not occur, the active phase of the trade cycle could be indefinitely prolonged, at the cost, no doubt, of an indefinite rise of prices and an abandonment of the gold standard.”
• 65The process of contraction is cumulative no less than the process of expansion. “When credit has definitely turned the corner, and a contraction has succeeded to an expansion, the downward tendency of prices is sufficient to maintain the process of contraction, even though the rate of interest is no longer, according to the ordinary standards, high.”
• 66In his earlier writings Mr. HAWTREY had already mentioned the theoretical possibility of a complete credit deadlock arising. That is a situation where even exceedingly low interest rates fail to evoke a new demand for credit. In such a situation, the ordinary means of bank policy prove wholly ineffective. In his Good and Bad Trade he ascribes this phenomenon to the fact that “the rate of depreciation of prices” may be so rapid that “nothing that the bankers can do will make borrowing sufficiently attractive” to lead to a revival in the flow of money.
• 67One 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.
• 68But even so, Mr. HAWTREY thinks, the recurrence of the breakdown is not inevitable. The expansion could go on indefinitely, if there were no limits to the increase in the quantity of money. The gold standard is, in the last resort, responsible for the recurrence of economic breakdowns. Under the gold standard, it is the slow response of people’s cash balances which prevents the banks from stopping expansion or contraction in time. “If an increase or decrease of credit money promptly brought with it a proportionate increase or decrease in the demand for cash, the banks would no longer either drift into a state of inflation or be led to carry the corresponding process of contraction unnecessarily far.” Given, however, this slow response of the people’s cash balances, “so long as credit is regulated with reference to reserve proportions, the trade cycle is bound to recur”.
• 69“Thus there is a principle of the instability of velocity of circulation, which is quite distinct from the principle of the instability of credit, but is very apt to aggravate its effect.”
• 70In more recent publications, under the impression of the slump of the nineteen-thirties, Mr. HAWTREY has modified his views to some extent. He now doubts whether it can be legitimately assumed that “the expectation of falling prices is (always) the result of a preceding experience of a prolonged actual fall” and that such a condition of stagnation is not possible except in the course of a reaction from a riot of inflation.
• 71To complete the picture of Mr. HAWTREY’S theory, a word must be said as to the policy banks should pursue in order to eliminate the credit cycle, and with it the trade cycle. The banks, and especially the leaders of the banking system, the central banks, should not watch the reserve proportions so much as the flow of purchasing power. The demand for goods, the flow of money, is the important thing—not the outstanding aggregate of money units. The aim of banking policy should be to keep the consumer’s outlay constant, including (as has been pointed out) outlay for new investment. But account should be taken of changes in the factors of production—not merely the growth of population, but also the growth of capital—and allowance ought to be made for the proportion of skilled labour of varying grades and for the appropriate amount of economic rent. In other words, the aim should be to stabilise, not the price level of commodities, but the price level of the factors of production.
• 72If the rate of interest falls because of increased savings, the demand for capital can be satisfied to a greater extent and the equilibrium point moves down along the curve of demand for capital. Investments which were extra-marginal under the higher rate now become permissible. Factors of production are shifted from the lower to the higher stages of production. The production process is lengthened and eventually the output of consumers’ goods per unit of input (in terms of “original factors” of production) is raised.
• 73In more recent publications, under the impression of the slump of the nineteen-thirties, Mr. HAWTREY has modified his views to some extent. He now doubts whether it can be legitimately assumed that “the expectation of falling prices is (always) the result of a preceding experience of a prolonged actual fall” and that such a condition of stagnation is not possible except in the course of a reaction from a riot of inflation.
• 74This comes about in the following way. Entrepreneurs who want to invest are provided with purchasing power by the banks and compete for capital goods and labour. Prices will rise or be prevented from falling—this last case we shall discuss in detail later—and consumers’ goods industries (the demand for the pro-duct of which has not risen, or not risen so much as the demand for capital goods, which is swollen by the newly created purchasing power) will be unable to retain at the enhanced prices all the factors of production which they used to employ. They will be compelled, therefore, to release means of production for use in the higher stages of production—that is, for the production of additional capital goods.
• 75Treatment of these theories is complicated by the fact that there is as yet no agreement as to the exact use of the expression “forced saving”. It has been used to indicate the extra saving created by the transfer of resources and incomes from creditor to debtor, from rentier to State, from wage-earner (at least temporarily) to employer, as the result of inflation. Professor STRIGL has objected to this theory of forced saving that, if those with relatively fixed incomes get less and are obliged to restrict consumption, others expand their incomes to a corresponding amount and, unless they refrain voluntarily from expanding consumption to the required extent, there cannot be a net increase in capital formation. In other words, there is no forced saving, but only ordinary, voluntary saving.
• 76Apart, however, from the increase of saving as a result of what Professor PIGOU styles a “doctoring of past contracts”, there is a more direct channel whereby additional bank credits may increase investment. This is the process which Professor ROBERTSON discusses at length in Banking Policy and the Price Level under the head of “Automatic Stinting”. Either dishoarding or the expenditure of newly created money, he says, “brings on to the market an additional daily stream of money which competes with the main daily stream of money for the daily stream of marketable goods, secures a part of the latter for those from whom the additional stream of money flows, and thus deprives the residue of the public of consumption which they would otherwise have enjoyed”. As PIGOU argues in the particular case of the expansion of bank credits: “What in substance has happened is that the bankers have transferred to business-men purchasing power and, through purchasing power, real stuff in the form of wage goods and so on, formerly belonging to other people. They have done this by giving new money titles to business-men while leaving the money titles in other people’s hands untouched in exactly the same way as they would have done had they taken money titles from other people and handed them to business-men.”
• 77Professor Francesco VITO uses the expression “forced savings” for what is usually called “corporate saving”. If a business firm or company fails to distribute its entire profits to the shareholders, this may mean that the latter have been “forced” to save (against their will) by the directors of the corporation. Professor VITO believes that this type of forced saving is likely to cause the same troubles as the type envisaged by Professor HAYEK.
• 78Under the automatic working of the gold standard, “the length of the cycle was determined by the rate of progress of the processes on which the cycle depended, the absorption of currency during the period of expansion and its return during the period of contraction”.
• 79But suppose it had become impossible to carry through this ambitious plan. Suppose the Government had come to the conclusion half-way that the population could not stand the enormous strain and had decided to change the policy. In such a case, they would have been forced to give up the newly started roundabout methods of production and produce consumers’ goods as quickly as possible. They would have had to interrupt the construction of power-plants, steel works and tractor factories and try instead to produce as quickly as possible simple implements and tools to increase the output of food and shoes and houses. That would have involved an enormous loss of capital, sunk in the abandoned construction works.
• 80With the purely monetary explanation of the business cycle, it is comparatively easy to account for various kinds of international complications. The analysis of any given international constellation involving two or more countries must invariably turn on the question of how the money supply in each of these countries is likely to be affected. This analysis has not yet been worked out systematically from the standpoint of the explanation of the business cycle. But the instruments of the analysis are ready to hand. The theory of the international money mechanism under different monetary standards is one of the most fully elaborated chapters of economic science.
• 81Furthermore, it can be shown that a mere stoppage of expansion without actual contraction is very likely to lead to serious trouble. The process of expansion and investment involves the banking system in heavy commitments for the future, not in the legal but in the economic sense. The newly started roundabout methods of production can be completed only if a flow of capital is available over a considerable period. If this flow is not forthcoming, the completion of the new schemes is impossible. This must not be interpreted in too narrow a sense. What is meant is not merely that the construction of an indivisible piece of investment, a railway line or a power-plant or a new Cunarder, may have to be interrupted. A much more important case is where a higher stage in the structure of production has been so much developed that it can work with full capacity only if the lower stages are adding to their equipment. If the steel industry, for example, has been developed to satisfy the needs of a rapid expansion in the building or automobile industry, it may suffer a contraction as soon as the building or automobile industry—without actually contracting—stops expanding and no longer adds to its equipment. This proposition will be discussed in greater detail in connection with the so-called “acceleration principle”. It explains or helps to explain why the transition from expansion to a stationary state is so difficult.
• 82It sounds perhaps paradoxical that a general increase in demand for consumers’ goods should have an adverse influence on the production of capital goods in general, which derive their economic value from the consumers’ goods which they help to produce. The paradox has puzzled many writers, but it is not difficult to explain. It should be borne in mind in the first place that the proposition holds good only if all factors of production are reasonably well employed or if at least some of the factors attracted to consumers’ goods trades would otherwise have been employed elsewhere. In other words, under full employment, the production of consumers’ good or that of producers’ goods are alternatives. At the end of the boom, the condition of reasonably full employment can as a rule be assumed to be true. Secondly, it is assumed that the demand for consumers’ goods rises relatively to the demand for producers’ goods. This second assumption excludes the possibility of a compensatory expansion of credit, since, if credit for the purpose of acquiring producers’ goods could be expanded pari passu with the increased demand for consumers’ goods, it would no longer be true that the proportion between demand for consumers’ goods and producers’ goods has changed. The change involves a rise in interest rates; for prosperity in consumers’ goods industries holds out good prospects of profits in the higher stages of production. Producers in the higher stages of production will be eager to continue lengthening the productive structure and will try to raise the necessary funds by borrowing from the banks. Demand for credit rises; but supply is unchanged, or not sufficiently changed—for it is assumed that credit ceases to expand, or does not expand sufficiently. This entails a rise in interest rates; and such a rise, as Professor HAYEK has shown, falls more heavily on production costs in the higher than in the lower stages of production. The situation is now, therefore, that money cost has risen, but demand has not risen (or not sufficiently risen), because the necessary funds are no longer forthcoming.
• 83The whole stream of money or flow of purchasing power—that is, the demand for goods in terms of money per unit of time—is at any given point of time divided between producers’ goods and consumers’ goods. Since the productive process is split up into numerous successive stages—or, in other words, since the original factors of production (whatever that may mean) have to undergo numerous successive transformations before they are ready for final consumption—the money volume of transactions in producers’ goods per unit of time is a multiple of transactions in consumers’ goods. Much more money is spent per unit of time on producers’ goods in all stages than on consumers’ goods. If a part of income is saved and invested, ceteris paribus the proportion between the demand for consumers’ goods and the demand for producers’ goods is modified in favour of the latter; and it must be permanently modified because, by the act of saving, the stock of capital, as well as the volume of transactions in capital goods, has been permanently increased.
• 84An analogous change in the proportion between money spent for consumers’ and producers’ goods may be induced by injections of bank credits for production purposes. But in that case, in contradistinction to the case of voluntary saving, there is a strong probability that individuals will tend to restore the old proportion. “Now, the sacrifice is not voluntary and is not made by those who will reap the benefit from the new investments. It is made by consumers in general who, because of the increased competition from the entrepreneurs who have received the additional money, are forced to forgo part of what they used to consume. . . There can be no doubt that, if their money receipts should rise again, they would immediately attempt to expand consumption to the usual proportion.” And receipts will rise sooner or later, for the new money is spent partly to hire labourers, partly to buy capital goods of all sorts; and in both cases the money, partly at once, partly after a while, becomes additional income in the hands of the owners of the factors of production.
• 85There is another factor which tends to swell the demand for consumers’ goods. Bookkeeping is more or less based on the assumption of a constant value of money. Periods of major inflations have shown that this tradition is very deeply rooted and that long and disagreeable experiences are necessary to change the habit. One of the consequences is that durable means of production—such as machines and factory buildings—figure in cost accounts at the actual cost of acquisition, and are written off on that basis. If prices rise, this procedure is illegitimate. The enhanced replacement cost should be substituted for the original cost of acquisition. This, however, is not done, or is done only to an insufficient extent and only after prices have risen considerably. The consequence is that too little is written off, paper profits appear, and the entrepreneur is tempted to increase his consumption. Capital in such case is treated as income. In other words, consumption exceeds current production.
• 86It sounds perhaps paradoxical that a general increase in demand for consumers’ goods should have an adverse influence on the production of capital goods in general, which derive their economic value from the consumers’ goods which they help to produce. The paradox has puzzled many writers, but it is not difficult to explain. It should be borne in mind in the first place that the proposition holds good only if all factors of production are reasonably well employed or if at least some of the factors attracted to consumers’ goods trades would otherwise have been employed elsewhere. In other words, under full employment, the production of consumers’ good or that of producers’ goods are alternatives. At the end of the boom, the condition of reasonably full employment can as a rule be assumed to be true. Secondly, it is assumed that the demand for consumers’ goods rises relatively to the demand for producers’ goods. This second assumption excludes the possibility of a compensatory expansion of credit, since, if credit for the purpose of acquiring producers’ goods could be expanded pari passu with the increased demand for consumers’ goods, it would no longer be true that the proportion between demand for consumers’ goods and producers’ goods has changed. The change involves a rise in interest rates; for prosperity in consumers’ goods industries holds out good prospects of profits in the higher stages of production. Producers in the higher stages of production will be eager to continue lengthening the productive structure and will try to raise the necessary funds by borrowing from the banks. Demand for credit rises; but supply is unchanged, or not sufficiently changed—for it is assumed that credit ceases to expand, or does not expand sufficiently. This entails a rise in interest rates; and such a rise, as Professor HAYEK has shown, falls more heavily on production costs in the higher than in the lower stages of production. The situation is now, therefore, that money cost has risen, but demand has not risen (or not sufficiently risen), because the necessary funds are no longer forthcoming.
• 87If this cannot be achieved—and the chances that it will be achieved are almost nil—the new extensions to the structure of production are doomed to collapse. With some slight exceptions which are introduced as after-thoughts and treated as theoretical curiosities of no practical importance, the authors of the monetary over-investment school conclude that every credit expansion must lead to over-investment and to a breakdown. It is asserted over and over again with great emphasis that it is impossible to bring about a lasting increase in the capital stock of society as a whole by means of forced saving and that no permanent extension of the structure of production can be accomplished with the help of an inflationary credit expansion. What is thus built up during the upswing will inevitably be destroyed in the breakdown.
• 88It sounds perhaps paradoxical that a general increase in demand for consumers’ goods should have an adverse influence on the production of capital goods in general, which derive their economic value from the consumers’ goods which they help to produce. The paradox has puzzled many writers, but it is not difficult to explain. It should be borne in mind in the first place that the proposition holds good only if all factors of production are reasonably well employed or if at least some of the factors attracted to consumers’ goods trades would otherwise have been employed elsewhere. In other words, under full employment, the production of consumers’ good or that of producers’ goods are alternatives. At the end of the boom, the condition of reasonably full employment can as a rule be assumed to be true. Secondly, it is assumed that the demand for consumers’ goods rises relatively to the demand for producers’ goods. This second assumption excludes the possibility of a compensatory expansion of credit, since, if credit for the purpose of acquiring producers’ goods could be expanded pari passu with the increased demand for consumers’ goods, it would no longer be true that the proportion between demand for consumers’ goods and producers’ goods has changed. The change involves a rise in interest rates; for prosperity in consumers’ goods industries holds out good prospects of profits in the higher stages of production. Producers in the higher stages of production will be eager to continue lengthening the productive structure and will try to raise the necessary funds by borrowing from the banks. Demand for credit rises; but supply is unchanged, or not sufficiently changed—for it is assumed that credit ceases to expand, or does not expand sufficiently. This entails a rise in interest rates; and such a rise, as Professor HAYEK has shown, falls more heavily on production costs in the higher than in the lower stages of production. The situation is now, therefore, that money cost has risen, but demand has not risen (or not sufficiently risen), because the necessary funds are no longer forthcoming.
• 89In his Prices and Production, Professor HAYEK argues that, even where the extension of the structure of production which entrepreneurs were induced to undertake by the artificial cheapening of credit is completed, the old arrangement tends to be restored later on for the reason that consumers will “attempt to expand consumption to the usual proportion” and “the money stream will be re-distributed between consumptive and productive uses” in the same, or nearly the same, proportion as it was distributed before such proportion was artificially distorted from the normal by the injection of money.
• 90In his Prices and Production, Professor HAYEK argues that, even where the extension of the structure of production which entrepreneurs were induced to undertake by the artificial cheapening of credit is completed, the old arrangement tends to be restored later on for the reason that consumers will “attempt to expand consumption to the usual proportion” and “the money stream will be re-distributed between consumptive and productive uses” in the same, or nearly the same, proportion as it was distributed before such proportion was artificially distorted from the normal by the injection of money.
• 91It is evident that no collapse would occur if the credit expansion could go on indefinitely. It follows—the point is made by Professor HAYEK himself—that a crisis is equally inevitable in the case of voluntary saving if the flow of saving is suddenly reduced. It is, however, asserted—although the reasons given are not always quite convincing—that sudden changes are not likely to occur in respect of voluntary saving, while forced saving must come to an end abruptly. It is therefore very important to ask why should the expansion of credit stop. The answer is that in a closed economy, leaving out of account purely monetary and institutional factors (inability of the banking system to continue expansion within the limits fixed by the gold standard or some other legal or customary rules), the continuance of the expansion will involve a progressive rise in prices. A progressive rise in prices and the danger of a complete collapse of the monetary system is the only insurmountable barrier which prevents an indefinite continuation of the expansion.
• 92In any case, the theory in its fully developed form seems to make the emergence of a serious disequilibrium dependent upon relatively small fluctuations in the rate of forced saving. This being so, the question arises whether fluctuations of this order of magnitude are not equally likely to occur in the flow of voluntary savings. If they do occur, evil consequences must be expected, even in the absence of credit inflation. (We shall see, in connection with the discussion of other theories, that there are numerous other disturbances possible which may interrupt the upswing and start a vicious spiral downward—disturbances which are probably of the same, or even of a higher, order of magnitude than the fluctuations in the rate of forced or voluntary saving discussed above.)
• 93The theory of the depression is not nearly so fully elaborated by the authors of the monetary over-investment school as the theory of the boom. The depression was originally conceived of by them as a process of adjustment of the structure of production, and was explained in non-monetary terms. During the boom, they argued, the process of production is unduly elongated. This elongation has accordingly to be removed and the structure of production has to be shortened or, alternatively, expenditure on consumers’ goods must be reduced (by retrenchment of wages and other incomes which are likely to be spent wholly or mainly on consumers’ goods) sufficiently to make the new structure of production possible. This involves a lengthy and painful process of rearrangement. Workers are thrown out of work in the higher stages, and it takes time to absorb them in the lower stages of production. In modern times especially, with inflexible wage systems and the various other obstructions represented by all kinds of State intervention, this process of shifting labour and other means of production is drawn out much longer than is necessary for purely technological reasons.
• 94(a)   Professor RÖPKE has studied the question in various publications and has come to the conclusion that the process of deflation has a tendency to become cumulative and self-perpetuating. Genetically, it is true, it is connected with the extravagances of the preceding boom and the real maladjustment which the boom has produced. But the intensity of the deflation by no means necessarily corresponds to the extent of the over-investment. It is also untrue, he believes, that the deflation contributes (as is more or less vaguely suggested by the other authors of the monetary over-investment school) to bringing about the necessary adjustment (shortening) in the process of production. Once started, the deflation is propelled by its own momentum and by a number of institutional factors. What these factors are and how they work, we shall discuss at greater length in another connection. HAWTREY, KEYNES, PIGOU and ROBERTSON have contributed most towards the understanding of this phenomenon.
• 95The most coherent theory of the depression along these lines is that of Professor STRIGL. He admits that the breakdown of the boom induces a process of hoarding and deflation. After the breakdown of the boom, the banks will not merely stop expansion: they will contract credit in order to increase their liquidity. Under the influence of the general feeling of insecurity and pessimism, industrial firms will also seek to strengthen their cash reserves, and amortisation quotas will be kept in liquid form instead of being invested. This general struggle for liquidity involves hoarding. It means that money, whose function it is to be the vehicle of investment of real capital, fails to fulfil this function and is sterilised for the time being in swollen cash reserves or, in the case of bank money (deposits), annihilated altogether. The general price fall which ensues operates as a further deterrent to investment. The profit rate falls below the money rate. Perhaps the most important external symptom of this process is the intense liquidity and the extremely low rates on the money market which develop during the depression. The low money rates are caused by the fact that the overflow of funds from the money market to the capital market is impeded by an invisible barrier of distrust and pessimism.
• 96It goes without saying that the writers of the group not only admit, but even stress, the fact that the pressure of deflation is intensified and prolonged by all kinds of ill-advised intervention by the State and other public bodies, such as the competitive raising of tariffs, the scramble for gold in order to liquidate existing gold-exchange standards, and all similar measures designed to keep up prices and incomes.
• 97The concept “effective quantity of money” is very complicated. It is not easily defined in theory and is hopelessly difficult to measure statistically. The difficulty comes in principally through the factor “V”. The velocity of circulation meant is not the transaction velocity, nor is it the income velocity. One might perhaps call it trade velocity, the term being understood to cover all transactions which involve an exchange of goods in all stages of production, but to exclude financial transactions (e.g., on the stock exchange). If the quantity and the transaction velocity of money remain constant, but at the same time the requirements of the financial circulation rise, the result will be a decrease in the effective quantity of money as defined above. But these qualifications are not yet sufficient. Allowance must also be made for integration and disintegration of the process of production. If two or more successive stages in a particular line of industry (such as spinning and weaving), which are carried out by independent firms, are integrated by the formation of a vertical trust, the transfer of the intermediate product from the higher to the lower stage, which formerly gave rise to monetary transactions, may in future be effected by mere entries in the books of the new firm. Thus the merger may set free a certain amount of money. The trade velocity of money need not be changed, but the supply of money ought to be restricted; otherwise inflationary consequences will ensue.
• 98Against this objection, the following argument has been advanced. It is true, in an economy where the output, owing to improvements in the methods of production, grows at a constant rate, that a steady expansion in terms of money may be made: that is to say, per unit of time a constant amount of new money may be put into circulation. But even if this is just enough to keep the price level of finished goods constant, prices of factors of production will rise continuously. Hence, successive additions to the money stock will only be able to buy successively diminishing amounts of the factors of production. But, to render the completion of the newly initiated processes of production possible, the entrepreneurs in the upper stages must be enabled to absorb factors of production àt a constant rate; and, as the prices of factors of production rise, a credit expansion at an increasing rate will be necessary to enable them to do so. The conclusion is that a relative inflation, such as can be made within the limits of a constant price level, is not sufficient to allow of the completion of the new roundabout methods of production which have been initiated under the stimulus of the expansion. Either the rate of expansion of credit will be sufficiently increased and prices will be driven up and the inevitable breakdown will be postponed, or the boom will collapse at once owing to an insufficiency in the capital supply.
• 99The writers of the group under review are, however, well aware of the great danger that the discrepancy between the money rate and the equilibrium rate of interest, which prevailed during the depression, will at once be succeeded by a discrepancy in the opposite direction. In view of the falling prices and the state of pessimism and discouragement, the money rate during the downswing stands above the natural rate. When the fall of prices comes to an end and pessimism gives way to a more optimistic outlook, the current money rates, without being changed, will soon stand below the equilibrium rate. In other words, the equilibrium rate is likely to rise above the money rate. In terms of supply and demand, this can be expressed by saying that the credit demand curve will move to the right or, loosely speaking, that demand will rise. At the same time, the banks will be in a liquid position, and there is every reason to expect that they will liberally comply with the increased demand for credit. The barrier between the money market and the capital market is broken down, and the funds accumulated behind the barrier flow into the investment market.
• 100This process has never been analysed so closely as the process of expansion starting from a position of full employment. But, applying the same type of reasoning, the conclusion seems to be as follows: A disequilibrium between the higher and the lower stages is produced by the fact that the unemployed resources are not distributed among the different stages of production in the way they ought to be if ultimate equilibrium is to emerge. A larger amount is absorbed into the higher stages than can in the long run be employed there with the given rate of voluntary saving. Thus the recovery from the depth of the depression has a wrong twist from the beginning.
• 101Professor MISES believes, furthermore, that the commercial banks alone without the support of the central bank can never produce a dangerous credit inflation, because they would immediately lose cash and become insolvent. It is only with the backing of the central bank that it is possible to expand credit sufficiently to produce a dangerous boom. The ability of the central banks to increase the circulation is due to the monopoly which they hold of the issue of bank-notes. If the issue of notes were not a monopoly, if competition were restored in this field of the central banks’ activities—that is to say, if every bank had the right to issue notes, convertible into legal tender money (gold)—a dangerous expansion of credit and reduction of the interest rate would be impossible. The unsound banks would quickly be eliminated, and the sound banks would learn by experience that expansion is punished by bankruptcy.
• 102Professor MACHLUP has called attention to one factor which helps to explain the recurrence of the cycle and throws into relief the passive rôle of the banks, at any rate during the first phase of the upswing. It is this. A considerable portion of the payments which have to be made during a given period, say a year, are not evenly distributed, but are concentrated at certain dates, some of them at the end of each month and others at the end of each quarter. Therefore, even with the most elaborate clearing and compensation arrangements, no complete continuous offsetting of the debts and liabilities of each firm is possible. At the critical dates, at the end of the month and of the quarter, there is therefore always a strong demand for short-term credit and a resultant strain on the money market. If the banks were not able and willing to relieve this monthly and quarterly tightness of money by granting temporary credits, individual firms would be compelled to provide for their requirements at the critical dates by accumulating cash during the intervals between them. But, as the banks lend money to overcome these difficulties—credit expansion for such a temporary stringency being generally regarded as perfectly legitimate and safe—it is not necessary to accumulate cash, and the sums involved can be invested instead.
• 103It is clear that we have here a source of inflation; and the inflation, according to Professor MACHLUP, will not be confined to the single occasion of the first introduction of these “ultimo loans”, but will tend to recur cyclically. “While the utilisation of temporary surplus cash together with (inflationary) bank credit created the possibility of initiating illicitly long processes of production, the depression, after the elimination of the untenable enterprises, will release these sums again” (pages 175 and 176). During the depression, the investment of these sums is impossible, and they accumulate on the money market; but, as soon as the spirit of enterprise revives, they can be utilised for financing the boom for a long time without any, or with very little, additional bank credit.
• 104To sum up, we may say that the theory has not proved rigorously that a stabilisation of prices in a progressive economy must always lead to over-production, crisis and depression. The practical importance of this conclusion is considerable in view of the American prosperity in the twenties, a notable feature of which was the fact that wholesale prices did not rise.
• 105Any improvement in the balance of payments—that is to say, any increase in the demand for the means of payment of a given country in terms of the money of other countries—will have an expansionist influence. This improvement may be due to a great variety of circumstances—changes in the demand for particular commodities, crop changes, capital movements, etc. The erection of new tariff walls by an individual country, if not followed by compensatory action on the part of other countries, will have a favourable influence on the international monetary situation of the country which has raised its tariffs. In other words, it will enable the latter to expand its circulation without a deterioration of its exchange rate. Thus, the immediate influence of protectionist measures may be a stimulation of prosperity or an alleviation of depression. But the conditions in which this is true must be borne in mind. If many countries pursue this policy at the same time, the stimulating influence is lost. In the long run, the raising of tariff walls impairs the national dividends of all the countries involved. Indirect effects (e.g., on capital movements) may prevent even the immediate stimulation afforded by protectionist measures. Finally, an improvement in the balance of payments can always be utilised as a means of increasing the gold and foreign-exchange reserve in lieu of expanding the circulation.
• 106(a)   Professor RÖPKE has studied the question in various publications and has come to the conclusion that the process of deflation has a tendency to become cumulative and self-perpetuating. Genetically, it is true, it is connected with the extravagances of the preceding boom and the real maladjustment which the boom has produced. But the intensity of the deflation by no means necessarily corresponds to the extent of the over-investment. It is also untrue, he believes, that the deflation contributes (as is more or less vaguely suggested by the other authors of the monetary over-investment school) to bringing about the necessary adjustment (shortening) in the process of production. Once started, the deflation is propelled by its own momentum and by a number of institutional factors. What these factors are and how they work, we shall discuss at greater length in another connection. HAWTREY, KEYNES, PIGOU and ROBERTSON have contributed most towards the understanding of this phenomenon.
• 107A feature of particular interest in Mr. HAWTREY’S monetary theory of the business cycle is the demonstration and analysis of the cumulative nature of the process of expansion and contraction. In this respect, there is, as we shall see, much agreement between theorists of different schools of thought. Mr. HAWTREY’S propositions on this point, largely taken over from MARSHALL and the Cambridge tradition, have found a place in the theory of a great number of writers.
• 108In arguing on the basis of the over-investment theory, special attention must be paid to international capital movements. They not only affect the purely monetary situation by stimulating or retarding the expansion or contraction of credit: they have also a bearing on the structure of production. An individual country may finance a boom, wholly or partly, by capital imports from other countries instead of by an internal expansion of credit and forced saving. So long as this is possible, the reaction which the theory under review holds responsible for the breakdown—namely, a corresponding rise in the demand for consumers’ goods—may be staved off. Thus, in so far as a particular country is concerned, the boom may be prolonged. On the other hand, international capital movements are subject to risks and disturbances which are absent in the case of an internal expansion.
• 109The most valuable and original contributions of the monetary over-investment theory are (1) the analysis of the maladjustment in the structure of production brought about by the credit expansion during the prosperity phase of the cycle and (2) the explanation of the breakdown as consequent on that maladjustment. But our analysis has also shown that the theory is not in all respects complete. The claim to exclusive validity is open to doubt. It is a little difficult, for example, to understand why the transition to a more roundabout process of production should be associated with prosperity and the return to a less roundabout process a synonym for depression. Why should not the original inflationary expansion of investment cause as much dislocation in the production of consumers’ goods as the subsequent rise in consumers’ demand is said to cause in the production of investment goods?
• 110The writers of the group under review are, however, well aware of the great danger that the discrepancy between the money rate and the equilibrium rate of interest, which prevailed during the depression, will at once be succeeded by a discrepancy in the opposite direction. In view of the falling prices and the state of pessimism and discouragement, the money rate during the downswing stands above the natural rate. When the fall of prices comes to an end and pessimism gives way to a more optimistic outlook, the current money rates, without being changed, will soon stand below the equilibrium rate. In other words, the equilibrium rate is likely to rise above the money rate. In terms of supply and demand, this can be expressed by saying that the credit demand curve will move to the right or, loosely speaking, that demand will rise. At the same time, the banks will be in a liquid position, and there is every reason to expect that they will liberally comply with the increased demand for credit. The barrier between the money market and the capital market is broken down, and the funds accumulated behind the barrier flow into the investment market.
• 111The most prominent writers in this group are Professors A. SPIETHOFF and G. CASSEL. In the writings of these two authors (of SPIETHOFF especially), we find the culmination of a very important line of thought which can be traced back to MARX. Spiethoff’s immediate forerunner was the well-known Russian author TUGAN-BARANOWSKI. Both SPIETHOFF and CASSEL have had a great influence on business cycle theory, particularly in Germany, but also in the Scandinavian and Anglo-Saxon countries. WICKSELL himself adopted SPIETHOFF’S explanation of the cycle.
• 112It is convenient at this point to introduce the question of the existence of unused productive resources of all kinds. The explanation given by the writers of the school under review for the upswing, or rather for the boom, almost invariably starts from an equilibrium position with full employment of the means of production. But the argument can easily be adapted to the other case. If there are unemployed resources, evidently the expansion of credit may go on much longer than when all resources are employed. There need, then, be no shift of factors from the lower to the higher stages, but only the absorption of unused resources predominantly in those stages of production which are especially stimulated by the expansion—namely, in the upper stages (capital goods industries). Arguing along the lines of the theory under review, one has to assume that the unemployed resources are mainly put to work in the higher stages (capital-goods industries). But, so long as there is a reserve of unemployed resources, the reaction from excess investment, which consists (as we have seen) of a comparative rise in the demand for consumers’ goods, will not produce a breakdown, since there is no necessity to detach factors of production from the higher stages. Prices need not rise much. The expansion of credit can go on.
• 113With regard to Professor CASSEL, it must be remarked that we are here dealing primarily with the theory as expounded in the earlier editions of his Theory of Social Economy. In his later books and especially in his popular writings, he has more or less accepted a purely monetary explanation, at least so far as the 1929-1936 depression is concerned.
• 114Professor MISES gives the following answer to the question why the cycle of prosperity and depression recurs again and again. The behaviour of the banks is responsible for the occurrence of the business cycle. If the banks did not push the money rate below the natural rate by expanding credit, equilibrium would not be disturbed. But why do the banks make the same mistake again and again? “The answer must be: because the prevailing ideology among business-men and politicians looks on the reduction of the rate of interest as an important aim of economic policy, and because they consider an inflationary expansion of credit the best means to attain that objective” (page 58). “The root cause of the phenomenon that one business cycle follows the other is thus of an ideological nature” (page 60).
• 115Both Professors SPIETHOFF and CASSEL emphatically assert that the business cycle is characterised by changes in the production of capital goods, especially of fixed capital equipment. The production of consumers’ goods does not exhibit the same regularity of change during the business cycle. Professor SPIETHOFF makes the point that upswings have occurred during which consumption has actually fallen. This was the case, according to him, in Germany in the years 1845-1847/48, when the economic situation of the working classes positively deteriorated because of rising food prices due to a series of crop failures. But, even if no account is taken of changes in agricultural production, which are only remotely connected with the ups and downs of industrial production, “the production of consumption goods shows no marked dependence on trade cycles. This means that the alternation between periods of boom and slump is fundamentally a variation in the production of fixed capital, but has no direct connection with the rest of production.”
• 116An interesting question is how the composition of exports and imports of a country changes during the different phases of the cycle. It might be supposed that capital imports during the upswing are bound to be effected through the import of capital goods. As a general statement, this would, however, be wrong. In any given situation in respect of tariffs or otherwise, what a country imports will depend on the comparative cost situation or, in other words, on the comparative facilities of the various countries for the production of different types of goods. It is conceivable that capital for investment purposes may be imported, not in the shape of capital goods (raw materials, machinery, electrical equipment, etc.), but in the shape of consumers’ goods. This will be the case in a country where capital-goods industries and the production of raw materials are well developed, while consumers’ goods industries are less so.