Prosperity and Depression

CHAPTER 11 THE TURNING-POINTS. CRISIS AND REVIVAL

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§ 1.    INTRODUCTION

The problem.

In the preceding sections, we have discussed the reasons why our economic system is subject to cumulative processes of expansion and contraction. We have shown why, once started, such processes are cumulative and self-reinforcing. The question now arises how they can be started, how they actually or usually are started, and how they can be, and usually or actually are, brought to an end.

The problem falls into two parts.

A.   How can an expansion be, and how is it in the normal course of events, brought to an end? Why does it not go on indefinitely? Why does it not lead up to a position of stable equilibrium instead of being always followed by a more or less severe contraction? The problem is closely connected—it is indeed almost identical—with the problem of how a contraction process is started. We therefore call it the problem of the upper turning-point or crisis.1

B.   How can a contraction be terminated, and how is it usually reversed? The problem is identical with that of the initiating causes of the expansion. We call it therefore the problem of the lower turning-point or revival.

“Accidental” and “organic” restraining forces.

In both cases, we can distinguish between two types of disrupting or mitigating forces—viz., those which arise quite independently of the process of expansion or contraction which they interrupt and those which are usually or necessarily brought about by the process of expansion or contraction itself. In other words, an expansion or contraction may be interrupted on the one hand by an accident such as changes in the harvest due to weather conditions, influences from abroad (other than such as are induced by the contraction or expansion itself), spontaneous shifts in demand, etc, or it may on the other hand itself give rise to maladjustments in the economic system (counter-forces) which tend to check and reverse the very process (i.e., the expansion or contraction) by which they were brought about. These maladjustments or counter-forces may be very various: they may be of a monetary or non-monetary character: they may be treated as the inevitable consequence of any expansion or contraction, or as dependent on circumstances not necessarily to be found in every expansion and contraction.

Most cycle theorists have tried to prove that the second type of restraining forces is all-important. Indeed, they usually accept the existence of such forces as a dogma, at least so far as the expansion is concerned. If this can be definitely established, the cyclical movement is in a higher degree an essential attribute of our present economic system2 than in the first case. We shall investigate both possibilities. For, even if the second hypothesis can be proved to be correct—if, that is to say, a process of expansion or contraction cannot go on for ever because it generates forces which will counteract and ultimately reverse it—it is none the less important to show that it may be brought to an end by certain accidental factors, before those forces come into operation. An analogy will make this clear. It is true that every man must die sooner or later of old age: but it is none the less true—and deserving of attention—that many die earlier because they catch an infection or are victims of an accident.

The importance of this consideration lies in the fact that (as has already been indicated and will be shown in detail) an expansion becomes more sensitive to accidental disturbances, after it has reached a certain stage, and similarly a contraction can be more easily stopped and reversed by some stimulating factor, after it has progressed for some time. Therefore, even if we were not in a position to prove rigorously that expansion generates contraction and contraction generates expansion, a fairly regular succession of periods of prosperity and depression, of expansion and contraction, might be explained by accidental shocks distributed in a random fashion over time.

A.    The Down-turn: Crisis

§ 2.    THE METHOD OF PROCEDURE

Three stages of the argument.

It has already been pointed out, by way of illustration, that a deliberate policy of deflation, pursued for whatever reason by the monetary authorities, or the interruption of an ambitious construction scheme may start a process of contraction. We shall now consider how this works out in detail and what other events or factors must be held in mind. As a first step (§ 3), we shall suppose that such disturbances occur, and enquire how they exert their depressing influence and, in particular, how an expansion may be interrupted and a general contraction be started by a factor which directly affects only a more or less restricted part of the economic system. At first we assume such disturbances to occur independently of the cycle. That is to say, they may arise in any phase of the cycle, during the contraction phase just as well as during the expansion. If they occur when a general contraction is going on, the contraction will be intensified. If they occur during a general expansion, the expansion may be slowed down or, if the shock is violent enough, cut short.

As a second step (§ 4), we shall show why the system becomes more and more sensitive to disturbances after the expansion has progressed for a while, so that such disturbances are likely to have much more serious consequences if they arise in the later phase of the upswing than in its earlier part.

The third step (§ 5) consists in discussing those unfavourable influences or maladjustments which are likely to arise during the course of the upswing, or which are inevitably brought about by the expansion.3

§ 3.    THE PROXIMATE CAUSES OF CONTRACTION

Contraction in aggregate demand versus sectional disturbances.

An outright and deliberate contraction of the circulating medium may be the proximate cause of the down-turn. Then we have at once a decrease in the total demand for goods; and it is comparatively easy, as has been shown in the preceding sections, to explain the further development of the contraction.

It is much more difficult, however, to explain how a disturbance which does not in itself consist of a decrease in aggregate demand and which affects directly only a part of the economic system—as, for example, a particular branch of industry—can lead to a decline in aggregate demand rather than to a mere shift in demand from one commodity or group of commodities to another. If we have explained how it brings about a decrease in aggregate demand, then we may rely for the further explanation on the cumulative forces of contraction as analysed in the preceding section.

We start by discussing the simpler cases where we have from the very beginning a decrease in the aggregate demand for goods due to a decrease in the supply of investible funds.

Deflation by Governments or banks.

If a Government decides to deflate (that is, to retain a part of its revenue from taxation or other sources), the situation is quite clear; but this occurs only in very exceptional circumstances. A case of greater practical importance is that of a restrictive credit policy undertaken by the central bank of a country. It is not difficult to find examples in financial history. The motive is usually to stop an internal drain on reserves or to restore external equilibrium. The latter may be threatened by a great variety of causes. Prices in general may be too high in respect to prices abroad, because of an expansion at home or a devaluation or deflation abroad. A flight of capital or a cessation in the inflow of capital may have occurred. The loss of foreign markets due to a rise in tariffs or to some other reason (e.g., the rise of a foreign competitor) may have rendered the international balance of payments unfavourable. A bad harvest in an important crop may reduce exports or necessitate increased imports.

Without being forced either by the external situation or an internal drain on its cash resources, the central bank may contract credit because it fears the consequences of a prolonged expansion, no matter whether these apprehensions are justified or not.

The commercial banks may contract credit for similar reasons on their own initiative without being forced or warned by the central bank.

The catalogue of possible cases might be lengthened. Each of the cases mentioned might be analysed in greater detail and minor variations might be distinguished. But, at this stage, it may be sufficient to say what is true of all cases equally—namely, that a tightening of the supply of funds by the monetary authorities has a depressing influence and is capable, if strong enough, of interrupting an expansion and of ushering in a contraction.

This explanation will frequently be adequate to explain why a process of expansion has been slowed down or turned into a contraction in a particular country at a particular point of time. It is not, however, a sufficient answer in all cases—other interrupting forces will be discussed presently—and, even if in a particular case a restriction of the money supply can be shown to have brought an expansion to an end, it does not follow that the expansion could have continued very long had the restrictive measures not been taken. This point will be discussed in § 5.

All these cases turn on a tightening of the supply of funds. The proximate cause of the contraction is a decrease in the supply of funds, while, in the cases to be analysed next, the demand for investible funds falls and ushers in a cumulative process of contraction. (As soon as this process has once got under way, contraction of demand and of supply interact and reinforce one another in a cumulative fashion as already shown.)

Consequences of a partial breakdown.

We have now to discuss whether a disturbance occurring in a particular branch of industry can give rise to a general contraction and, if so, how. Suppose that, in an individual industry (say motor-car production), a number of firms are forced to curtail output or to cease operating altogether.

The causes and attendant circumstances of such a partial breakdown of an industry may be very different in different cases, so that it is impossible, without a number of specific assumptions, to say anything definite as to its probable consequences. The causes of the breakdown may be such as to exercise stimulating influences in some other direction in addition to the immediate depressing influences to which they give rise, so that the two tendencies may conceivably cancel out. This would be the case, e.g., if the breakdown was caused by an unexpected shift in demand. Then we might have an increase in demand for commodity A and a decrease in demand for B. That which depresses industry B stimulates industry A. Even in this case it does not necessarily follow that the two influences offset one another in so far as the effect on total demand is concerned.4 Moreover, in other cases arising from different causes, there is no such instantaneous and automatic increase in demand at all, as we shall see presently.

We shall discuss first the probable influences on total demand of such a partial breakdown under different circumstances irrespective of automatic counter-influences set up by the cause which brought about the breakdown. Afterwards we shall enquire about the latter.

A reduction in the level of output of a particular industry will reduce the earnings of the factors employed: the wage-bill will diminish: and this will cause some decrease in the demand for wage goods. If sales go on for a while in the process of liquidating stocks, the proceeds may be used for repaying bank loans and other debts instead of being reinvested in the purchase of labour, materials, etc—and this will have a deflationary effect.

We have furthermore to consider the repercussions on the subsidiary industries. The magnitude of these repercussions will depend on a number of circumstances. It will be greater if the reduction in output occurs unexpectedly than if it has been foreseen. If the industry in question has been expanding for some time and a further expansion has been anticipated, a corresponding expansion in the subsidiary industry may come to a sudden end and the repercussions may be very serious. The conditions may vary in detail, international complications may come into the picture—e.g., the industries furnishing raw materials and other means of production may be located in another country than the industries using them—and thus many cases with quantitatively different reactions and repercussions are conceivable. In any case, however, there is a clear tendency towards a reduction in the flow of money, a fall in total demand.

This tendency will be intensified if the firms involved happen to be heavily indebted to the banks. If a bank gets into difficulties and proceeds to contract credit, we have a clear deflationary move: we may refer to what has been said on earlier pages for an explanation of the consequences. But, even if no bank is so seriously involved that it is forced to liquidate credit, difficulties of an important industry or of particular big firms may be taken as a warning signal for caution and may make the banks more reluctant to grant or renew loans.

Possible counter-tendencies.

So much for the consequences of such a partial breakdown irrespective of the causes by which it was brought about. Now we turn to the latter and consider whether they are likely to set up stimulating counter-tendencies.

The curtailment in output of a particular industry may be due either to a decrease in demand or to an increase in cost. If a decrease in demand is the consequence of a deflationary move, we obviously cannot expect to find an offsetting increase in demand elsewhere. There is then no opposing force to the deflationary influences spreading from the breakdown in the industry concerned. But this case is ruled out in the present instance, because what we are seeking to explain is how a reduction in the total flow of purchasing power can be brought about by a disturbance which neither in itself involves nor results from such a reduction. If contraction is already under way, it is (as we have seen) comparatively easy to explain how it develops further.

If a decrease in demand for commodity A is due to a shift in demand to commodity B, then we have a decrease and an increase at the same time, and it depends on a number of circumstances which have been discussed in connection with the acceleration principle of derived demand5 whether on balance it works out as an increase or decrease in total demand. In the absence of further indications, we may classify this case as neutral.

Suppose, however, that a fall in production has been brought about by the producers’ being disappointed in their expectations about demand. Production has been begun or expanded in anticipation of a certain increase in demand. If this demand is not forthcoming, or if the expectations are revised in a downward direction, a resulting fall in production will not—except by chance—be offset in its influence on the flow of money by a simultaneous increase in demand somewhere else. This would seem to be a very important case: it will be specially apt to arise during the upswing of the cycle, when production is being carried in various directions into unknown territory.

Delayed reaction of investment.

It may be argued that a decrease of investment in a number of branches of industry will liberate investment funds, reduce the rate of interest, and thus provide an incentive to invest the funds somewhere else. But this is unlikely to happen all at once. Even in the most favourable case, where no business failures result from the cessation of investment and no banks are affected so that no special inducement to hoard is produced, there will usually be a delay between the new funds’ becoming available and their use for new investment. Investment plans are not always prepared in advance, so that they can be put into operation at short notice when the situation changes. They must be planned; and, even when they are planned, a certain amount of preparatory work is usually required before orders are given and the money is actually spent. Therefore, a temporary hold-up in the flow of money is an eminently probable contingency.

The same is true where a shift in demand is such that the increase is to the advantage of foreign goods, while the decrease is to the disadvantage of home industries.

Rise in cost as cause of a partial breakdown.

We turn now to the case where the curtailment of output is due to an increase in cost items. If the capital cost, that is the rate of interest, rises because the banks are forced to restrict credit or because capital goes abroad, the situation is clear. Here the rise in cost is the modus operandi of a contraction in the supply of funds and the reduction in output caused thereby will intensify the contraction. There are, in this case, no automatic and instantaneous offsets provided by the crircumstance (viz., the rise in cost) which is responsible for the reduction in output.

Nor, again, is there any direct offset in the important case where the increase in cost is due to public intervention or to the monopolistic action of the owners or producers of one of the means of production. Suppose that wages are being raised by trade-union action or by Government decree and that this rise in cost leads to a reduction in output. In this case, no offset is provided against the deflationary influences set up by the reduction in output.

The same will usually be true where the price of a raw material or semi-finished good is raised by the producers’ monopolistic action.

A somewhat different situation arises where the rise in cost of industry. A is due to increased competition for the means of production by other industries. Then a compensatory change is provided in the shape of the increased production of the other industries.

Conclusion.

This discussion leaves us with the conclusion that a breakdown in an individual industry may very well cause at least a temporary fall in total demand below the level at which it would otherwise stand. Whether this will start a cumulative process of contraction or not depends, first, on the magnitude of the disturbance and secondly on the general situation. If a general expansion is going on which has not yet exhausted its force, such a disturbance may be overcome, provided it is not too strong. If, however, the expansion has already lost its élan, the economic system will be vulnerable and may easily be plunged into a process of general contraction. This point we propose to consider in the following section.

Static theory and the cumulative process.

A word may be said as to the relation of this analysis of the probable consequences of partial disturbances to the familiar analysis of the same events on the basis of static equilibrium theory. According to the latter, a reduction of output and employment in a particular industry liberates forces which tend to restore equilibrium: wages should fall, and this should make for re-employment of the dismissed workers. Of course, wages may be kept up and the mobility of the workers may be defective—in which case unemployment may persist for a long time. But this need not cause a general contraction. On the other hand, if the process of investment in a particular industry is interrupted or scaled down, because expectations about the future demand have been revised in a downward direction (for any reason whatever), funds which otherwise would have been invested in the industry in question are set free: the rate of interest should fall, and this should induce investment somewhere else.

The tacit assumption underlying this reasoning, in so far as it applies to a monetary economy at all, is that the total flow of money, MV, is not reduced—so that on this assumption it is impossible to explain why such a partial disturbance should lead to a general contraction. Our analysis has shown that the static theory is inadequate. It describes (as it were) an ideal case which may occur, but only under particular favourable circumstances. In the probable event of a hold-up—even a temporary hold-up—in the total stream of purchasing power, the forces of contraction may drive the economy farther away from equilibrium; and the equilibrating tendencies may not have time to come into play or, if they do come into play, may not be strong enough to restore equilibrium, since the disturbance of the latter will have been still further increased in the meantime. What is treated in the static theory as an instantaneous adjustment may be a long-drawn-out and painful process of contraction. It may occupy the whole period of the downswing of a business cycle, during which the whole situation may undergo far-reaching changes, so that the equilibrium eventually attained will in all probability differ considerably from the equilibrium which in more favourable circumstances might have been reached, if not at once, at any rate soon after the occurrence of the disturbance.

§ 4.    WHY THE ECONOMIC SYSTEM BECOMES LESS AND LESS CAPABLE OF WITHSTANDING DEFLATIONARY SHOCKS AFTER AN EXPANSION HAS PROGRESSED BEYOND A CERTAIN POINT

Why the expansion tails off.

We have seen that an expansion is in its first phase of a somewhat precarious nature, so that it is liable to be reversed by an accidental disturbance. If it has a chance to develop undisturbed for a while, it is likely to gather momentum and then becomes, to a certain extent, immune against disturbances, such as those analysed in the preceding section, which tend to reduce total demand and bring about a general contraction. This immunity is the result of the fact that total demand is increasing so fast that an adverse influence, which in other circumstances would have initiated a contraction process, does not lead to an absolute fall of total demand, but only to a slowing-down of the upward movement. Expectations are not yet excessively optimistic and are again and again surpassed by results. We must now enquire why the movement should necessarily slow down after a while and eventually come to a standstill, so that there is a growing danger that a contraction process may be started by some chance disturbance, such as is at any time liable to occur.

Inelasticity of money supply.

The two most essential conditions for the smooth progress of an expansion are, broadly speaking, an elastic supply of money and an elastic supply of means of production. Both conditions are essential. If either is lacking, the situation becomes precarious. Suppose that the money supply is inelastic in the upward direction (with or without full employment of the means of production—that is to say, with or without perfect inelasticity of the supply of means of production). By an inelastic money supply we mean in this connection that an increase in the demand for investible funds evokes no further increase—or only a small increase—in the total supply of money (i.e., of MV, which is another expression for the aggregate demand for goods) and exhausts its effect instead in a rise in the rates of interest. It must not be assumed, however, that the supply of money is equally inelastic in a downward direction—that is, that a decrease in demand will produce at once a sharp fall in the rate of interest so as to stabilise MV. If, in such a situation, a partial disturbance arises of the sort analysed in the preceding section, tending to produce a hold-up in the stream of money, we get an absolute decrease in MV (not only a decrease in the rate of increase), which may easily engender a general contraction.

In a general way, it is evident—we shall come back to this point—that, under almost any monetary organisation with which we are acquainted, a continuous expansion will in practice lead sooner or later to a growing inelasticity in the money supply. The potentialities of monetary expansion which were stored up during the preceding depression are gradually exhausted—not to speak of restrictive counter-tendencies, to which we shall refer in the next section.

Inelasticity of supply of means of production.

Let us turn now to the other requisite for a smooth development of the expansion—viz., a fairly elastic supply of means of production. Here, again, it is the elasticity in an upward direction—capacity for extension—which is in question. The supply of labour, at least, is presumed to remain extremely elastic in a downward direction: that is to say, a fall in demand does not lead to a heavy fall in wages in such a way as to stabilise employment. Elasticity of supply in the downward direction, coupled with inelasticity in the upward direction, is equivalent to a downward rigidity and an upward flexibility in wages. It is of the very essence of the expansion that it leads to fuller employment and that the supply of the means of production becomes less and less elastic in the upward direction. An increase in demand leads rather to a rise in wages than to an increase in supply and employment. Unfortunately, this lack of elasticity in the labour supply, which is a desirable thing in so far as it is due to increasing employment and to the exhaustion of the reserve of unemployed, has (as will be explained presently) the same effect as an inelastic money supply in that it makes the economic system less resistant to the impact of deflationary forces. The situation is the more serious in that—unlike an inelastic money supply—it cannot be remedied by purely institutional (i.e., monetary) reforms.

Take first an extreme case. Suppose there is full employment of all factors of production. The money stream, MV, must then remain constant in face of the forces making for expansion—except to the extent to which the natural increase in the supply of factors (population growth) and in their efficiency (technological progress) permits of an increase in output—or else prices must rise and an outright inflation develop. If the latter happens, it is easy to see why the position is untenable, why the rise in prices will become progressive and will lead sooner or later to a breakdown.6 If, on the other hand, MV is kept constant, in spite of the rise in the demand for funds, equilibrium may be preserved; but (as has been explained above) the system is then very sensitive to deflationary shocks and may easily be plunged by some accident into a spiral of contraction.

These considerations make it clear that, under full employment, a given deflationary shock is more likely to entail a general contraction than if the supply of labour and other factors of production is elastic. In addition, it can be demonstrated that certain events which necessitate a shift in production will cause more serious disturbances, and are therefore more likely to produce a deflationary shock, under conditions of full employment than when the aggregate supply of factors of production, and therefore the supply of finished goods in general, is capable of expansion.

Shift in demand with rigid factor supply.

Suppose, for example, there is a shift in demand. The demand for commodity A increases and that for B decreases. An increase in the production of A must, under full employment, have an unfavourable effect on the cost of production in other industries. Since the factors are not perfectly mobile and interchangeable, we cannot assume (except in very special circumstances) that this pressure on other industries is at once relieved by the liberation of factors of production in industry B.

This case can be generalised. Anything that necessitates an increase of production in one industry will affect other industries adversely by raising their cost of production. Under full employment, one industry can expand production only at the expense of a contraction of output in other industries, whereas, under conditions of elastic supply of means of production in general, any one industry can to a certain extent expand production without raising costs to other industrie, simply by drawing on the existing reserves of unemployed labour and idle resources.

Sectional inelasticity of supply of labour.

We have so far contrasted the two extremes—full employment on the one hand and perfectly elastic supply of all factors (and therefore with a certain time-lag of finished goods) on the other hand. What we find in reality is, of course, always an intermediate state. Even at the bottom of a severe depression, the supply of factors and of finished goods is not perfectly elastic, while at the height of the boom there is never absolutely full employment. Technologically speaking, there is almost always scope for increasing total production to a certain extent by drawing into employment hitherto unemployed factors, provided we assume sufficient mobility of the means of production. But this does not by any means invalidate the argument, since it is sufficient to assume that, during the course of the upswing, the supply becomes less and less elastic, even if it does not start from the one extreme or ever fully attain the other.

This leads to a very important conclusion. The sensitiveness of the economic system to deflationary shocks will become great long before completely full employment has been reached. The reason is that the existence of a level of unemployment which might at first sight appear relatively high can by no means be taken as a safe indication of great elasticity of the supply of factors of production or of output in general. In other words, the mere fact that there is still much unemployment does not justify the conclusion that an increase in the total demand for goods in terms of money will elicit an increase in output and employment almost proportional to the increase in demand coupled with a comparatively slight rise of prices in general.7

The appearance of “bottlenecks”

The unemployed workers of a country as registered by the statistics at any particular moment are not a homogeneous reserve army from which each industry can draw the men needed with the required qualities at the prevailing wage rates. The total of unemployed is made up of unemployables, men of inferior quality, unskilled and skilled workers. Many of them, especially of the last group, are specialised for a certain type of work; and all of them are attached to a certain locality and cannot be easily moved to another part of the country. The existence of a large total does not in the least preclude the possibility of a shortage of labour in many special fields. When employment expands, there is naturally a tendency to re-employ first the better men; and the farther the expansion progresses, the greater the obstacle to general advance represented by the scarcity in particular lines. The same holds true, mutatis mutandis, for other means of production. “Bottle-necks” develop in the structure of industry at various points, with the result that, if monetary expansion continues and total demand increases, it is to an increasing extent prices rather than output or employment which rise.

In such a situation, it is clearly misleading to speak of elasticity of supply or output as a whole, or of elasticity of labour or factors of production in general, and to measure it by the total figures of unemployment or by some average over the whole industry of the technically possible increase of output. The elasticity of supply is not uniform: it depends very much on the path which expansion tends to follow. In other words, it depends on the increase in total demand and the distribution of the given increase in demand among the various products. If, in the course of the expansion, demand increases for the product of those industries where a large part of unemployment and over-capacity is concentrated, the elasticity of supply and employment will be greater than in the case when demand tends to flow into channels where there are no unemployed factors. In the latter case, a given increase in demand will lead to a rise in cost and prices, and the favoured industries may draw away factors of production from those industries where demand has not risen.8 It follows that it is quite wrong to think that there is no danger of a rapid rise in prices from an expansion so long as there is considerable unemployment.

Conclusion.

We may sum up the findings of this section as follows. During the course of an expansion which has started from the depth of a depression, the economic system becomes the more vulnerable the nearer full employment is approached. That is to say, on the one hand the system becomes more sensitive to deflationary shocks, and on the other hand the deflationary possibilities of certain changes become accentuated.

§ 5.DISTURBANCES CREATED BY THE PROCESS OF EXPANSION ITSELF

Organic maladjustment.

Having now shown that, with the progress of expansion, the economic system becomes more and more sensitive to deflationary shocks, and that certain changes in demand and production which may occur at any time become more and more liable to produce on balance a deflationary rather than an inflationary effect, we proceed to enquire into the likelihood of the expansion itself (or certain more or less regular features of the expansion process) giving rise to serious maladjustments in the body economic which operate as starters and intensifying factors of a cumulative process of contraction. The analysis of existing theories of the cycle has furnished a number of hypotheses. Few of these seem to be definitely wrong or a priori impossible. What is unsatisfactory, however, is the exclusiveness with which many writers proclaim one or other of these hypotheses as the only possible solution. Our task therefore will consist in setting out in a logical order the various possibilities and determining their mutual relationship.

Monetary versus non-monetary disturbances.

We may distinguish two groups of disturbances which may possibly be created by the expansion itself or, to speak more precisely, may be expected to arise in the economic system in the course of an expansion, (1) There may be a mechanism which works in such a way that a monetary expansion is after a while turned into a contraction without the latter being induced by previous loss, or the expectation of loss, in any particular industry. In other words, there may be no difficulty in any particular industry: cost may everywhere be covered by actual and expected selling price; but there comes a hitch in the flow of money, the total demand for goods falls off, and this gives rise to a cumulative process of contraction. (2) The other and (as we shall see) much more promising hypothesis is that, as a result of the maladjustments in the structure of production which are regarded as inevitable in any expansion, some particular industry or group of industries is forced to curtail output and employment, and thereby start a general contraction in the manner described in § 3 of this chapter.

The first hypothesis may be called a purely monetary explanation of the down-turn, while the second has a non-monetary character. But it is not intended to attach special importance to this terminology.

The purely monetary explanation of the down-turn.

We begin by discussing the first hypothesis. Under any monetary arrangement which implies a limitation of the quantity of legal tender money, such as the gold standard, there is an upper limit (gradually approached during the upswing) to the expansion of MV. This, as we have seen, explains the fact that the economic system becomes more and more sensitive to deflationary shocks. It does not, however, explain why, in the absence of such shocks, an expansion of MV should immediately be followed by a contraction rather than by a period of stability in MV.

Mr. HAWTREY (as was shown in the first part of this book) has endeavoured to establish the existence of a monetary mechanism in which the mere cessation of credit expansion leads to a subsequent contraction. His theory is based on the lag of cash reserves in the banks behind the expansion of credit. The drain of cash continues after the expansion of credit has come to an end. The banks watch only the present position of their cash reserves and do not foresee that these will shrink for a while after credit has ceased to expand. So they are led to expand too long, and later they are forced to contract in order to maintain their reserve proportions.

The theory is not very convincing. It implies that all that is required to forestall the contraction is for the central bank to furnish the commercial banks with the necessary cash to relieve them of the necessity for contracting credit. The discussion of our second hypothesis and of the different cases which it covers will show that this implication is hardly acceptable. Moreover, it is difficult to believe that the banks would not learn from experience, and would repeatedly make the same mistake of underestimating the drain of cash consequent on a given expansion of credit. The following discussion, by showing that the situation at the end of the boom is much too involved to be put straight simply by preventing a contraction in the money supply, will afford an effective criticism of this particular explanation of the down-turn.

Besides the reason given by Mr. HAWTREY, is there any other reason why a hitch in the flow of money should regularly occur in the absence of difficulties in any particular line of production? It is easy to conceive of all kinds of chance disturbances of a purely monetary or institutional character, arising at home or abroad, which might be capable of inducing hoarding on the part of somebody. But it is difficult to see why this should be a necessary or probable result of an expansion, provided that it is not the consequence of a disturbance in the productive process. The rise in interest rates which we almost invariably observe during the upswing as a result of a rise in the demand for investible funds provides an incentive against hoarding. (High interest rates as such may, of course, be the result of a tendency to hoard. But this is rarely the case in the earlier part of the upswing. The question is only whether such a tendency does not manifest itself in the last phase of the boom.)

Structural maladjustments likely.

We turn now to the second group of possible disturbances which the expansion may bring about: viz., maladjustments in the structure of production arising out of the fact that, in some industries, the selling-price of the product falls short of the cost of production or, in other words, that demand is insufficient to take up production at remunerative prices. There is no initial decrease in the total monetary demand for goods—i.e., in the money stream; but the flow of goods does not correspond in all its ramifications to the flow of money and its divisions, and therefore in some lines of production demand does not cover cost. The expectations of some people have been disappointed, which need not be offset by favourable surprises of others.

Prima facie, it is not at all surprising that serious dislocations in the structure of production should make their appearance during the course of a general expansion, when far-reaching changes occur in many parts of the production process. What we find during an expansion are not slight adjustments on the margin of production in this or that industry—in which connection it is safe to disregard indirect repercussions and to assume, if not perfect, at any rate approximately correct, foresight on the part of the producers. On the contrary, we find that far-reaching changes are under way: long-term investment is taking place in many lines: new commodities are being introduced (though the line between the introduction of “new” goods and the improvement of the quality of old ones is very hazy): goods, the consumption of which was so far confined to the upper classes, are being made accessible for the consumption of the masses: new processes of production are being put into operation: and all these changes must profoundly influence conditions of cost and of demand for any given industry. Consumers are induced to rearrange the system of their expenditure. Relative prices of the various finished products and of half-finished goods and factors of production change.

Is it so astonishing that, under these circumstances, serious maladjustments should develop in the industrial structure as the expansion goes on? Without as yet being able to specify the exact nature of these maladjustments, it would seem highly improbable that, in a rapidly expanding system, the expansion should proceed smoothly and eventually tail off into an equilibrium state of full employment.9

Operation of the acceleration principle.

If we go on to enquire what kind of maladjustments are likely to develop during an expansion, we must remember that an expansion always starts from a position of partial employment of labour and other means of production. For some time, output can and does rise all around—i.e. both in consumers’ and producers’ goods industries—although the rate of increase is not everywhere the same. As has already been pointed out, an expansion could not go on very long if it started from a state of full employment or after it has reached such a state in the course of its progress. Prices would rise rapidly. No industry could expand output except at the cost of a contraction in other industries. That is certainly not the situation we actually find during an upswing. We must put this picture from our minds if we are to view what happens at the end of the boom in the right perspective.

We have seen that an expansion, however it may have been originally set afoot (whether by an initial increase in consumers’ or producers’ spending, in consumption or in investment), is characterised by a rapid increase in investment. During the preceding depression, repairs, replacement and improvements in all industries which require the investment of capital have been postponed and, so to speak, stored up. Gradually all this latent demand for investment becomes effective and feeds the boom. The expansion in investment generates income and demand for consumers’ goods. Consumption industries expand, and this enhances the demand for investment goods. Since there is a reserve of idle factors of production, the process may continue for some time unobstructed.

This is a fact of considerable importance. If a general expansion can proceed a long way smoothly, the acceleration principle of derived demand has time to work itself out. That is to say, a number of industries will be developed to a level which they can maintain only if other industries (or the system as a whole) go on expanding at a given rate. Quite apart from any limits which may be set by insufficiency of demand or any other cause, this rate of expansion is feasible only so long as there is a fairly elastic supply of unemployed factors of production. This type of maladjustment is not so likely to arise, or at least to develop to the same extent, if an expansion starts from full employment. In that case, it will very soon encounter strong resistance in the shape of steeply rising costs, and it is not likely that any considerable number of industries will be able, by the installation of highly durable equipment, to adapt themselves to a rate of expansion in other industries which it is not possible to maintain. At any rate, the danger of the development of a serious maladjustment in the structure of production is much greater in the case where an unusually rapid expansion all along the line is made possible by the existence of unused resources which are gradually drawn into employment than in the other case where we start from fairly full employment. If a certain industry expands production and hence increases its demand for producers’ goods (say, machines), the producers of these machines will hardly jump at once to the assumption that this increased demand will continue to be forthcoming for a very long time. Consequently, they will not at once adopt the most up-to-date capitalistic methods of production requiring the installation of highly durable plant which cannot be amortised except over a considerable period of activity on an enlarged scale. The longer, however, an expansion of production in various directions continues unobstructed, the more optimistic will become the expectations as to its future continuation at the same or an increasing rate. Producers in a number of industries get accustomed to a level of demand which cannot continue for ever: possibly they are led to expect a rising demand, or even rising prices—which are still less likely to be long maintained. It is very improbable, therefore, that the system will be in equilibrium when it approaches the upper limit of the expansion. The mere cessation, or even the slowing-down, of the expansion will produce a serious setback in a number of industries; and this may very well lead to a general process of contraction in the manner described in § 3 of this chapter.

Effect of credit shortage on derived demand.

If this analysis is correct, the following important conclusion seems to be justified. If a general expansion which has been in progress for some time comes to an end for purely monetary reasons, the economic system will very probably find itself in the presence of serious maladjustments in the structure of production, which make it very likely that the expansion will be immediately followed by a contraction rather than by a period of stability. Let us analyse this case more closely. An expansion is going on, so far undisturbed by any maladjustment in the structure of production. There is scope for a further expansion of production since there are still idle factors which can be drawn into employment, and no serious “bottlenecks” have so far developed. There is a sufficient demand for investible funds; the output of the capital-goods industries increases; and so, although at a lower rate, does output in the consumers’ goods industries. Now, the monetary authorities put the brake on the expansion of credit because of the international situation of the country or for some other reason. The total demand for goods in terms of money ceases to increase and the expansion comes to an end. It is possible, and even probable, that this cessation in the inflow of new credit will at once produce difficulties in the capital-goods industries, because a number of investment schemes have been started which cannot be completed in the absence of investible funds. But, even if we assume that the difficulty in raising the necessary funds for their completion can somehow be overcome—e.g., by inducing people to provide the necessary capital through increased savings—there remains the other more fundamental difficulty that the scale of output in the capital-goods industries is geared to an expanding production in the consumers’ goods industries. If the latter stop expanding, the former lose a part of their market and are compelled to scale down the level of their activity—even where they might be able to raise the necessary sums to carry on at the old level. Clearly, the situation cannot at once be rectified by increased voluntary saving for the reason that the money saved will not, in the situation assumed, find an immediate outlet in new investment.

It should be noted that this disrupting effect of a cessation of monetary expansion is independent of: (a) any credit restriction which the banks may be forced to make for the reason given by Mr. HAWTREY; (b) the fact that, when MV is no longer rising, the economic system becomes sensitive to chance deflationary shocks (as explained in § 4 of this chapter); and (c) the fact of a substantial rise in prices having taken place. The setback may occur in a comparatively early phase of the upswing, when supply of factors is still fairly elastic and prices have not perceptibly risen. If prices have gone up for a while and producers in various industries have been led to expect a further rise, the disappointment caused by the cessation of expansion and of the rise in prices will be all the greater; but the rise in prices is not an essential condition.

In this case, the collapse of the boom and the onset of the contraction could be avoided, for the time being, by removing the hindrances to a further expansion of credit. (Whether this is feasible from political, social, or psychological points of view is another question, which we need not discuss here.) But it goes without saying that it does not follow that the boom could go on indefinitely, if only the supply of credit were kept elastic.

Effect of shortage of factors on derived demand.

Let us now drop the assumption that the expansion comes to an end prematurely because of an insufficient money supply. Let us suppose that it has a chance to develop without hindrance from the monetary side. What are then the possible and probable outcomes?

In the previous case, we have assumed that the general expansion of production comes to an end because the increase in the flow of money is more or less suddenly stopped. Suppose now that the check to expansion comes at an advanced stage of the upswing when almost all idle factors, especially labour, have been drawn into employment. On this assumption, the general increase in employment and output must now come to an end (or, more precisely, slow down to the rate which is made possible by population growth, inventions, etc.). If at this point the level of activity in a number of industries is still dependent on the growth of employment and production in other industries—i.e., if replacement demand has not yet picked up by so much as to absorb the whole output of machines10— volume of output will not simply stop expanding and go on at the level which it has reached. It will actually decline in the capital-goods industries, which are geared to the expanding consumers’ goods industries.11

Evidently, the situation cannot be put straight simply by trying to continue monetary expansion. The total production cannot go on increasing at the rate so far maintained. Some capital-goods industries are adapted to an expansion of the lower stages. Hence there must be some change in the direction of production (or else the production in the capital-goods industries in excess of replacement requirements must be taken on stock—an impossible assumption which we may discard a limine). Only a degree of foresight on the part of producers in general which it is too much to expect in the real world could obviate the appearance of such a situation. If it has once arisen, serious repercussions on employment could be forestalled only by a degree of adjustability of producers and mobility of labour which does not exist in reality.

Shift in production inevitable.

Let us now try to compare this situation with those which we have analysed in the first part of this report. Can we classify the situation with which we are now concerned as a case of under-saving or over-saving? In the first part of this work, we defined a maladjustment due to under-saving (shortage of capital) as one which could be avoided if people would save and invest more and spend less on consumption, and a maladjustment due to oversaving (under-consumption) as one which could be avoided by the opposite procedure. In our present case, there must be some shift in production. If this cannot be achieved, neither more nor less saving on the side of the public can prevent trouble. If such a change in production is possible, the further outcome depends on the direction in which it can technically be achieved with least resistance. If in the capital-goods industries which lose part of their market because the lower stages no longer expand output capacity can be comparatively easily adapted to produce other capital goods, an increase in saving will be conducive to re-establishing equilibrium, because it will enable various industries to adopt more capitalistic methods of production—that is, to increase their demand for capital goods without complementary resources being available.12 On the other hand, it may be that an adaptation to the production of some sort of consumers’ goods could be more easily achieved. In that case, less saving will be better calculated quickly to restore full employment. In both cases, however, it is a question, not only of changing the ratio of spending and saving, but also of consuming the required goods and investing in the required direction.

Thus, as soon as one goes into details, the problem becomes extremely involved: a number of variants have to be distinguished: and it is almost impossible to tell which is the most likely outcome. It is, however, practically certain that important shifts in production are necessary and that there is no guarantee that they can be effected smoothly. Temporary unemployment is almost inevitable and a certain number of breakdowns and bankruptcies are very likely to occur. Hence the probability that a contraction process will be started would seem to be great.

Where will “bottle-necks” arise?

We have assumed so far that the expansion proceeds smoothly up to the point where all unemployed factors have found employment and then comes to an end rather abruptly. This is, of course, an extreme case, which will probably not (and need not for our theory to hold) be realised in a pure form. If the expansion does not happen to be directed along “the path of least resistance” as determined by the distribution over various industries of the available resources and their mobility, the situation which we have discussed will arise before all unemployed factors have been absorbed. This will manifest itself in the emergence of “bottle-necks”—that is, in the increasing scarcity of some factors of production leading to a rise in prices of certain commodities and a slowing-down of the expansion in this or that industry.

These bottle-necks may make their first appearance in any part of the economic system. They may first appear in the consumers’ goods industries or in the capital-goods industries, or may be distributed in a random fashion over the whole economic system. It is hardly possible to generalise about their probable localisation, which depends—given the distribution of the available resources at the beginning of the expansion—on the direction in which the latter develops. Let us briefly consider the main determining factors. The boom may be concentrated to a higher or smaller degree in the capital-goods industries. In other words, the roundabout ways of production which are undertaken during the upswing may be longer or shorter. Whether they are longer or shorter depends: first, on the rate of interest and the elasticity of supply of investible funds as determined (a) by monetary factors (banking policy, supply of investible funds from private hoards, etc.), (b) by the public’s propensity to save part of their current income and (c) to an increasing extent by the budgetary policy of Governments; secondly, on technological opportunities to invest, the nature of the “new combinations” which have become available, etc.; and, thirdly, on the amount and direction of consumers’ demand. Compare, on the one hand, a boom fed and propelled by armament demands and public constructions such as is in progress at the present time in various countries, where the share of the capital-goods industries in the increase of production as a whole is exceptionally great, and, on the other hand, one which relies more on current consumption for private purposes.

Clearly all these circumstances may be such that the physical limits of expansion of production are first reached either in the capital-goods industries or in consumers’ goods industries; or the bottle necks may be distributed in any other fashion.

Now, when a number of industries to which others are so geared that their sales vary with the rate of the expansion of the former reach the limit of expansion, a serious setback in the latter is the consequence.

Monopolistic restrictions on supply of factors.

If we say that an industry has reached the limits of expansion, we must interpret this in a broad way. It does not mean that it is physically absolutely impossible to increase production; but it means that cost of production rises so much as to make a further increase of production unprofitable.

This rise in cost may be due to the exhaustion of the supply of particular means of production. Complaints about a scarcity of this or that type of skilled labour in this or that industry become frequent in the later phases of any boom. It is, however, clear that this scarcity and the brake which it puts on the expansion of output can be due to other factors than the exhaustion of the reserve of unemployed. Two of these factors may be mentioned (to which we have already had occasion to refer): viz., a rise in wages due to increased monopolistic pressure by trade unions and an all-round decrease in efficiency.

There is no doubt that the attitude of labour organisations stiffens during the upswing of the cycle. To be sure, money wages will rise even under a regime of perfect competition in the labour market. But it is equally certain that the bargaining position of the trade unions becomes stronger, financially and morally, with rising employment, and that they use it to accelerate the rise in money wages. The power of the labour organisations is also used to reduce the mobility of labour by preventing the entry of newcomers into particular industries, when the reserves of unemployed labour attached to these industries have been absorbed.13

Decline in efficiency.

Labour cost is further enhanced—in other words, efficiency wages raised—by the fall in efficiency of the workers, which occurs everywhere during the upswing. As was pointed out in Part I (pages 108 et seq.), two tendencies must be distinguished. The average output per worker falls, because inferior plant, less-qualified workers and so on are drawn into employment when output expands. This is a consequence of the gradual exhaustion of the supply of idle means of production. We are here, however, concerned with the other tendency: viz., the fall in efficiency of each worker below the previous level for the reasons indicated by Professor MITCHELL.

These tendencies to a rise in money cost may be, and in many cases actually are, compensated or over-compensated by monetary expansion and a rise in prices. But this will again tend to stimulate the demands of organised labour, so that the spiral of rising cost and rising prices will be accelerated.

It is very likely that the attitude of labour and the rise of wages during the upswing will put a brake on the further expansion of employment and output in a number of industries long before the physical limits have been reached. This is especially true when the money supply is beginning to give out for one reason or another—e.g., because the pace of monetary expansion in the country is more rapid than in neighbouring countries. Increasing monopolistic pressure on wages and reduced mobility of labour create an artificial scarcity of labour, as it were, long before the physically available stock of unemployed has been exhausted.

It goes without saying that the monopolistic restriction of the supply of factors of production other than labour, and the raising of prices other than wages, have the same effect of slowing-down general expansion.

Drop in investment because of insufficient demand.

So far we have discussed the case where the expansion is allowed to develop up to the limit set by the amount and distribution and willingness to work of the available means of production, or where the expansion comes to a halt because of an insufficiency of the money supply. We have seen that it is very likely that serious maladjustments will make their appearance when the general expansion comes to a standstill for the reasons indicated, or even when it slows down to a certain extent.

We have now to enquire whether there is not a strong probability that the expansion will be interrupted at an earlier stage for the reason that it generates a type of maladjustment other than that which we have discussed, before it reaches the limits in question. The type of maladjustment which we have in mind is an insufficient demand either for consumers’ goods in general, or for certain types of them, or for certain types of capital goods. It is that type of maladjustment which Professor ROBERTSON ascribes to the temporary “gluttability of wants”, or which Professor PIGOU has in mind when he says that the optimistic forecasts which have been made during the boom, and have materialised in heavy investments in different lines of industry, are brought “to the test of facts”—and, by that test, are found wanting—after the close of the gestation period for a number of things the production of which was started during the upswing. A maladjustment of this sort is also what Professor SCHUMPETER has in mind in his explanation of the collapse of the boom.

The idea is that the investment activity which takes place during the upswing is to a large extent concentrated in particular lines of industry—railway construction, automobile production, electrical machinery, etc. Then comes a day when the investment opportunities in these fields are exhausted; the want—or, rather the demand—is satisfied. Investment in these lines must come to an end. There is no guarantee at all that replacement demand will meanwhile have risen to such an extent as to enable it to keep the whole productive apparatus busy.

Repercussions not foreseen by producers.

When this point of saturation has come, suddenly or gradually, there are several possibilities as to the outcome. The industries directly concerned may have correctly foreseen that demand is no longer going to rise, and may even fall, and may have adjusted their output so that they are not involved in difficulties. Alternatively, they may be taken by surprise: the “competitive illusion”, undue optimism, or any other reason may have led to an over-expansion of the particular industries concerned.

In the second case the boom will explode with a more or less strong “detonation” of bankruptcy, to use an expression of Professor PIGOU; and (as has already been shown in previous sections) it is easy to explain when and why this will lead to a general depression. In the first case, no such detonation occurs in the industries directly concerned. They simply reduce output and employment. But it is very likely that some tributary industries which supply raw materials or equipment will be taken by surprise, since it is unreasonable to suppose that all producers—including those who are removed by one or two stages from the point where the initial setback occurs—will foresee correctly what is about to happen at this point and what its repercussions on other industries will be. Moreover, there are always the unfavourable repercussions on the consumption industries which are still less likely to be foreseen by the producers. If output and employment fall at any point, the demand for consumers’ goods is bound to suffer; and this then reacts on the higher stages of production. If the primary satiation of demand in some lines and the consequent drop in output have occurred, these repercussions on the consumption trades are almost unavoidable. They could be avoided only under perfect mobility of factors and a smooth working of the capital market; and (as has been already explained in detail) neither of these two conditions is likely to be fulfilled. We cannot assume that the sums which are liberated by a decline or cessation of investment in certain lines will automatically and instantaneously find an outlet in other lines of investment. It is more than probable that at least a certain lag will occur, which will be quite enough to allow the deflationary tendencies to come into operation through the agency of a fall in the demand for consumers’ goods and other developments.

There is no need to repeat our explanation of how these deflationary effects arising at any particular points may be compensated by inflationary tendencies in other directions. Such a development is not unlikely in the first part of the upswing, when the momentum of the expansion has not yet been lost, because investment is still going on or is being started in a number of directions. But, as has been explained earlier, this partial immunity against deflationary shocks must sooner or later give way to a state of greater vulnerability. If at that stage such a maladjustment as is described above should occur, it may easily lead to a general contraction.

This type of maladjustment inevitable?

But, to return to the nature of the first impact with which we are here concerned, is it possible to say generally that such maladjustments are bound to occur during any expansion, or are likely to occur, or the contrary? It would seem that theoretical reasoning, backed by a limited amount of actual experience of broad tendencies, is not sufficient to prove rigorously either that such maladjustments are the absolutely inevitable outcome of any expansion or the reverse. We can only say there is a prima-facie probability that they are. We can figure out the consequences approximately—always again in terms of possibilities and probabilities: but only extensive empirical studies can show whether the contention of so many well-known writers is correct, and it is actually a fact that processes of expansion regularly develop a certain type of maladjustment and in turn are brought to an end by them.

Recently, Mr. N. KALDOR, in an interesting article,14 adopted a very similar position and tried to classify the probable reasons of the breakdown of a boom along similar lines as in the preceding pages, with some variations in detail (mainly of a terminological nature). He attempts to put them in the order in which they are likely to appear successively in time, and likens the boom to a peculiar steeplechase where the horse has to overcome a series of hurdles and is almost certain to fall at one of the obstacles.

B. The Up-turn: Revival

§ 6. INTRODUCTION

The order of the argument.

We have now to answer the question what the limits of a cumulative contraction process may be, and how it can be brought to an end. How is the downswing usually stopped and reversed? In many respects, we need only adapt the assumptions and arguments adduced when we discussed the opposite problem: viz., that of the down-turn. Without pressing this parallelism too far, we may proceed in the same order which we adopted there.

In § 7, as a first step, we shall discuss the inflationary counterparts of the deflationary shocks analysed in § 3 of this chapter. We assume the occurrence of certain changes—such, for example, as an inflationary move on the part of the monetary authorities or anybody else, or a favourable turn confined to a particular industry—and investigate how this may bring about a general expansion. We leave open for the moment the question whether such changes are more likely to occur in any one phase of the cycle—e.g., the latter part of the depression, rather than in any other.

In § 8, as a second step, we shall show why, after a contraction has continued for a time, the economic system becomes more and more sensitive to stimulating influences, in the same way as with the progress of an expansion it becomes more and more exposed to deflationary shocks.

In § 9, as a third step, we shall discuss those favourable reactions and stimulating influences which are likely to be brought about in the economic system after a contraction has gone on for some time.

The logical relation between the second and third steps may also be stated as follows. A process of contraction is likely in the course of time to exhaust its strength and lose its momentum. The downward movement may then be easily reversed by any such favourable stimulus affecting a particular industry as is bound to occur from time to time. The same stimuli will not so easily start an upward movement, if they occur at an earlier moment, when the contraction has not yet spent its force.

Besides thus paving the way for the expansionary influence of some chance event, the contraction is also likely itself to give rise to inflationary stimuli. We shall see that it is sometimes difficult to draw the line between the two types of stimulating shock: that is to say, it is not always easy to decide whether a certain event, which actually played the role of the starter for an expansion, would have arisen in the absence of the previous contraction. Neither the validity, however, nor the usefulness of our distinction is destroyed by the existence of doubtful cases.

§ 7. THE PROXIMATE CAUSES OF REVIVAL

Asymmetry between turning-points.

An expansion can always be stopped and a contraction process started by a restriction of credit by the banks. A contraction, however, cannot always be ended promptly merely by making credit cheap and plentiful. There will always be a rate of interest high enough to discourage even the most eager borrower; but, when prices and demand are falling and are expected to fall further, the demand for investible funds may be at so low an ebb that there is no rate (short of a negative figure) which will lead to a revival of investment and entail an increase in the effective circulation of money—that is, in the total demand for goods in terms of money per unit of time. There is thus a certain asymmetry between the upper and the lower turning-points which necessitates some departures in the method of exposition from that adopted in the corresponding section on the down-turn.

Producers’s spending.

We shall now attempt to set out the various possibilities and factors involved in an orderly and systematic fashion on the basis of our demand-and-supply schema for investible funds.

An expansion can be brought about by an increase in the expenditures either of producers or of consumers. In the further course of the upswing, each type of expenditure stimulates the other: but here we are concerned with the initiating forces. First we propose to discuss the possibilities of an increase in producers’ spending—that is, of a revival in investment as the starter of an expansion.

A stimulus to investment can come either from a change on the demand side or, if there is still a latent demand for investible funds—latent, i.e. not effective, because the ruling rate of interest is too high—from a change on the supply side. Anything that has the effect (other things, including the demand for consumption goods, being equal) of shifting the demand curve or the supply curve to the right tends to bring about an expansion.15

Let us now discuss in turn those factors which affect supply and those which affect demand.16

Factors increasing supply of investible funds.

If the demand for investible funds is really so inelastic over a certain range that a change in the interest rate has no influence at all on the amount of money invested (that is to say, if the demand curve is a vertical straight line), a change on the supply side will make no difference to investment or to the effective quantity of money. This is, however, not the rule, even at the bottom of a depression. It may be the case for certain types of credit—e.g., short-term loans: but usually there will be some latent demand which could be satisfied if the terms of credit for the particular purpose were less onerous. This is especially true of long-term credit and the branches of production financed thereby, notably the constructional trades. The demand for private houses is especially sensitive to the rate of interest on long-term loans, and shows a tendency to rise in the depression, when interest rates are low, in spite of the shrinkage of incomes. It is sometimes found, however, that the public evinces a reluctance to lend for long periods at times when short-term money is cheap. The reason for this is lack of confidence in general—i.e., the fear of risks of every sort.17 Modern economists are accustomed to describe this state of affairs by saying that the liquidity premium is high or the liquidity preferences are strong. It requires a large differential between long-term and short-term rates to induce people to part with their liquidity by investing for a longer period rather than for a short one.

Given, then, the state of demand for loans of various types and maturities, we may say that anything which makes supply more plentiful tends to initiate an expansion. We cannot give here a complete catalogue of all factors which might conceivably have an influence in this direction. One of the most important influences is that of the central and commercial banks, whether exercised through discount policy with a view to increasing the liquidity of the short-term (money) market or through open-market operations which affect primarily the long-term market. There are, however, technical difficulties in extending such a policy, at least so far as the central banks are concerned, to other than Government securities. Apart from the initiative of the banks, anything that removes risks and strengthens general confidence will have an encouraging effect on the supply of capital.

A change in the international economic situation of a country will often be a prerequisite to any increase in the supply of capital or reduction in the rates of interest. The existence of price discrepancies between countries and the consequent pressure on the balance of payments in the high-cost country frequently block a fall in the interest rates of the latter. The history of the post-war period and of the recent past offers plenty of examples of the various devices which may be employed to eliminate such price differences (e.g., devaluation of the currency), or to prevent them from having an influence on the balance of payments and the internal money market (e.g., rigid exchange control), or to remove the causes for flight of capital from a country or to hinder it effectively. These various measures need not be discussed here in detail.

Increase in demand for investible funds.

We turn now to the discussion of factors exercising a favourable influence on the demand for capital. Whilst it seemed necessary to show by a detailed analysis why a partial disturbance, which primarily affects production only in a particular branch of industry, may under certain circumstances produce a temporary hold-up in the money stream and thus engender a general contraction, it would seem to be more obvious that an event which leads to an increase in production in a particular industry will in most cases also lift the total flow of money to a higher level than it would otherwise attain, if only the money supply is elastic. If in an individual firm or industry output is being expanded, workers must be hired, raw materials bought, machines and other equipment ordered. If for that purpose money is used which would not be used otherwise, the money stream swells and the demand for other goods rises. It is of course immaterial whether new money is created by the banks or idle funds are utilised; in other words, whether the increase in total demand is financed by an increase in M or an increase in V.

Discussion of particular stimuli to investment.

Are there no offsetting influences which tend to nullify the expansion in the flow of money, corresponding to those which we have discussed in connection with the problem of the down-turn? In some cases there are; but it would seem that in most there are not.

If an increase in production in industry A is due to a shift in demand, then there is of course a compensatory change in the shape of a decrease in demand and output in industry B. We have already discussed on what circumstances it depends whether a shift in demand will have on balance an inflationary or a deflationary effect.

In many other cases there are no offsetting influences except perhaps in very special circumstances. If a capital-goods industry increases production because equipment must be replaced somewhere, or if an invention is made which necessitates the installation of capital equipment, or if the scale of output is raised somewhere simply because an increase in demand is anticipated, or if cost of production is lowered in a particular industry—e.g., by the reduction of wages or of the price of some means of production, so that the industry is induced to expand production and to disburse more money for labour and means of production—in all these cases there is an immediate increase in the flow of money from the rise in output without offsetting influences coming into play. At any rate, they will not come into play at once (it is always possible, of course, to conceive of complicated attendant circumstances under which compensatory forces might be brought into operation indirectly). Any such change may therefore act as a starter for an expansion.

A general reduction in wages over the whole industry, on the other hand, is a doubtful case which we shall discuss laters (§ 9 below).

The imposition of a tariff will usually stimulate capital investment in the protected trades and thus raise their demand for investible funds. Moreover, the supply of money will be favourably influenced by a reduction in imports, except where there are indirect counter-effects (e.g., retaliation by foreign States).18 Reserves of gold and foreign exchange in the banks will be increased as a result of the reduction in imports, and this will tend to ease credit conditions. It should be noted that the two effects which a tariff has on the demand and supply of money are independent of each other. If, for example, durable plant is installed in the protected industries, the influence on the demand for investible funds during the period of construction of the plant may be much greater than the influence on the supply side. Under other conditions, the “indirect” influence on investment through the supply of funds may be more important than the “direct” influence through demand.

Increased consumers’ spending.

So far, we have discussed factors arising in the sphere of production, prior to a rise in consumers’ demand, although leading subsequently to increased consumers’ spending. We come now to the other important group of phenomena referred to above which may act as powerful stimuli on investment and on the demand for investible funds: namely, inflationary increases in the demand for consumption purposes.19 An increase of foreign demand for home-produced goods will have similar effects.

We have seen that an increase in consumers’ demand is an indispensable link in the cumulative process of expansion. It is difficult to see a reason why an increase in consumers’ spending should not stand at the beginning of such a process. Notwithstanding Professor SPIETHOFF’S opinion to the contrary, there can be no doubt that, ceteris paribus, a net increase in consumers’ demand will not only lead to revival in consumers’ goods industries, but will also stimulate investment—always on the assumption that there is an elastic money supply.

A net increase in consumers’ spending might conceivably be brought about by acts of dishoarding by private individuals. Precipitate purchasing because of the fear of rising prices is a case in point. This case, however, does not seem to be typical of the process by which revival is set going after a depression. A much more important influence—not so much for the past as for the present and the future—is the increase in consumers’ spending deliberately induced by Government action in the shape of public works programmes, increases in ordinary expenditure and relief measures, all financed in such a way as to create a net increase in the total demand. We cannot here go into the numerous and complicated problems of a fiscal, administrative and political nature connected with such schemes. Only this much may be said—that from the short run economic point of view the main task is to finance these works in such a way that they stimulate demand for goods without restricting it in other directions, which would probably be the case if the necessary funds were raised by taxes. In the Anglo-Saxon countries it should furthermore not be forgotten that only a few other countries can borrow huge sums from the market without either making funds scarce for private investors or provoking psychological repercussions which may easily check private investment. Such a situation may be created by an alarming rise in central-bank money, especially in countries such as Germany, where the memory of a hyper-inflation is still fresh. It may be added that the budget deficit created by reduction of Government revenue (e.g., tax remissions) may be just as effective as one created by an increase in expenditure (e.g., public works). The tax remission method may recommend itself to many people, in as much as it does not involve the danger of a permanent extension of Government activities.20

Summary.

The upshot of the discussion in this section is that there are many different types of expansionary shocks and influences, each of which can conceivably act as a starter for a general process of expansion. Whether they actually do so or not depends in any given case on the magnitude of the particular change and on the general situation. If a process of contraction is under way, a strong expansionary impetus is required to restrain and reverse it. If the contraction has spent its force, a slight stimulus may be sufficient to start the system on the up-grade.

§ 8. WHY THE ECONOMIC SYSTEM BECOMES MORE AND MORE RESPONSIVE TO EXPANSIONARY” STIMULI AFTER THE CONTRACTION HAS PROGRESSED BEYOND A CERTAIN POINT

The contraction loses momentum.

We have seen that a process of contraction, if it has had a chance to develop unobstructed for a time, gathers force and becomes too strong to be reversed by expansionary stimuli such as those analysed in the preceding section, except when these are very powerful. This paralysis is the result of the fact that the total demand is shrinking continuously and idle capacity is piling up everywhere, so that a stimulating event which under other circumstances would cause an increase in the total demand is now unable to do more than retard the downward movement: it cannot turn the tide. We shall now enquire why the contraction is likely after a while to lose its strength, with the result that the economic system regains its responsiveness to such expansionary forces as may make themselves felt from time to time.

It has been demonstrated that the economic system during an expansion tends to become increasingly vulnerable when it approaches full employment, first, because the supply of means of production in general and labour in particular becomes more and more inelastic in the upward direction and, secondly, because the expansion of total monetary demand, of MV, must sooner or later slow down or else prices must rise continuously—which again cannot go on for ever. We have now to apply this reasoning to the inverse situation as its develops during a contraction process.

Restored elasticity in supply of factors.

There is obviously a tendency for the elasticity of supply of means of production of all kinds, of labour and producers’ goods (produced means of production) to become greater the farther a contraction goes. The supply of labour recovers its elasticity in the upward direction: that is to say, an increased demand for labour can again be satisfied at constant, or only slightly rising, wages by abandoning short time or taking on new men. (As has been explained earlier, the supply is elastic in the downward direction—i.e., wages are rigid in that direction—even at the height of the boom.) Similarly, monopolistic restriction by entrepreneurs—whether by means of amalgamations, cartellisation, or other methods of organised joint action by producers, or whether it is the result of the lethargy of individual competitors and their fear of “spoiling the market”—often succeeds in maintaining relatively stable prices for certain goods and services right through the contraction. In this way, elasticities are created in the supply of means of production and products at various stages of preparation. An effect similar to that of increasing elasticity of supply may be brought about in the course of the decline by an increase in the quantity of sub-marginal agents of production—land, or industrial plant—which acquire a value and a use as soon as demand revives. The consequence is, as we have already demonstrated elsewhere, that it becomes easier for any one industry to expand production in response to an actual or expected increase in demand for its product, without thereby increasing the cost of production of other industries. In other words, the depressing consequences of certain changes are thereby mitigated, while the expansionary consequences have free play.

Restored elasticity of credit supply.

The second prerequisite for an easy start and smooth development of the expansion process—viz., an elastic money and credit supply—is eventually restored in the course of the contraction. As prices fall, the value of central-bank money which is at the base of the credit structure will rise. So long as the structure itself remains undamaged, each tier will be broader-based than before. The gold reserve will cover a larger proportion of the central-bank money; the cash reserve of the banks will rise relatively to their short-term liabilities; circulating currency and deposits in the hands of the public will rise relatively to the money income which they receive and the capital which they possess. But this process need not be continuous: it may encounter a whole series of setbacks. The mounting debt burdens and the struggle to avoid bankruptcy themselves create a need for ready cash, while bankruptcies and the fear of good debts turning into bad ones give rise to a flight to liquidity which is not satisfied even by increased reserve proportions and rising hoards. If the credit structure gives way spasmodically, we may see an oscillatory movement in which liquidity diminishes and increases several times in the course of the depression. It is, however, only a matter of time till the course to bankruptcy is arrested, and the monetary munition accumulates for a new expansion.

Limits to the fall of MV.

But, we must now ask, is there a bottom to the fall of MV, the monetary contraction? In the corresponding problem of monetary expansion, we were able to show that there is a limit to the rise in MV, beyond which the continuation of the expansion becomes very precarious. The limit in that case was found to be inherent in the tendency of the expansion to produce increasingly a rise in prices, rather than a rise in employment and production, as the state of full employment is approached. Is there a corresponding limit to the fall in MV? The deflation can, of course, be stopped by any one of the factors making for expansion analysed in the preceding section. (These factors may arise by chance; but, as will be shown in the following section, they may be expected to arise in any case with the lapse of time as a reaction against the contraction process.) Supposing, however, that no such change for the better, strong enough to turn the tide, occurs—is there a general reason why the contraction of MV should come to an end?

Logically it is of course conceivable that, in the absence of an expansionary impulse, the contraction should go on and on indefinitely: but there is good reason, based on general experience of human behaviour, to suppose it will not do so. In this connection, there is one important consideration which is sometimes overlooked. A persistent shrinkage in MV—i.e., in the total monetary demand for goods—must be accompanied either by a continued destruction of money or by a continued accumulation of money hoards. How far the process of destruction will go in a concrete case depends on the monetary organisation, institutional factors and international situation of the country concerned. Nowadays, it is mainly deposit money, rather than central-bank money, which is exposed to destruction. To what extent the destruction of deposit money goes depends on the organisation of the banking system and to a great extent also on factors which may vary from one depression to the other, such as the methods adopted in handling a panic, the special connections between the banks and the particular industries especially hard hit by the depression, and so on. The way in which the banking organisation influences the severity of the deflation through money destruction is well illustrated by a comparison between what happened in the United Kingdom with its unified banking system on the one hand and the United States with its thousands of small insolvent banks on the other hand during the depression of 1929 to 1933 as well as in previous cycles. It is common knowledge what happened: the sole purpose of the preceding remarks is to give the question of the influence of the banking organisation its proper place in our system.

Accumulation of money hoards.

After the destruction of money has come to an end—as sooner or later under any monetary system it must do—continuance of the contraction must be accompanied by a growing accumulation of money hoards in various shapes; liquidity increases, M2 goes up. The magnitude of these hoards will increase, as measured in terms of the monetary unit, at the expense of money in circulation: it increases still faster, owing to the fall in prices, in terms of real purchasing power.

These hoards will grow in relation to real income as well as in relation to real wealth. In other words, people will hold an increasing proportion of their real income and wealth in the liquid form of money. It should be noted that, so long as people are adding to their hoards—in other words, so long as “the struggle for liquidity” goes on—the rate of interest (on investible funds) will be kept relatively high in spite of the fact that the demand of producers for money for investment purposes is at a low ebb. Under unfavourable circumstances, such a situation may last a long time: but, as it implies that money hoards are growing all the time in magnitude, we are probably justified, in the light of our general knowledge of economic behaviour, in assuming that there will be a limit to such hoarding. After liquid resources have reached a certain high proportion of wealth, the need for liquidity will eventually become satisfied and people will stop adding to their hoards. If the rate of interest remains high, because there is still a demand for credit for purposes of real investment (as will be the case in poor countries rather than in rich communities), hoarders will be tempted to put their funds on the capital markets sooner than if the rate of interest has already fallen to a low level. But, even if the rate is very low, there will come a point when hoards reach such a high proportion of income and wealth that there is no point in increasing them. One or both of two things will then happen. Either more money will be lent out on the capital market, with the result that interest rates will be forced down (beginning probably with the short-term rates and ending later with the long-term rates) and investment will revive; or, if the demand of producers for credit is absolutely inelastic, people will become less disposed to save—in Mr. KEYNES’ terminology, the propensity to consume will rise in addition to the decrease in the liquidity preference—and the demand for consumers’ goods will cease to fall, or may even rise. Instead of putting away their money receipts in their hoards, people will either spend them on consumption or lend them out through the capital market.21

The upshot of this analysis is that on very general grounds there is a strong probability22 that there is a limit to the fall in MV, even in the absence of any special stimulus for expansion. An assumption to the contrary would imply an increase ad infinitum of money hoards in relation to income and wealth. When MV has ceased to fall, when (that is) contraction has come to an end, the economic system becomes very responsive to expansionary impulses and comparatively immune from deflationary shocks.23

This analysis is not intended to suggest that contractions always or usually develop up to that very distant limit or that it is safe or good policy to allow them to pursue their course to this “natural” end. The object has been to present the problem in its most general form to serve as an introduction for the following section. Closely connected with—and sometimes almost indistinguishable from—the factors which operate to limit the shrinkage in MV, there are other forces or reactions which make for an expansion of MV. These it is now proposed to discuss in conjunction with other expansionary impulses which are more or less likely to arise, sooner or later, in connection with the progress of a contraction.

§ 9. EXPANSIONARY TENDENCIES WHICH ARE LIKELY TO ARISE DURING THE CONTRACTION

The “natural” forces of readjustment

In § 7 of this chapter, we analysed a number of factors which are capable of generating an expansionary impulse and so starting a process of expansion. The expansionary impulse was there taken for granted as a point de départ, and the question whether such hypothetical impulses arise by act of God or Government, or whether they may be expected to arise automatically with the operation of the mechanism of the market, was left for subsequent consideration. In the present section, we shall enquire whether the economic system is capable of putting an end to a contraction process and turning it into an expansion, on the assumption that (a) the Government does not take active steps (such as a public works scheme) to start an expansion, and (b) that no chance event (such as a new invention or a series of good harvests or an impulse from abroad) comes to the rescue. It is here that we shall have to analyse the “natural” forces of readjustment, the tendencies towards equilibrium which are frequently too readily taken for granted as being inherent in the economic system, if only the price mechanism is allowed to function unobstructed. We shall see that there are expansionary impulses of this kind which can be relied upon with a fair degree of certainty to occur automatically sooner or later and to turn contraction into expansion. (But, in so saying, we are not by any means arguing that it is desirable to wait until these “natural forces” start the system on the up-grade, in preference to taking action to expedite the revival and, possibly, to directing the expansion into channels other than those which it would take if left alone.)

In § 7, it was shown that an expansion can be started by some event or factor which brings about in the first instance an increase of consumers’ spending, or by one that stimulates producers’ spending (investment). (After the expansion has once been started, both types of expenditures stimulate each other: investment generates income and demand for consumers’ goods, and an increase in consumption induces further investment.) When we look for automatic expansionary impulses, we shall find them primarily in the shape of factors which directly stimulate producers’ spending (investment). Here, again, it is convenient to distinguish between changes on the side of the supply of, and demand for, investible funds; but it must not be forgotten that there are factors which affect demand and supply at the same time.

Return of confidence.

We begin with changes on the supply side. We assume that demand for investible funds has not completely vanished—that is to say, that there is a latent demand at a positive rate of interest which cannot be satisfied because the ruling rate of interest is too high owing to the supply situation (lack of confidence on the part of the banks and the investing public, high liquidity preference). This being so, the cessation of the hoarding process, as described in the preceding section, will not only bring the contraction in MV to a halt: it will also lead in course of time to an expansion. When the banks, industrial firms and private individuals have on the whole reached the conclusion that their cash reserves are large enough—in other words, when they have attained the degree of liquidity which they deem in the circumstances to be desirable or necessary24—the rate of interest will fall, because a certain amount of money will be put on the capital market instead of going into hoards. Investment will pick up a little; and this will stabilise MV and the aggregate demand for goods. It will also bring about a stabilisation of employment and production. If such a state of comparative stability has lasted for a while without new business failures and other shocks to confidence, confidence will return and people will be tempted to reduce their hoards. When prices have once ceased falling, or when they are expected to remain stable or to rise, there is a strong inducement to dishoard, since hoarding means the sacrifice of the profits of investment.25 On the other hand, during the contraction, the debt burden of industry will have been reduced in various ways and thus the basis for a revival of financing increased production by loans, etc., will have been restored.

This process of a gradual restoration of the basis for a new expansion of investment has been frequently described. The analysis could be much more detailed. Such expressions as “general state of confidence” or “pessimism” and “optimism”, even if restricted to the suppliers of investible funds, relate to very complex phenomena. Different types of risks and fears may be distinguished, some of which refer only to long-term investments while others refer to long and short-term investments of various types. A number of institutional complications might be introduced. We confine ourselves to analysing the process in outline. The basic fact which one has to keep in mind is that the return of confidence and the disappearance of pessimism lead to dishoarding, to an increase in the supply of investible funds and, if there is demand for such funds, to an increase of MV (demand for goods) and of employment and production.

Revival of investment.

We turn to the demand side. When a contraction has continued for a long time, when prices are sagging and demand is falling almost everywhere, the demand for investible funds may have reached almost the vanishing-point, so that a fall in the supply price (that is, of the market rate of interest) even to a very low level may have very little influence. Nobody dares to invest. But the reason is not that the accumulation of real wealth has gone so far that physically there are no investment opportunities left—i.e., that there is no possibility of increasing output by adopting time-consuming processes of production. The reason is rather the fear that prices will fall and a lack of confidence, a feeling of uncertainty about the future in general. It follows that, when total demand and prices have once settled down at some level or other, the demand for investible funds will rise automatically with the mere lapse of time. The fear that prices will fall further will gradually disappear and certain investments, which would have been possible and profitable but have not been undertaken because of the fear that demand and prices would fall further, will begin to be made.

It is very likely that during the contraction, when investment was at a standstill, new inventions may have been made which, in spite of the fact that (at the ruling prices) they would reduce the cost of production,26 have not been put into application because they necessitate more or less heavy investments which the entrepreneur is not willing to make when he expects a fall in demand and prices. Thus a stock of investment opportunities is accumulated, which is likely to induce investment expenditure as soon as the general price fall has been stopped. The way in which, after a long spell of depression, the ice is broken by some enterprising spirits who have the courage to try something new in some line of production, and the way in which the example they set is followed by others in the same or other branches of industry, are described in classical language in the various writings of Professor SCHUMPETER. “Whenever . . . new things have been successfully done by some, others can, on the one hand, copy their behaviour in the same line . . . and, on the other hand, get the courage to do similar things in other lines, the spell being broken, and many details of the behaviour of the first leaders being applicable outside their own field of action.”27

Replacement demand.

Another factor closely connected with, or even indistinguishable from, the revival of new investment (probably in new and untried combinations) is the increase in replacement demand. During the contraction, not only new investment, but also reinvestment has been curtailed. On the other hand, the capital equipment of industry deteriorates by wear and tear and obsolescence. Therefore, even with the reduced volume of output, it is very probable that sooner or later the need for replacement will make itself felt in one industry or another, which leads to dishoarding or new borrowing and an increase in MV.

There is a further point. Producers know from experience that prices will not fall for ever. When prices have fallen for a time, they will probably become more and more inclined to anticipate a reverse in the price movement. Accordingly, they will not put off improvements and replacements for so long as is possible from the technological point of view without impairing the process of production: they will rather seize the opportunity of having the improvements and replacements made when prices are still low.28

Fall in wages.

We must now discuss one very important type of adjustment which under a competitive price system would appear to be the natural cure for unemployment—namely, the reduction of money wages and other cost items.29

We are not here concerned with the social and moral aspects of the problem. Nor do we focus attention on the problem of whether a reduction in wages is the best method of bringing a depression to an end (assuming that it is a possible method and that there are alternative methods). The problem with which we are concerned is a more modest one, although it would seem that its solution is an indispensable preliminary to any answer on the questions of policy.

The problem is this. Is the fall in money wages which we observe during any major depression to be regarded as a factor which tends to put an end to the contraction? Would depression be alleviated and revival hastened if money wages were more flexible and fell more rapidly so long as unemployment persists ?30

This is a very-much-disputed question. Many economists see in a reduction of wages the unavoidable and infallible remedy against unemployment. Others denounce it as useless or even detrimental.

Monetary implications.

A large part of what has been written on the subject has been vitiated by the fact that the monetary implications of the various theories have not been made clear. Many argue on the tacit assumption that MV can be taken as constant, or at any rate as independent of changes in money wages. If this were true, if total monetary demand were not influenced by a reduction in money wages, then of course, with lower money wages, employment and production would be greater than with higher wages, because, with lower wages and prices, the same amount of money would buy more goods and provide more employment. Others have assumed tacitly or without adequate proof that MV will fall by the same amount as pay-rolls have been reduced (or even by more), so that the general situation remains unchanged (or even deteriorates). Each of these extreme assumptions—or, for that matter, an assumption intermediate between the two—maybe true under certain circumstances and false under others. Without specifying the attendant circumstances and distinguishing a number of different cases, nothing definite can be said.

We begin by assuming an isolated country, leaving complications arising from international trade for later treatment. What holds true of an isolated country holds true substantially also of any big country which need not allow its internal policy to be influenced by considerations of international trade.

Effect of wage reductions a particular industry.

If an individual firm manages to reduce wages, it will usually be able to expand production at the expense of other firms in the same industry, so that the others will be forced to follow suit. Therefore, we had better start with the assumption that money wages are reduced throughout the entire branch of industry concerned. What will be the possible or typical reaction of the wage-cut on this industry—leaving aside for the moment indirect influences on other industries and repercussions of these secondary effects on the industry where wages were reduced? We shall try to answer this question with special reference to the problem of how MV is likely to be affected.

A priori, there is a wide range of possibilities. At the one extreme the industry may expect a great increase in demand from a fall in price made possible by the reduction of cost, and may accordingly increase production by so much that employment increases by more than the wage has fallen, so that the sum disbursed for wages directly and indirectly through the purchase of raw material and equipment is actually greater than it was before. (We characterise this by saying that the elasticity of the industry’s demand for labour, including indirect demand exercised through the purchase of means of production, is greater than unity—which involves an even greater elasticity of demand for the product of this industry.)31 In the other extreme, there is the possibility that output and employment are not increased at all (the elasticity of demand for labour being zero) so that the amount saved is withdrawn from circulation—e.g., by repaying bank loans or by not contracting new ones. The position of the banks is thereby improved: but, since we are speaking of a period of contraction, we cannot assume that the whole of the sums repaid will be re-lent to other borrowers. We are certainly nearer to the truth if we assume that at least a part will be used to strengthen the reserves of the banks.

In order to avoid a post hoc ergo propter hoc argument, we must make the preceding statement more precise. We may say that employment will, or may, rise to such an extent that wage disbursements (directly in the industry concerned, and indirectly in the preceding stages through the purchase of raw materials and other means of production, etc.) are raised above the level which they would have attained had the reduction in the wage rate not occurred. This formula covers the case (which during a general contraction may easily occur) of a wage reduction inducing an industry to refrain from contracting its employment and pay-rolls by so much as it otherwise would have been forced to do, so that the wage reduction does not bring about an increase in employment and pay-rolls in comparison with the preceding period but prevents it from falling to a lower level. The other extreme is then the case where employment is not increased at all above the level which it would have attained if there had been no reduction in wages—a level, namely, which would probably be lower during a general contraction than in the preceding period—so that the amount of money withdrawn from circulation is greater than it would be if no wage reduction occurred.

In the first case, the wage reduction has an expansionary influence, so that the contraction is mitigated or even reversed. In the second case, the influence is deflationary, and the contraction is hastened and intensified.

Will pay-rolls rise or fall?

We now ask, Is it possible to decide on general grounds which of the two possible outcomes of a wage reduction is likely to prevail during a contraction process? Can the fall in money wages be regarded as something which, on balance, mitigates and shortens the contraction, or is it an intensifying factor? We may certainly assume that employment and output in the industry directly concerned will be influenced favourably.32 It is hardly conceivable that an industry would react to a fall in money wages by giving less employment than it would otherwise do. But it does not necessarily follow that employment and output must rise to such an extent that wage disbursements increase. For various reasons, during a depression, especially its first phase, wage reductions are less likely to have a strong expansionary influence than during the upswing of the cycle. There is excess capacity (surplus equipment) in many lines of industry; and there may be large stocks from which raw materials and semi-finished products can be obtained—i.e., output can be increased without heavy new investment. If new investment in fixed capital were required, it would be difficult to raise the necessary sums. Pessimism prevails, and people are reluctant to take the risk of investment for longer periods. But, as we have seen, these conditions are likely to change gradually when the contraction has progressed far enough. On the other hand, a reduction in wages is bound to have a favourable psychological effect on business-men, and will make them more inclined to invest and the banks more inclined to lend; and this tends to mitigate deflation.

Influence of cost reduction on sales receipts under competition and monopoly.

There is another very important point to be mentioned. The case where producers use part of what they save through the cut in wages to strengthen their liquidity or to repay bank loans implies that total receipts from sales do not fall by so much as pay-rolls. In other words, if prices fall so much that all that is gained by cutting wages is passed on to the consumer, the position of the producer is not improved and there is no scope for additional hoarding so far as he is concerned. This could only happen under conditions of perfect competition and even then not to a full extent. Even on the assumption of perfect competition in the strict sense of economic theory, when every producer regards the price at which he can sell as given independent of his own action and expands his production accordingly up to the point where his marginal cost equals the price—even on this assumption total receipts will not fall by as much as pay-rolls except in the improbable case of marginal prime cost being constant—i.e., the marginal cost curve being horizontal. In all cases where marginal cost rises, only a part of the reduction in the total cost of production which has been achieved by the cut in wages will be passed on to the consumer.33 In other words, gross profits will be increased—though net profits will still be negative, since the gross profits do not cover amortisation of the fixed capital—and there is therefore scope for increased hoarding or repayment of bank loans. This is a fortiori the case where there is not free competition in the strict sense of economic theory, and prices under monopolistic or quasi-monopolistic conditions (or simply as a result of friction or fear of spoiling the market) are prevented from falling to the point of equality with marginal cost—in other words, where producers fail to expand production up to the point at which marginal cost equals price.

We conclude, therefore, that the freer the competition and the more flexible the price the greater the favourable effect of wage reductions and the smaller the danger of an intensification of deflation. That conclusion is no more nor less than was to be expected. It does not follow, however, that such an intensification of the hoarding process as a consequence of a wage reduction is impossible, even under competition in the strictest sense.

Repercussions on other industries.

Suppose employment and output in a particular industry to have been somewhat increased in response to a fall in money wages, but not by so much as wages have been reduced, so that there results a decrease in the disbursements of wages by the industry in question. This increase in employment and output is certainly desirable: but we have also to take into consideration the effect on other industries. This depends on what happens to the increased (gross) profits. Suppose a part of them is hoarded. Then demand for other products will be reduced,34 and the increase in employment in the industry directly concerned will be partly or wholly offset by a decrease somewhere else. This may even react back on the first industry and partly nullify there the original increase in employment.

It may be useful to put the same thing in a slightly different way. It may happen that, if wages had not been reduced in the particular industry, employment and output would be smaller in this industry, but the industry would have disbursed more money for wages, etc., and would have financed this either by borrowing more from the banks or by refraining from repaying bank loans or from building up monetary reserves or by drawing on idle funds at its disposal (by reducing its liquidity).

Wage reductions in many industries.

So far we have analysed the case from the standpoint of one particular industry, assuming other things being equal. But, if wage reductions occur in a number of industries at the same time, or one after the other at short intervals, it is still more difficult to tell what the aggregate result will be. If the primary influences on each industry are such that on balance no change in MV takes place, the hoardings induced in some industries being balanced by induced dishoardings35 in other industries, the net result will be an increase in total employment. If the dishoarding in some industries is larger than the hoarding in others, the result will be a still greater increase in employment. But this need not necessarily happen. On balance, the tendency to hoard may be stronger than the tendency to dishoard. To be sure, a certain amount of net hoarding, as evidenced by a decline in MV, is consistent with an increase in employment and output. But, if it goes beyond a certain point, the stimulating effect of a reduction in money wages may be frustrated, the fall in wages being accompanied by a fall in demand and in prices. Employment and output will be no higher; they may even be lower than they would have been without the fall in wages.

Wage reductions increase liquidity.

But, even in this unfavourable and perhaps improbable case, where a reduction of money wages has the immediate effect of intensifying contraction, the policy of reducing wages and prices, if pursued long enough, will be sufficient to create a situation out of which a revival (a new expansion) is likely to emerge sooner or later without any special expansionary stimulus from without being required.36

This follows from what has been said earlier in this and the previous section. We there demonstrated that, with the continuance of contraction, banks and individual firms become more and more liquid. Money hoards grow, both in terms of money and—since prices fall—still more in purchasing power. Now, it is clear that this process will be accelerated if wages are reduced and prices fall more than they would without a fall in wages. In other words, the fall in money wages and prices reduces the volume of work which money has to perform in mediating the exchange of goods and services in the different stages of production. Money is set free in ‘this line of its employment, and becomes available for hoarding.37 Pari passu with the fall in prices, existing money hoards (M2) rise in real value and, sooner or later, the point will be reached where even the most cautious individuals will find an irresistible temptation to stop hoarding and to dishoard.

We may put the matter in yet another way. Assume for the moment that, independently of the behaviour of money wages, there is a definite level of liquidity which must be reached before the economic system can again start on the up-grade. It is clear in this case that the more rapidly wages and prices are allowed to fall the more quickly the desired level of liquidity will be reached. Flexibility of money wages, and competition in the labour market as a means to the attainment of flexibility may be regarded as a factor conducive to the restoration of full employment. But the problem is not quite so simple as that, because the level of liquidity which must be attained need not necessarily be independent of the movement in money wages. If wages are very flexible, and if this flexibility has an initial deflationary effect (as explained above), disturbances may result, confidence may be shaken and thus a higher degree of liquidity may be required than when wages were somewhat more rigid. But, the argument runs, even in this unfavourable case—which is by no means the only possible case, or even the most probable,—there is somewhere a higher level of liquidity which is sufficient in all circumstances.

Conclusions.

The question with which the above discussion began, as to whether a continued fall in money wages under conditions of general unemployment is to be regarded as a factor which will bring a contraction to an end, must therefore, if we carry the argument to its logical conclusion, be answered in the affirmative. It must, however, be emphasised once more that this does not imply the necessity for a process of contraction’s always, or even in the majority of cases, running its course through to its “natural” end. One or the other of the expansionary impulses which have been analysed in the present and the preceding section will usually intervene. Nor again, in answering the question in the affirmative, is there any intention of prejudging the issue of the advisability or otherwise, in the absence of a spontaneous expansionary impulse, of attempts to check the course of the contraction by State intervention in one form or another. In answering that question, many extraneous considerations arise, some of them of a non-economic nature, which cannot be discussed here. But so far as the problem in hand is concerned—namely, the problem of the influence of the behaviour of money wages—the following conclusions may be drawn.

Some problems of policy.

An isolated policy of keeping money wages up is very dangerous, although it is impossible to deny that a policy of wage-cutting may on occasion, up to a certain point, intensify the contraction before its favourable influence on employment and output makes itself felt. It may be very difficult to decide beforehand whether such a temporary intensification is, or is not, to be expected from a given reduction in money wages in a number of industries. If there are reasons to believe that even without a wage reduction contraction of MV will go on—and, as we have seen in the chapter on the contraction process, a certain shrinkage in MV is the invariable concomitant of a cyclical depression—it will certainly increase unemployment and prolong contraction if wages are not allowed to fall, If a contraction in a country is dictated by its international situation, the situation is still clearer. Wages and prices must be allowed to fall if a rise in unemployment and a fall in output are to be prevented. (It is another question whether, and in what circumstances, it is possible and advisable to cut short this process of adjustment by currency devaluation.)

On the other hand, where a country need not consider its international economic situation and has a free hand as to its monetary policy, it is comparatively easy to make sure that the possible deflationary influences of wage reductions are eliminated while at the same time the expansionary influences are not hampered. All that is required is to combine a policy of wage reduction with expansionary measures such as public works financed by inflationary methods. The effect will be to forestall any decrease in total wage disbursements, and consequently in the demand for consumers’ goods, which might otherwise result from the wage reduction.

What has been said of wages is equally true of other prices which -are kept up by monopolistic manipulation or State intervention.

 

 

________________

38 See remarks on pages 257 and 258.

39 The term “cycle” carries with it the suggestion that it is a coherent whole in the sense that one phase necessarily grows out of the other. We have used the term in the less ambitious meaning of a mere alternation of prosperity and depression, leaving it open whether one phase is the inevitable outcome of the preceding one, or whether the connection between the successive phases has to be conceived as less rigid.

40 In the literature on the subject, the group of problems listed under the third head have attracted most attention, and the first two categories have been somewhat neglected. The first step in our scheme is, however, an indispensable preliminary to the third. Even if we are able to demonstrate that the expansion process creates maladjustments in the structure of production, it remains to show how difficulties which affect a part of the industrial system are generalised and spread over the whole economy so that a partial breakdown brings about a general contraction. The problem is the same, whether the maladjustment has arisen independently or been brought about by the expansion itself. (There may, however, be a quantitative difference to the extent that maladjustments due to the expansion may be assumed to be especially serious.)

Until all the three groups of problems and possibilities distinguished in the text are clearly recognised and analysed, we cannot hope to build up a theoretical structure which will do justice to the manifold complexities we meet with in real life.

41 See Chapter 3, § 24, above.

42 See Chapter 3, § 24, above.

43 This statement might, perhaps, be somewhat modified: a slow rise in prices may perhaps be maintained for a long time without degenerating into a headlong inflation. This qualification does not, however, substantially affect the argument.

44 On these and the following considerations, compare L. M. Lachmann, “Investment and Cost of Production” in American Economic Review, Vol. 48, September 1938, pages 469-481 passim.

45 A striking illustration is provided by the situation in Germany during the years 1933-1935, which is described in Die Wirtschaftskurve, herausgegeben unter Mitwirkung der Frankfurter Zeitung (Heft III 1933/36, February 1936, pages 237-239) in a passage which may be summarised as follows:

Credit expansion in the form of notes and deposits took place in Germany in the years 1933 and 1934, though it was in part offset by the continuance of hoarding and debt repayment. At the time, however, the economy was just recovering from a deep depression; and raw materials, plant capacity and labour were available in abundance. Owing to the elasticity of supply in all branches of industrial production, the additional purchasing power was fully compensated by a rise in production with scarcely any rise in prices.

In 1935, on the other hand, owing to the rapid recovery—and, in part also, to the foreign trade difficulties—shortage of raw materials developed in certain directions: stocks diminished: and here and there plant capacity was exhausted, and even the labour supply ran short. The elasticity of supply having thus declined, expansion became possible only at increasing cost; and, the writer considers, the limits of compensatory credit expansion were reached.

It is true that the industries producing for consumption hung behind the investment-goods industries to a greater degree than in any previous upswings; and it was only in the latter that there was any evidence of approaching exhaustion of the forces of expansion. Conceivably, the expansion might have been directed to the consumption industries but for the programme of rearmament, under which Government orders continued to be concentrated on investment-goods industries. In spite of the possibilities of expansion in the direction of the consumption industries, a continuance of the policy of financing orders for the investment industries by credit expansion would have meant (the writer argues) a transition from compensatory to inflationary credit expansion; and it was for this reason that increased resort was had to taxation and to the savings of the public for the purposes in question.

46 This prima facie argument for the likelihood of a serious maladjustment’s arising has been especially stressed by Professor Schumpeter.

47 This possibility of smooth termination of a growth process has been discussed in the first part of this book (see page 91).

48 If I understand Mr. Harrod rightly, this is also his diagnosis of the breakdown. “In a revival, consumption grows at a rate that cannot possibly be maintained. At the outset, the slack of human capacity available for work is greater than that of capital equipment, since the former has been maintained and grown at its normal rate during the slump, while the latter has not. After the revival has proceeded a short distance, therefore, the demand for capital goods arising out of the (abnormally high) prospective increase of consumption stands at a level at which it cannot be maintained. The increase of consumption must slow down, once a considerable proportion of the unemployment is taken back into work. Consequently, a point is bound to come at which the volume of orders for additional capital goods which it appears profitable to give is reduced, and this . . . spells a major depression. (The Trade Cycle, Oxford, 1936, page 165). The only difference between Mr. Harrod’s position in respect to the explanation of the crisis and the one taken in these pages seems to be that Mr. Harrod puts forward the above as the exclusive explanation, whilst here it is treated as one reason among many others—although one which it is especially difficult to avoid.

49 In Mr. Hawtrey’s convenient terminology, we may say that a “deepening” of the capital structure must take the place of the “widening” which has come to an end, when the co-operating unemployed labour resources are becoming exhausted. (Capital and Employment, London, 1937. Chapter III.) Whether this can be achieved rapidly is very doubtful. Probably a certain delay will be unavoidable which may easily be sufficient to cause a hold-up in the money stream, which in turn will start a general contraction (as explained in § 3 of this chapter).

50 Compare, e.g., J. Robinson, Essays in the Theory of Employment, London, 1937, Section I. As the author says, “it is idle to attempt to reduce such questions as trade union policy to a cut-and-dried scheme of formal analysis, but it is plausible to say, in a general way, that in any given conditions of the labour market there is a . . . level of employment at which money wages will rise” (page 7).

51 “Stability and Full Employment”, in Economic Journal, Vol. XLVIII, December 1938, pages 642 et seq. The author starts from the assumption that while it is not so difficult to say how a depression can be ended and to engineer a boom, it is still an open question how a state of fairly full employment can be maintained. It is the latter problem which he deals with.

52 In the Wickseilian terminology, anything that tends to raise the equilibrium or natural rate and/or to depress the money or market rate of interest has an expansionary influence. In Mr. Keynes’ terminology we have to express the expansionary factors as an increase of the propensity to consume; or as a shift to the right of the schedule of marginal efficiency of capital, both associated with an elastic schedule of liquidity preference proper (elasticity greater than zero); or as a downward shift of the liquidity-preference schedule. (See Chapter 8, §§ 3, 4, 5, above.)

53The distinction between factors affecting the demand for, and factors affecting the supply of, investible funds, although useful, should not blind us to the fact that there are many measures and events which obviously affect both demand and supply—e.g., the imposition of a tariff. (Compare, on this particular case, Chapter 12.) Certain forces and motives, which we describe as general optimism or pessimism, work on the mind of both the borrower and lender, and thus influence both supply and demand. If a firm has idle funds at its disposal—e.g., in the shape of demand deposits—and the question is whether it should use them for expanding production or not, it is borrower and lender at the same time, so that demand and supply are in the same hands.

54 In Chapter 8, § 3, page 220, it has been said that, according to Mr. Keynes (whose views have been strongly endorsed by Mr. Kaldor—Economica, December 1938, page 464, footnote 1 only the expectation (risk) that the long-term rate of interest may rise (i.e., that bond prices may fall) can explain the short-term rate remaining for any length of time much lower than the long rate. It would seem, however, that other kinds of risks and apprehensions may very well produce the same result. If people anticipate war, inflation, social upheavals or something similar, in a somewhat distant future without entertaining any particular view about the current interest rate, then they will be reluctant to buy long-dated bonds except at a low price (high current yield), because they will feel uncertain about the solvency of the debtor or the possibility of collecting the debt and of disposing of the receipts, though they may still buy short-dated debts at low interest rates. It would seem that these kinds of risk usually constitute much more powerful motives than mere expectation or uncertainty about the future course of interest rates.

55 It should be remembered that we are here concerned only with the short-run influences. Many considerations, therefore, which play a considerable part in the literature on international trade do not affect the argument. In the long run, exports will fall if imports are reduced; but, in so far as the reduction in exports is not due to retaliatory measures of foreign States, the process must operate through the money mechanism—that is, by contraction in the one, and expansion in the other, country. It is precisely this transitional aspect of the matter which we are analysing. It goes without saying that it is no part of our intention to give a general recommendation to Protection as a policy for overcoming depression. There can be no doubt that the fact that all countries have during the last depression tried to alleviate their own position by protective measures has operated as a most potent intensifying factor for the contraction— in spite of the fact that each country could, to a certain extent, have attained its purpose, if all the others had refrained from doing likewise.

56 How that has to be expressed in Mr. Keynes’ terminology has been discussed in Chapter 8, § § 3,4,5. When people spend from hoards on consumption we have to say that the propensity to consume has become stronger. This implies an increase in aggregate demand (in our terminology, an “inflationary” increase in demand) provided it is assumed that the other determinants of Mr. Keynes’ system (the quantity of money, the schedules of marginal efficiency of capital and of liquidity preference, etc.) remain unchanged and that the liquidity-preference schedule proper (demand for idle balances) is perfectly or highly elastic. It may seem simpler to state explicitly that an increase in aggregate demand is assumed.

57 For an exhaustive discussion, see: J. M. Clark, The Economics of planning Public Works, Washington, 1935; A. D. Gayer, Public Works in Prosperity and Depression, National Bureau of Economic Research, New York, 1935; E. R. Walker, “Public Works as a Recovery Measure”, in The Economic Record, Vol. XI, December 1935.

58 The whole analysis might be put into technical language; but it may be doubted whether much would be gained by so doing. In terms of our demand and supply schema, we can take the hoarding factor either on the supply or on the demand side. We may either say that the amounts which are hoarded reduce the supply of investible funds, or we may say that hoarding is a special sort of demand which competes with the demand for industrial purposes. We have chosen to take it on the supply side because we have defined demand as demand for the purpose of actual investment.

59 There is no question, of course, of an absolute certainty. There may be a rational incentive for indefinite continuation of hoarding— viz., the expectation of a continued fall in prices. But, in all circumstances, it remains true that the incentive to dishoard must grow continuously with the growth of hoards in terms of money and goods. Compare the interesting analysis by Professor J. Viner on the abhorrence of idle cash—like the horror vacui of nature—displayed by the economic system, and the various devices employed by the modern financial organisation to satisfy the need for liquidity without increasing liquidity in terms of cash. J. Viner, “Mr. Keynes on the Causes of Unemployment: A Review”, in Quarterly Journal of Economics, November 1936, Vol. 51, pages 147-148 passim.

60 This analysis does not exclude the possibility of a more or less stationary state with unemployment and fairly stable prices as envisaged by Mr. Keynes and his followers. This has been discussed in Chapter 8, § 5, where it has been shown that a downward rigidity of money wages and prices is a necessary condition for that to happen (which is admitted at points but not sufficiently stressed by Mr. Keynes). Here we are concerned not with such an equilibrium state with unemployment, but with the contraction process. A contraction may tail off into a more or less stationary situation at a low level of employment (“depression equilibrium”, “bumping along the bottom of the depression”), but the point made in the text is that it is more likely that the system will automatically start on the up-grade again as soon as it has come to a stable point.

61 If the theory put forward in the text of the automatic cessation of hoarding and contraction is not accepted, it will be necessary to rely on those active stimulants which are likely to arise sooner or later (as explained in the following pages). The rest of the argument is not affected. In particular, the proposition that MV is likely to rise, as soon as it has stopped falling, holds good—whatever the factor may have been which brought the fall of MV to a halt.

62 We need not pause to translate that into Mr. Keynes’ terms. Compare Chapter 8, §§ 3, 4, 5.

63 See Mitchell, Business Cycles, Berkeley, 1913, page 567.

64 Schumpeter, Economica, December 1927, page 298. See also his Theory of Economic Development (English translation, 1934) and Pigou, Industrial Fluctuations, 2nd edition, 1929, pages 92 and 93. It should, however, be noted that Schumpeter uses this argument, not so much to explain how the lower turning-point is brought about, but to show how the system is carried, during the upswing, beyond the equilibrium point (compare footnote on page 81 above). However, there seems to be no reason why this dynamic factor should not in some cases make its appearance at an earlier point in the course of the cycle.

65 The problem of “replacement waves” has been discussed in the first part of the book (see page 84). Mr. Keynes, too, has availed himself of this standard tool of cycle analysis (General Theory, page 253)

66 An analysis in many respects similar to the following one was given by Professor S. Slichter in his book Towards Stability, New York, 1935, and in his paper “The Adjustment to Instability” in the American Economic Review, Vol. 26, 1936 (Supplement), pages 196-213 passim.

As was pointed out in Chapter 8, § 5, above, the following analysis has also many points in common with Mr. Keynes’ treatment.

67 An equivalent to a decrease in money wages is an increase in the efficiency of labour which does not augment other cost items (e.g., capital cost) at the same time. If the worker works harder, or if the work is better organised so that a smaller labour force can do the same work without an increase in capital equipment, the position, so far as the employer is concerned, is equivalent to a reduction in money wages. From other (e.g., the social) points of view, there may be important differences between the two methods of reducing labour cost. For the purpose of our problem they are equivalent.

The statistical measurement of efficiency presents extraordinary difficulties, which cannot be discussed here. It may, however, be noted that the ordinary statistical measure of “efficiency-wages”—viz.,labour cost per unit of output (pay-roll: volume of output)—cannot be taken as a precise measurement of the magnitude we have in mind.

68 Even if the output of the industry in question does not increase as a consequence of a wage reduction, the industry may be enabled by the reduction of its labour cost to give more employment, if it uses the money saved to improve or replace its equipment—or, in other words, if it was consuming its capital and the wage reduction puts a stop to such consumption. This is not, however, a typical case in a depression, since even the existing equipment is not then fully utilised, though it is not denied that capital consumption may be going on.

69 It may be, and has been, argued that, even if in principle a reduction in wages may be expected to exercise a favourable influence, the latter will not materialise at once and the delay will be sufficient to stultify its operation altogether. If an entrepreneur is led by a reduction in wages to increase his investment, he will need some time to put his plans into effect. First, he is likely to wait for a while and see how things develop. Secondly, his plans must be worked out in detail before orders can be given and the money actually be spent. In the meantime, wages and pay-rolls will have been reduced, and consequently the demand for goods in general will have fallen. This will cause the general situation to deteriorate, and may well induce the producer to drop his plan of increasing his output. If, therefore, his investments are not made at once, they are likely not to be made at all.

There is certainly much force in this argument; and we have already had occasion in our analysis (page 353) to refer to this inevitable lag between the conception of investment plans (or the occurrence of a change which makes the investment in principle a profitable proposition) and the actual expenditure involved.

But at this point of the argument the situation is somewhat different. In the first place, we are concerned not so much with new investment in fixed capital as with a possible increase of production within the framework of existing plant. In the second place, it must be remembered that a reduction in wages may not only stimulate an increase in output, but may also induce the employer to refrain from a curtailment of production and employment. In this latter case, the effect of the wage reduction may well be quite instantaneous.

70 It may be added that the view which one can frequently hear expressed that a wage-reduction can have a stimulating effect only if prices are correspondingly reduced, is not generally correct. Even if prices are not reduced at all more employment may result from a reduction in money wages, if entrepreneurs are induced or enabled to resume the replacement of their equipment which they had neglected.

71 Of course, an increase in wage disbursements need not result in an instantaneous increase in demand for wage goods, since the wage-earner may hoard part of it or use it for repaying debts. On the other hand, a decrease may be temporarily offset by drawing on hoards or incurring debts. We disregard these factors here as being quantitatively unimportant.

72 Some writers have displayed a certain aversion for the word “hoarding” (e.g., Mr. Kahn in his review of the first edition of this book). Others have obscured the concept by distinguishing all kinds of new meanings which the word is alleged to have in the writings of different writers without saying who those authors are (see Joan Robinson: “The Concept of Hoarding”, Economic Journal, Vol. XLVIII, June 1938, pages 231 to 237). It is difficult to attach any meaning to the statement that “‘hoarding’, except in the sense which is covered by the conception of ‘liquidity preference’, has no causal force” (op. cit., page 236). The meaning of “hoarding” which is used here and which was defined precisely in Chapter 8, § 3. is not the one to which alone Mrs. Robinson attributes “causal force”. But it has certainly causal significance in that the decision of individuals to hoard or not to hoard in this sense is of great importance for future events. How it can be translated into Mr. Keynes’ terms has been repeatedly indicated. In the present context it may help to translate “dishoarding” into “greater disbursements”, with the additional condition (carried by the expression “dishoarding”, but not by the word “disbursement”) that the increase in expenditure is an addition to aggregate expenditure of society as a whole.

73 Compare footnotes 1 on page 390 and 392.

74 In Keynesian terminology, less money is needed to satisfy the transactions motive and more becomes available for “speculative holding”: M1 decreases; M2 increases.

• 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.
• 3What 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.
• 4This 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.
• 5Trade and Credit, London, 1928, page 98.
• 6Currency and Credit, 3rd ed., London, 1928, page 153.
• 71913, page 186.
• 8Monetary Reconstruction, 2nd ed., London, 1926, page 135.
• 9See his paper “Money and Index-Numbers” in Journal of the Royal Statistical Society, 1930, reprinted in The Art of Central Banking, pages 303-332.
• 10It 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).
• 11See his book: Strategic Factors in the Business Cycle, passim.
• 12The 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).
• 13Kapital und Produktion, Vienna, 1934, page 195, and “Die Produktion unter dem Einfluss einer Kreditexpansion”, in Schriften des Vereins für Sozialpolitik, Vol. 173, 1928.
• 14Banking Policy and the Price Level, 1932 ed., page 48.
• 15See 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.
• 16For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
• 17Since 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.
• 18Such 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.
• 19This 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.
• 20HAYEK: Prices and Production, 2nd ed., London, 1934, page 57.
• 21In 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).
• 22If competition in the labour market and the mobility of labour are imperfect, the condition of full employment can, of course, be relaxed.
• 23Op. cit., page 171.
• 24The 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.
• 252nd ed., pages 55 et seq.
• 26Hayek: “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.
• 27Cf. 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.
• 28Cf. C. Bresciani-Turroni, “The Theory of Saving” in Economica, 1936, pages 165 et seq.
• 29Currency and Credit, 3rd ed., page 155.
• 30See especially L. Robbins: The Great Depression, London, 1934.
• 31See: 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.
• 32Kapital und Produktion, Vienna, 1934, pages 208 et seq.
• 33See especially L. Robbins: The Great Depression, London, 1934.
• 34On 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.
• 35Strigl, 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.
• 36See, however, Bresciani-Turroni, “The Theory of Saving” in Economica, May 1936, pages 172-174.
• 37See below Ch. 3, §§ 8,16, and Part II, Ch. 11.
• 38The 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.
• 39It 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.
• 40One 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.
• 41The 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).
• 42“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.”
• 43The 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.”
• 44The 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.
• 45It 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.
• 46To 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.
• 47If 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.
• 48With 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).
• 49This 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.
• 50Treatment 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.
• 51Apart, 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.”
• 52Professor 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.
• 53One 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.
• 54But 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.
• 55Furthermore, 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.
• 56The 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.
• 57An 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.
• 58There 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.
• 59It 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.
• 60“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.”
• 61If 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.
• 62In 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.
• 63It 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.
• 64In 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.
• 65In 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.)
• 66Under 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”.
• 67The 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.
• 68(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.
• 69The 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.
• 70It 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.
• 71The 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.
• 72The 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.
• 73This 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.
• 74With 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.