Prosperity and Depression

CHAPTER 12 INTERNATIONAL ASPECTS OF BUSINESS CYCLES

——————

§ 1. INTRODUCTION

Previous treatment of international aspects.

In the preceding chapters, the analysis of economic fluctuations has been pursued without much attention to their international aspects. In all references to “countries”, we have had in mind, not indeed completely closed economies, but areas within whose borders all the characteristic features of the business cycle—the swings of rising and falling money demand, the reciprocal interactions of demand for consumers’ goods and demand for producers’ goods, the variation through time in the degree of employment and scarcity of productive factors—could come into play. Repercussions on, and disturbances from, economic relationships with the outside world have made their appearance in the argument at various points, but only incidentally: they have been treated as isolated facts and have not been further analysed. The attempt has now to be made to deal with these international aspects in systematic fashion. The argument has to be adapted, as and where necessary, to the fact that the real world is neither one big economic unit nor a congeries of closed systems, but a complex system of economic relationships of various kinds between individuals. The closest connections these individuals tend to have with their neighbours and their own countrymen; but they are linked up—sometimes directly, always indirectly—with the farthest corners of the earth.

This adaptation of the argument incidentally links up two branches of economic theory which too often are kept apart—the theory of international trade and the theory of economic change.1

Methods of exposition.

In setting out the international complications in orderly fashion, there are two alternative methods of exposition which we may adopt. The first method would be to start from the assumption of two or more completely independent and isolated economies, and proceed to introduce one by one the various types of economic connections which we find in the real world (exchange of goods and services, capital movements, the various types of monetary connections), and so investigate the influence of each of these connections on the course of the cycle in the various countries, and the extent to which a parallelism in the alternation of periods of prosperity and contraction in the different areas concerned is thereby produced.

The other method of approach, which is that adopted in the following pages, is to start with the hypothesis of a spaceless closed economy embracing the whole world and to introduce one by one the circumstances which divide and disintegrate that economy. The disintegrating factors are so arranged as to start with the most general, natural and inevitable physical facts, and from these to proceed to the more artificial human devices, in such a way as to exhibit the operation of the earlier factors without the later factors but not of the later factors without the earlier.

The first disintegrating factor to be introduced is transportation cost—in other words, imperfect mobility of goods and services. The second is the localisation of investment, credit and banking (imperfect mobility of capital). The third, perhaps the most important, is national currency autonomy. Thus we have a series of situations representing an increasingly close approach to reality. In the discussion at each stage of approach, it will be necessary to make further distinctions in relation to what we conceive to be the distribution of resources (in the widest sense of the word) among the various “countries”. It is the uneven geographical distribution of economic resources and activities that gives the disintegrating factors their importance. If each area or country possessed all types of resources in sufficient quantity, the existence of high transport costs between them would be irrelevant.

It goes without saying that some of these disintegrating factors—especially the first, but also the second to some extent—operate, not only between countries separated by political borders, but also within political areas between different regions. When, therefore, we speak simply of “countries”, the expression is to be understood with the obvious qualifications implied by the context.

§ 2. INFLUENCE OF TRANSPORT COSTS: IMPERFECT MOBILITY OF GOODS

Localisation of expansion and contraction.

The most natural and inevitable of all disintegrating factors is the existence of costs of transport. Costs of transport should be interpreted in a broad sense as covering, not only the expenses involved in transferring goods between producers, or from producer to consumer, in different localities, but also the trouble and expense involved in moving the consumer to the goods and services. It is assumed that resources are to a considerable extent localised, whether by nature or, in the case of labour, by a multiplicity of causes. It should further be kept in mind that, at this stage of the argument, we still assume a unified money and credit system for the whole world.

Given a certain geographical distribution of resources, the effect of transport costs is to permit of cumulative upward and downward movements in money demand, not wholly confined to, but centred in, particular areas. In the absence of transport costs in the sense defined above, the specialisation of particular areas to particular lines of production arising out of the unequal distribution of resources between localities would have full play. Suppose now a fortuitous expenditure on the part of a group of people. There will be a consequent primary increase of income accruing to the workers and entrepreneurs producing the articles to which the additional demand is directed. Probably this primary income increase will affect some districts more favourably than others. When the primary increase in income comes to be spent, however, there will be a secondary increase in incomes; and there is no reason to believe that this will accrue particularly to those districts which enjoyed the primary increase, nor yet to those whose fortuitous increase in expenditure set the whole process going. There is no presumption that the cumulative expansion process will be localised in or centred around its first starting-point; but it will spread in a random fashion all over the economic surface.

When we introduce transport costs, however, specialisation and division of labour between areas tend to diminish; and we find that the primary employment and income increase tends to accrue in a greater degree to those living near to the group which increased their expenditure. The secondary increase in incomes will likewise tend to accrue to those living and working near the beneficiaries of the primary increase in incomes, and so on.

Counter-influence of uneven distribution of resources.

The cumulative expansion movement need not, of course, be confined to any particular locality. The influence of transport costs tends so to confine it; but, on the other hand, the influence of the uneven distribution of resources tends to maintain a geographical division of labour, to promote inter-regional exchange, and so to ensure that some portion of the increased income of individuals in a given locality is expended in the period immediately following on “imports” of one sort or another. Thus, the more strictly the various areas are specialised in particular types of economic activity the less scope there will be for local or regional monetary expansions and contractions.

In seeking to picture an expansion from the point of view of any particular country or area, we must bear in mind the fact that each locality is differently placed in respect to the given distribution of economic resources over the earth’s surface. Each locality has its own characteristic potentialities for the production of different goods and services, and its own characteristic constellation of transport costs affecting its exchanges with other centres of production. As a result, a fortuitous increase in the monetary demand for goods and services in one area may tend to confine itself to that area, whereas in another area an increased demand may rapidly overleap its own borders.2

In a country like the United Kingdom, for example, the primary increase in income will be spent very largely on products (food, textiles, and so on), the earlier stages of whose production are located abroad. Thus, a considerable portion of the expenditure of secondary and subsequent income increases will be drained off to agricultural countries; and the favourable repercussion on British exports may be small and long delayed. A similar argument will apply to a country like New Zealand, whose inhabitants will spend a considerable portion of any increase in income on the manufactured products of the United States and Europe. On the other hand, we may take the United States as an example of a country in which only a very small proportion of an increase in consumers’ incomes will find its way abroad.

It is necessary, however, to keep in mind, not only the expenditure on consumption goods, but also the expenditure on investment goods which is to some extent dependent on the former. In an undeveloped country, without heavy industries, the process of monetary expansion by way of reciprocal stimulation of consumption and investment—the so-called Wicksellian process—will be of minor importance. If a revival of British industry takes place, it provides a stimulus for the building and extension of plant. The existence of a world capital market (which in this stage of the argument is still assumed to function smoothly) ensures an unlimited supply of investible funds, so that the investment can proceed unhampered by rising interest rates. The funds invested will be spent on the products of British heavy industries, and the flow of money incomes will be enhanced. On the other hand, if the original impetus to prosperity develops in some part of China, it may become profitable to extend, e.g., the railway system—in which case a large proportion of the money invested will be drained off to Europe or America, who supply the required capital goods.

Tendency of local expansions to overflow.

It must not be assumed that the proportion of expenditure in any country which finds its way abroad in payment of imports will remain the same in all phases of a cyclical movement. As a local expansion or contraction develops, there will be changes in the distribution of income and expenditure which may involve a greater or smaller proportion of purchases from abroad; but there is no reason to expect any systematic movement. More important is the point already touched on that, as the volume of the demand for investment goods changes in relation to the volume of the demand for consumers’ goods, the foreign drain will become less or more considerable. In this event, some systematic movement in the direction of a greater or smaller foreign drain is to be expected in each individual case; but we cannot say in general which direction the movement will take.

We can say, however, that the further a local expansion goes the more it is likely to “spill over” into other regions—and that for a different, a third, reason. Imports will increase, not merely pari passu with incomes, but faster. As the expansion goes on, stocks are taken up, unemployed workers reabsorbed, and plant is used to fuller capacity. Hence wages and other prices will rise and, by the operation of the mechanism described in the classical expositions of international trade theory, both home and foreign demand will be switched away from local products to foreign substitutes. For a local boom even more than for a general boom, the stage of price-inflation is a dangerous one and marks the beginning of the end. On the other hand, where prices are kept steady as a result, e.g., of technological progress, the boom may obtain a longer lease of life.

Coexistence of prosperity and depression facilitated.

The effects of transport costs are not, however, confined to the imposition of a check on the spread of prosperity and depression from one area to another. They also make it possible that, at one and the same time, a cumulative contraction process should be taking place in one region and a cumulative expansion process in another region. The simplest, though not the most likely, cause of such a development would be a change of taste or income distribution in the world as a whole, leading to a transference of demand from the products of one region to those of another. In a “spaceless” economy, such “horizontal” demand shifts, while significant for the industries directly concerned and for their subsidiary industries, would be relatively a matter of indifference for the rest of the economic system, unless the consequence of the shift was to set afoot a net expansion or contraction. In the real world, the effect may be to promote an upswing in one quarter and a downswing in another.

A somewhat similar case is the effect of innovations in methods of production or transportation, the introduction of new types of finished goods, etc. In most of these cases, the stimulus provided for the new industries will find its counterpart in a check to the old competing industries—i.e., those industries which produce the equipment or material replaced or rendered superfluous by the new processes, and those which have lost their market because demand has been drawn away by the newly invented types of goods. This setback in the old industries may not become serious until after the new methods have been put into operation; but, when it does, it is calculated—in a “spaceless” economy—to precipitate the down-turn. If, however, the new industries are localised in areas other than those in which their unsuccessful rivals are to be found, the continuance of prosperity in the former region may be but little hampered by the misery of the latter. The danger of excessive anticipations in one country need not drag the whole world down.

Influence of existing tariffs.

Much of what has been said about the influence of transport costs is equally applicable to tariff barriers and other hindrances to international trade. Customs duties in particular resemble transport costs in that they impose an obstacle to the movement of goods; but the obstacle can be overcome if the price disparities in the exporting and the importing country are sufficiently high. For this reason it is convenient- to mention them at this point, though they may be regarded as more “artificial” than some of the other disintegrating factors treated below.

Whereas transport costs tend to increase the proportion of demand directed to goods and services produced in nearer or more accessible regions, Customs tariffs—being levied at political frontiers only—tend to confine demand to the products of the same State, or to other States whose imports are relatively little affected by the tariff barriers. Often, this means that tariffs act as an additional factor tending to localise monetary expansions and contractions. It need not be so, however, since their effect may be to divert demand from nearer to more distant sources of supply. This will be the case for populations living close to political frontiers and hence to Customs barriers. The effect of high tariff protection will be that localities within the same country—or, it may be, within the same empire—may tend to have their periods of prosperity and depression at the same time, whereas other countries will tend to show a lesser degree of synchronisation.

Influence of changes in tariffs.

Changes in tariffs have exactly the same consequences as changes in transportation cost—in which connection we may refer to the short analysis of the possible expansionary influence of the imposition of a tariff in the protected country which was given on page 382 above. (This type of analysis can be easily adapted so as to apply to the effects of the removal of a tariff on both countries concerned.)

Tariffs differ, on the other hand, from transport costs in the fact that they can be altered by legislation, and therefore may be changed as a matter of policy systematically throughout the course of a cycle. A country may conceivably succeed, by raising its tariff wall, in diverting demand from foreign to domestic sources of supply (though, be it noted, a part of the demand thus diverted from the purchase of foreign goods may be sterilised in the form of hoards). It is conceivable, therefore, that a country might use its power to vary its tariffs as a means of mitigating the violence of its own industrial fluctuations, raising them when threatened by deflation in other countries or by the appearance of deflationary tendencies at home, and lowering them in the opposite case of danger of inflation whether originating at home or in other countries.

Although the trend of international commercial policy has been steeply in the direction of protection ever since the beginning of the last quarter of the nineteeth century, a certain cyclical movement is unmistakable. Every major depression brought a new outburst of protectionism, whilst prosperity periods have usually been marked by short steps back in the direction of freer trade.

But while it is conceivable that a single nation might succeed, by a policy of raising tariffs in bad times and lowering them in good times, in damping the impact on itself of the great international business cycles, the consequence of such a policy simultaneously pursued by all nations would be precisely the reverse. The raising of a tariff means a limitation of the investment opportunities of the potential importers. The money which is prevented from leaving the country is in part hoarded. The demand for foreign products will fall by more than the amount by which the demand for home products rises: and, if such a policy is pursued all round by every country, the depression will be rendered still more severe in the world as a whole and very probably in each individual country as well. For similar reasons, a policy of reducing tariffs in the upswing, simultaneously pursued by all nations, will not lead to stability in the total money demand, but will rather afford a further expansionary impetus to each country.

§ 3.    INFLUENCE OF THE LOCALISATION OF INVESTMENT, CREDIT AND BANKING: IMPERFECT MOBILITY OF CAPITAL

Equalisation of interest rates.

In the last section, we introduced into our picture of the cyclical movement the influence of an uneven distribution of (a) resources and (b) transportation cost of goods and services. We have continued, however, up till now to assume a common money circulation within the whole of the area under consideration. This assumption we shall still maintain in the present section. We have further assumed perfect mobility of capital. This assumption will now be dropped; and in its place we shall introduce the assumption of a more or less complete localisation of investment and banking activity—in other words, we shall assume imperfect mobility of capital.

Let us first enquire into the exact meaning of imperfect mobility of capital and of its opposite. By perfect mobility of capital we mean perfect mobility of loanable funds, that is to say, a state of affairs in which loanable funds will flow to those parts of the world where demand is highest or, rather, in which they will be distributed over the various countries in such a way that the rates of interest in general—or, more precisely, the rates of interest for different types of loans with equivalent maturities and risk—will everywhere be the same.

Mobility of capital versus mobility of goods.

It should be noted that perfect mobility of capital, that is complete inter-local equalisation of the rate of interest is not incompatible with high, or even prohibitive, transportation costs (including artificial costs such as tariffs) for goods in general and capital goods in particular. Suppose two countries, A and B, between which the transportation of capital goods of all kinds is completely impossible, the trade between the two consisting exclusively of consumption goods. If the currency of the two countries is firmly based on gold, and if the position in respect of debtors” morale, legal protection of investors and possibilities of supervision of investments is the same in both countries, there is no reason why the investors in the country where the interest tends to be lower should not turn to investments in the other country. There will be a complete equalisation of the rate of interest; and capital will eventually be transferred in the shape of consumers’ goods and luxuries. Short of the quite extreme case where there is no exchange of goods or services whatsoever (a case which need not detain us here), imperfect mobility of goods does not directly reduce the mobility of capital. It cannot, however, be denied that, indirectly, increasing restrictions on the movement of goods and services tend to restrict the movement of capital, and render foreign investment more and more risky. If the volume of trade between two countries is large, and if there are many actual and potential export and import goods, the repercussions of the transfer of a given amount of investible funds (money capital) will be slight. A mild expansion in one country relatively to the other3 will suffice to produce an export surplus from the capital-exporting country. If, on the other hand, the volume of trade is comparatively small, the movement of the same amount of money capital will produce a more violent expansion, and probably a sharp rise of prices, in the one country, and contraction and a sharp fall of prices in the other country. The same thing can be expressed by saying that, where the volume of trade is large and the economic connections are close between two countries, the money which flows out of one country to seek investment in the other will soon find its way back through increased exports or reduced imports. If the volume of trade is small, it will not return so quickly. The slump in the capital-exporting country may drive up the interest rate and thereby remove, at least for the moment, the incentive for the migration of capital. But it may also incite a flight of capital and precipitate the crisis.

In the extreme case where no movement of goods or services is possible, a transfer of money capital will be wholly inflationary in the one country and deflationary in the other;4 but even in this case the transfer is not impossible, although it is difficult to see how an equalisation in the rate of interest can be permanently achieved, unless one believes the interest rate can be permanently lowered by monetary inflation or permanently raised by deflation.

We may sum up as follows. The smaller the volume of trade the more violent will be the inflation in the borrowing, and deflation in the lending, country consequent upon the movement of a certain sum of money capital, or, if exchanges are allowed to vary, the more violent will be the fluctuations in the exchange rate. If this development does not directly check the tendency of capital to migrate, it will at least afford incentives to State interventions such as transfer moratoria and the like, and is for this reason indirectly fatal to foreign investment.

The reasons for differences in interest rates.

So much for this digression. We return to the main theme. As everybody knows, equalisation of interest between different countries is not the typical situation we find in the real world. What we find is, on the contrary, a persistence of discrepancies, sometimes of a very high order of magnitude. The mobility of capital is usually far from being complete. People tend to invest their money at home in local land, physical capital, property rights, debts and so on, even though the rate of interest which can be earned is much lower than that to be obtained by equivalent investments abroad. The reasons for this are rather obvious. Partly they are, so to speak, of a physical nature. Transport costs and costs of communication place obstacles in the way of that personal supervision which is usually necessary to obtain the highest income from investment in physical capital, while they enhance the difficulty of obtaining that first-hand knowledge of the business and political situation in other countries which is necessary to dissipate uncertainties in regard to business propositions and the value of equities. But, on the whole, the barriers to international lending and investment are less physical than political, social and institutional. Ignorance of foreign tongues, inadequacy of legal protection, risk of transfer restriction or outright confiscation—and, to anticipate a little, fear of exchange instability—are nowadays certainly more important factors than actual distances.

Changes in mobility of capital.

We are not concerned here with the effects in the long run of the immobility of capital on the economic structure of the world and the economic development of the capital importing and exporting countries. We do not try to answer questions as to what, for example, the world would look like to-day without the enormous capital movements which took place in the nineteenth and twentieth centuries. We are here concerned with (a) the proximate influences of the imposition, removal, strengthening or relaxation of the impediments to international capital movements, and (b) the modifications brought to the short-run cycle of expansion and contraction by the very existence of a certain degree of localisation of investment, credit and banking.

On the basis of the analysis in the previous pages of the nature and causes of cyclical expansions and contractions, it is comparatively easy to answer the first of these questions. Naturally, the answer cannot take the form of a brief and comprehensive formula: each case has to be taken individually. But we can indicate broadly what are the factors which must be taken into account.

Obviously, we must first distinguish between the effect on the capital-exporting and that on the capital-importing country, and must ascertain in each case in which phase of the cycle the change takes place. What will be the influence on the supply of investible funds and the rate of interest in both countries? Clearly, the imposition (removal) of restrictions on capital movements will tend to reduce (raise) the rate of interest in the capital-exporting country, and to raise (reduce) it in the capital-importing country. How will the demand for investible funds react to the change in supply? This will, in turn, depend on the phase of the cycle.

Thus the final outcome may differ according to circumstances. But we are in a position to indicate what in any particular case are the circumstances which determine that outcome.

Tendency to damp down local booms and depressions.

We turn now to the second question—that is, to the effects of a certain degree of localisation of investment, credit, and banking. They can be most clearly brought out by supposing the tendency towards localisation to be so strong as absolutely to prohibit lending and investment outside regional or national boundaries. In such circumstances, the general world market for capital (or investible funds) will be divided up geographically or nationally into watertight compartments. In each country, a different interest rate—or scale of rates—will prevail, determined by the local demand for funds and the local supply. The local supply will depend, among other things, on the supply of money in the country, on the basis of which we may suppose a more or less developed credit structure to have been erected. What will be the consequence of such an arrangement on the length and amplitude of cycles in the different countries? Here, again, the answer cannot be contained in a single formula.

On the one hand, localisation of credit tends to damp down local booms and depressions. Suppose a local boom flares up—because, e.g., the demand for the export goods of the area in question has risen or because of a purely internal stimulus to investment. With an international capital market in operation, funds may in such case be drawn from the whole world. The interest rate will rise much less quickly than it would, were only local funds available. A local depression may also be alleviated or shortened by imperfect mobility of capital. When the demand for investible funds is at a low ebb, the fact that such funds cannot leave the country will so reduce the rate of interest that the chances of revival are improved.

Reservations.

On the other hand, there are a number of reservations to this principle. While a boom, like a fire, is more easily extinguished where the supply of inflammable material is restricted, it may be that the causes of the fire provide at the same time the inflammable material. If the boom is caused by a rise in foreign demand, the influx of money will increase the supply of investible funds as well as the demand, and may, under a regime of localised credit, depress the rate of interest below the rate which would have prevailed had capital exports been possible. In the same way, a depression due to an adverse movement in international demand may be accentuated by a restriction of the supply of investible funds consequent upon a drain of money from the country.

But even if we restrict the generalisation about the moderating effect of credit localisation to booms and depressions where external causation is lacking or unimportant, it is applicable only to relative booms and depressions: that is to say, it is when a country is more prosperous than other countries that it suffers from the absence of capital movements. In the course of a general world boom, countries which, though enjoying a cyclical upswing, are less promising fields for investment than others may be drained of funds if capital movements are possible. It will be seen that anything which tends to hinder such movements may in the circumstances prolong the prosperity of some countries while limiting that of others. Similarly, localisation of credit may put a brake on depression in the most-depressed countries, while prolonging it in less-depressed countries.

A still further limitation must be placed on the general principle to allow for cases where capital exports and imports are not merely cyclical phenomena, but trend phenomena. Suppose that in some countries the supply of investible funds tends on the whole—counting in all phases of the cycle—to run ahead of the demand, and so to depress the rate of interest below that prevailing in other countries. If capital exports are possible, they will take place. If not, a part of the funds will be invested at home, bringing down the interest rate, while a part will be sterilised in hoards and cash reserves. Taking an average over good years and bad, the hoards will be larger if credit is localised than if it is not. But these hoards may be invested in boom periods at home. Their presence ensures that the supply of investment funds from domestic sources will be fairly elastic. It is even conceivable that the localisation of credit, by promoting the accumulation of hoards in advanced countries which would otherwise be capital-exporting, may make the supply of investible funds available to the entrepreneurs of those countries more elastic than it would be if international capital movements were possible.

Effects on “spreading” of cyclical movements.

Having attempted to sketch the effects of credit localisation on the cyclical movements of individual countries, let us now turn to the question of its effects on the spreading of such cyclical movements from country to country. Suppose that investment opportunities appear in country A, and a boom develops accompanied by rising interest rates. With a perfect world capital market, this would mean that funds would be drained from foreign countries, raising the rates of interest there. Foreign countries would thus experience at the same time a rise in their export trade to A, involving a rise in the demand for investible funds and a fall in the supply of those funds. It cannot in general be said whether the inflationary effect of the former would outweigh the deflationary effect of the latter. If, on the other hand, capital movements are impossible, the effect of A’s boom is unambiguous. A’s trade balance will become less favourable and money will tend to flow abroad, with the effect of increasing there the supply of, as well as the demand for, investible funds.

It might seem to follow from this argument that the localisation of credit is a factor tending to spread prosperity and depression from one country to another. But, even in the case considered above, this is not necessarily true. It was pointed out in the foregoing pages that in general—though there were exceptions—the effect of localisation of credit was to limit the extent of booms and depressions. In so far as it has this effect, it also limits the rise in A’s imports, which will take place during an upswing in A and so limit the extent of the stimulus to business in the outside world. If funds could be transferred to A from the outside world, the increased investment there would have its repercussion on imports, thus giving rise to an increased demand for goods in the outside world. On the other hand, the transfer of the funds will reduce the supply of investible funds in the outside world: but it is conceivable that the latter effect will be less important than the former. This is likely to be the case when, during a depression, the supply of loanable funds is very elastic, the rate of interest having reached a minimum level (set by institutional circumstances) in the face of a very low demand. Thus, localisation of credit may easily have the effect of hindering the spread of a boom by hindering the boom itself.5

International transfers of demand.

The disparate organisation of the world capital market opens up a new series of possible repercussions from changes which involve a transfer of demand from one country to another. The unequal development of credit in different parts of the world means that any movement of the balance of trade in favour of a country with a relatively highly developed credit structure will, ceteris paribus, have a net inflationary effect in the world as a whole.6

But, apart from this unevenness in the development of credit, a movement of funds from one national credit market to another brought about through changes in commercial currents will be likely to have a net effect. Whether this effect is expansionary or deflationary will depend on central-bank policy, confidence and liquidity of the banks, elasticity of the industrial demand for credit—all of which conditions are themselves largely dependent on the phase of the cycle in which the countries concerned find themselves when the change in demand occurs. In particular, any very violent diversion of demand between countries, such as may occur in the course of a world business cycle or as a result of war or large-scale harvest fluctuations, will probably be deflationary in its effect. The country losing money may be forced to contract, while the country gaining money will be unable at first to employ its new funds in investment.7

Sectional mobility of capital.

For the purposes of our exposition, we have so far contrasted two extreme cases: viz., a state of affairs with no international lending and investment at all on the one hand, and a world economy in which there are no hindrances to the flow of investible funds from any one area to any other. In reality, of course, while on the whole people do tend to lend and invest funds in their home country to an extent which prevents the complete equalisation of interest rates in different countries, there is normally a certain amount of international lending and investment.

In order to investigate such intermediate cases more closely, we must abandon the simplifying assumption that the market for investible funds is completely homogeneous. In reality, there are many sub-markets. One type of debt is not completely substitutable for another. It is therefore not surprising to find that the markets for certain types of debts are much more international than the markets for others.

Some Government obligations, for example, command a world market, whereas small business-men must borrow from those who know them and have some legal redress against them if the debts are not paid. For reasons of security, certain classes of debts are held exclusively by co-nationals of the debtors.

Another factor closely connected with security of repayment is liquidity, or quick saleability—a quality which makes debts to some extent a substitute for money. It is obviously more convenient to have one’s current account with a local banker than with one whose offices are abroad. Also, the fact that people prefer to buy local securities is in itself a good reason for anyone’s keeping that part of his wealth which he wants to be “liquid” in the form of local claims.

Mobility of short-term and long-term capital.

It therefore remains true that, even at a time when considerable international capital movements may be taking place, a flow of money from country A to country B on current account—i.e., as payment for goods and services exported by B in excess of imports—will bring about a diminution in the supply of investible funds available in A and an increase in the supply of investible funds available in B. If the capital market were international in all its branches, this would not take place. There would be an increase in the supply of investment funds in B; but it would be available to entrepreneurs in any country. In fact, however, the increased money in B will be deposited with the banks, and will lead to an expansion in the loans of the banks to industry and to the bill market, as also to an increase in the banks’ holdings of securities. If the bill market in B is well known internationally, the cheapness of discounting there may lead to an afflux of exporters from A and elsewhere desirous of benefiting by the low discount rates. Similarly, the high prices of bonds in B, due to bank purchases, may make it easier for other countries to float new issues in B, and in addition may induce holders of B bonds to exchange them for bonds of other countries. The reverse process will take place in A. In this way, a part of the money which leaves A on current account will “leak” back on capital account, without, however, completely nullifying the favourable effect on the supply of credit available to borrowers in B or the unfavourable effect in A.

It may be a permissible simplification of the situation to suppose that there is a world-market for long-term bonds and shares, but that working capital has to be provided by each nation from national sources. We may suppose that, in the case of two countries A and B, opportunities for the absorption of long-term funds are opened up in A, whether such opportunities arise in connection with real investment or with the phenomena of a stock-exchange boom. The result in either case is a flow of loanable funds from B to A, which may exceed the adverse trading balance that A will probably develop as incomes in A rise. Now, if all sections of the capital market were international in scope, business-men in B would suffer from the rise in interest rates consequent on the rise in the demand by A for loanable funds, and would gain by the increased demand for B goods in A. In the circumstances of the supposed case, however, they will suffer an additional handicap in that the flow of money from B to A will induce the banks in B to restrict credit, and may render the supply of working capital in B scarcer than it is in A.

Cyclical changes in the mobility of capital.

Even in the case of those sections of the capital market which are comparatively international in scope, the degree of internationalism depends upon factors—such as the policies of Governments and the state of confidence of individuals—which vary with the times. It may be possible to make the generalisation that during the downswing of the world business cycle, when the confidence of investors is at a low ebb, foreign lending is specially avoided as more dangerous than domestic lending, so that the brunt of the depression falls on the borrowing countries, while countries which normally are capital-exporting obtain some relief through the improvement of their balance of payments. The rôle of capital movements in the course of the world business cycle, however, is largely determined by events on the foreign exchanges, to which subject we now turn.

Summary.

The broad result of our analysis in this section is as follows. The influences of a localisation of investment and credit on the cyclical movement are manifold. Sometimes the tendency is to damp down local booms and depressions: sometimes the influence is the reverse. Everything depends on the details of the general economic constellation. While it may be said that the existence of transportation costs (that is, of a certain localisation of real goods) tends definitely to disturb the uniformity of the cyclical movement in the world and to make local booms and contractions possible, no such general statement can be made about the localisation of investment and credit in general. Given the existence of transportation cost and the geographical distribution of resources, it cannot be said that increased mobility of capital tends to synchronise the cyclical movement in all countries nor yet the reverse.

§ 4.    DIFFERENT DEGREES OF NATIONAL CURRENCY AUTONOMY AND THEIR INFLUENCE ON THE CYCLICAL MOVEMENT

Degrees of independence.

We have hitherto assumed a single basic money throughout the world, in terms of which all prices and debts are expressed, constituting together with bank notes and deposits, which represent essentially promises to pay the basic money, the sole medium of exchange. We shall ‘now attempt to bring out the full significance of this assumption for the course of the cycle by confronting this unified, worldwide system with a number of less unified systems.

Recapitulating partly what has been said or implied in previous sections, we shall have to work through a whole series of cases, in which the monetary systems of the various countries become increasingly independent of one another. We shall eventually arrive at the very opposite extreme to complete world unification—namely, complete independence in the monetary systems of different countries: i.e., completely free exchanges.8

A unified money system with mobility of capital.

When we were arguing on the assumption of a closed, spaceless system, we postulated the existence of some basic money such as gold and a note circulation on that basis issued by a central bank. The central-bank money (which includes deposits with the central bank) forms in turn the basis for a credit structure built up by the commercial banks. Evidently, we must make some assumptions about the supply of the central-bank money: that is to say, we have to define the policy of the bank of issue in respect to the ratio between the note circulation and the gold reserve which it seeks to establish at any given moment of time.

Our previous postulate was maintained when we first introduced the space factor by assuming a certain geographical distribution of resources and transportation cost for goods and services. The same money circulated everywhere, and the conditions of the supply of investible funds as furnished by the central bank, commercial banks or other sources were everywhere the same. We saw that in this case, in spite of the fact that the supply of investible funds was uniform—consisting, as it did, of a single pool to which would-be borrowers from all parts of the system had equal access—local booms and depressions were not excluded because, owing to a certain localisation of real resources, the demand for investible funds might be concentrated in particular localities.

We may conceive of the central-bank money as supplied by a single institution with branch offices in various localities, all of which pursue the same policy. They issue notes by discounting bills at the same rate (and under the same conditions) or by buying and selling securities at the same prices. The cash (gold) reserve—if any—is pooled and not kept separately for each branch.

Decentralised ban king with mobility of capital.

So long as we adhere strictly to the assumption that perfect mobility of investible funds implies 100% equalisation of interest rates, we do not raise any basically new problem if we proceed to assume that the issue of money in each area is effected by independent institutions. Each area has its own central bank; but the money such banks issue is expressed in the same units and is accepted everywhere. All of these banks are forced to pursue the same policy. If one of them charges a lower rate for discounts than the others, it will be overwhelmed by an increase in demand diverted from all the others. Either its rate will have to be raised again, or else the other banks will have to follow suit by lowering theirs in order to retain their customers. Supply conditions for investible funds will still remain the same everywhere, and it will be impossible for one country separately to effect a local expansion or contraction by a manipulation of the supply of funds. Differences in prosperity between countries can only come from the demand side. (An artificial increase in demand can of course be brought about for any particular country by State intervention —e.g., by State borrowing for public works. Whether and to what extent the ensuing boom will be localised will in such case depend on the localisation of resources, transport cost and the flow of purchasing power—that is, on the way in which the flow of new money is distributed by the successive recipients as between home goods and import goods.)

The problem remains of how the terms of lending, which must be the same for all the banks of issue, are determined.9 Several systems are conceivable. The system which is the most important in practice is to make the determining factor some ratio—not necessarily constant—of the note circulation to a gold reserve. If the gold-reserve ratio of any one of these banks falls to a level which is considered as the lower limit, it will restrict lending. But, since we still assume perfect mobility of capital, the effect of this will be that borrowers are diverted to other banks, and that there is merely a redistribution of borrowers as between the different banks. No differential rate can be charged by any one bank because we have ex hypothesi a perfect market for loanable funds.

Central-bank policy with localised credit.

This analysis may seem somewhat strange and unfamiliar. Our actual gold-standard experiences are certainly very different. The reason is that we are not really accustomed to assume perfect mobility of loanable funds, although we are not always aware of the fact. The assumption of perfect mobility of loanable funds does not indeed correspond to reality. Any abandonment or relaxation of the assumption at this stage will bring us much closer to the familiar realities of our gold-standard experience.

We shall continue to argue on the basis of a gold standard, under which the money is everywhere convertible into gold and a certain minimum ratio between the monetary circulation and the gold reserve is maintained. But we now propose to assume a more or less complete localisation of credit, and especially of central-bank credit. This will give the monetary authorities a somewhat wider scope in the pursuit of a policy of expansion or contraction by means of variations in the supply of investible funds, independently of what happens in other countries. The central bank of any particular country need not be afraid of being swamped by an immediate flood of demand for credit if it lowers its rate below the rate ruling in other countries. Needless to say, there are other limits to an independent policy in the fact that we still assume a common monetary standard: viz., gold. These limits depend on (a) the degree of localisation of credit and (b) the degree of closeness of trade connections as determined by the localisation of resources, transportation cost and the direction which is given to the flow of money by its successive recipients.10 Up to a certain point, these limits can be widened by increasing tariffs and other impediments to the import of goods.

Within these limits, the central bank of a country may try to offset expansionary or depressing influences from other countries. If, for example, the balance of payments takes an unfavourable turn and gold is withdrawn from the central bank for export, the central bank may maintain or even increase the amount of its liabilities by the purchase of some other form of asset such as Government securities. The length of time for which a country on the gold standard can persist in a policy of neutralising inflows and outflows of gold is, however, limited, in the case of an outflow, by the stock of gold in the possession of the central bank and, in the case of an inflow, by its stock of saleable assets other than gold. Even within these limits, the monetary authorities may be unable to “insulate” the country against fluctuations in the money flow due to international causes. Few would question their power to check a tendency to expand by means of a restrictive credit policy: but the deflationary effect of an unfavourable change in the balance of trade may be too strong to be counteracted by any purely banking policy. A mere maintenance of the outstanding volume of central-bank money (notes and deposits), while it obviates the necessity for the commercial banks to pursue an active policy of credit restriction, is probably insufficient to compensate the deflationary effects of an adverse balance of payments. It cannot completely compensate these effects unless the adverse balance is “caused” by an export of capital in the shape of purchases of foreign exchange and sales of Government and other national securities. If the cause of the adverse balance is a switch-over of demand from home-produced goods to foreign goods, we may presume that the higher price of Government securities and the continued willingness of the banking system to lend on short term will be unable to obviate—at any rate immediately—the deflationary consequences of a worsening of the anticipations of business-men.

The chief advantage of such a system as has been discussed is its ability to prevent the “secondary” unemployment which will otherwise follow a temporary dropping-off in foreign demand, and to counteract to a large extent the export of capital and the decline in capital imports. The chief disadvantage of the system is its tendency to give rise to doubts as to the maintenance of the gold parity, and encourage large-scale capital movements which in turn render much more difficult the task of maintaining the gold parity.

Different national money units.

By mentioning the possibility of a variation in the exchange ratios between the various currencies, however, we introduce a new factor of considerable importance into our analysis. This we must now investigate more closely. So far we have assumed that there is the same money in all countries. We shall now suppose that each country has a money of its own—dollar, pound sterling, franc, etc.—which within its frontiers is everywhere acceptable as payment for goods and services, taxes, etc., but is not normally acceptable outside these frontiers.

So long as we assume these currencies to be closely linked by a common standard which involves a constant exchange ratio between these currencies, and so long as we assume that no question arises in any quarter as to the stability of these exchange rates, and that nobody anticipates the possibility of a variation in these rates, no new problems of any importance are raised by the introduction of a variety of national monetary units.

A new element of great importance, however, is introduced into the analysis when the possibility arises of variations in the exchange ratios between the different currencies.11 It is not even necessary that such exchange variations should actually take place. The mere anticipation or apprehension of exchange variations will suffice to give rise to speculative movements of capital from one currency to another. People will naturally prefer to hold money (and claims expressed in money) which is expected to appreciate than to hold money (and claims expressed in money) which is expected to depreciate. The ‘movement of capital will probably affect also the equities of the two countries, as well as the bonds, unless there is some reason to expect that a relative rise in dividends will take place in the country whose currency is expected to depreciate.

Speculation on the foreign exchanges.

Speculation on foreign exchange, like all speculation, plays a double rôle. It may have a tendency either to offset or to accentuate disturbances arising from other sources. If it is believed that no change will take place in the exchange rates, short-term capital movements of a stabilising character will appear whenever the other items in the balance of payments tend to disturb those rates. In the case of a long-continued movement in one direction, such as might be caused by a transfer of demand for goods from country A to country B, speculative capital movements from B to A may offset the effect on the exchanges for some time; but later, either money (gold) must flow from A to B, or A’s currency must depreciate with reference to 23’s. If, however, the adverse development of A’s balance on trading account is expected to be sufficiently considerable and sufficiently lasting to cause a transfer of gold from A to B on such a scale as to lead to the abandonment of the gold standard by A, there will be a “flight” from A’s currency to B’s, which will accentuate the gold export and either advance the day when the gold standard must be abandoned or force A to a more severe deflation than would otherwise be necessary. Anticipations regarding movements in the foreign exchanges tend to their own fulfilment. Similar pessimistic expectations, with similar unfortunate consequences, are likely to be aroused by any signs of unwillingness on A‘s part to exercise a deflationary pressure in response to an adverse trade balance, or by such devaluation on the part of B as makes a more adverse trade balance for A probable.

Under a gold-standard regime, the appearance of capital movements of the type described is an unhealthy symptom. It means that the regime is thought to be in danger of breaking down. When, on the other hand, national policies cease to regard the maintenance of exchange stability as something which must take precedence over all other considerations, and when even a single important group of countries decides to envisage the use of exchange variation as an instrument of economic policy, speculation regarding the probable movement of the exchanges, and capital movements in connection with such speculation, are normal and inevitable features of economic life.

“Exchange standards.”

Before proceeding to enquire what happens to the business cycle in conditions where countries use exchange variation as an instrument of economic policy, we should perhaps pause to consider the cyclical implications of some of the other methods—i.e., the methods other than the gold standard—of maintaining exchange stability. So far we have assumed that each country offers to exchange gold at a constant rate against its own currency, and keeps a reserve of gold which varies in some ratio with the volume of the monetary circulation. An alternative method of keeping the exchanges stable consists in buying and selling foreign exchange at a fixed rate and in treating foreign means of payment and claims thereto (balances abroad) as reserve instead of gold. These are the famous “exchange standards”— “gold exchange standard”, “sterling exchange standard”, “dollar exchange standard”, etc. For convenience, we shall refer to the countries whose central banks hold their reserves in the form of assets expressed in the monetary unit of some other country or countries as “exchange-standard countries”, and the countries whose exchange provides the standard for the first group as “reserve countries”.12 A group of countries in which some (the “exchange-standard countries”) keep their reserves in the shape of the assets of the others (the “reserve countries”) may be called a single “monetary group” of countries—e.g., the “sterling bloc”. To maintain the unity of the monetary group, there must either be only a single reserve country whose currency, itself independent, provides the standard for the group or the reserve countries must have a common standard—e.g., gold.13

From the point of view of the individual exchange-standard country which thus “pegs” its exchanges to some other currency, the external money mechanism is exactly the same as under the gold standard; and the limits and possibilities of action to obviate expansionary or depressing influences from outside also remain in principle the same. If the policy is carried through by the central bank, with foreign exchange taking the place of gold as the reserve against liabilities which constitutes the country’s basic money, there is no difference from an ordinary gold standard. If it is carried through by some other Government department which issues no money, such as an Exchange Equalisation Fund, the effect is still the same, though the details are slightly different.14 If the central bank sells foreign exchange, it diminishes its liabilities to the public (including the commercial banks) and so stimulates credit restriction. If the Exchange Equalisation Fund sells foreign exchange and adds to its balance at the central bank, the public’s balances must diminish pro tanto and credit restriction will follow as before.

From the point of view, however, of the world as a whole, the adoption of the exchange standard in preference to the gold standard may make a considerable difference to the money supply and may thereby affect the cyclical movement.

The transition from the gold standard, where every country holds a gold reserve in a certain proportion to its circulation, to a system where a number of countries hold no gold is bound to have an inflationary effect on the world as a whole. A change in the opposite direction tends to have a deflationary effect.

The exchange standard in operation.

The very existence of such a system—and not merely its introduction or abandonment—is likely to exert some influence on the supply of money in all the countries concerned. Under the gold standard, any one country that expands faster than the others will lose gold and be forced to stop expanding. With some qualifications, which follow from what has been said in the previous sections, we may say that, under the gold standard, the country with the least-rapid expansion sets the pace for the whole system. Under the new system, where a number of countries belong to a single monetary group in the sense defined above, this restraining force will cease to operate in one direction. The reserve country or countries, even if they themselves are “on gold”, need not be afraid of losing gold to the dependent exchange-standard countries. This restraining force is, however, still effective in the opposite direction. When the exchange-standard countries expand more rapidly than the reserve countries, the monetary reserves of the former—that is, their balances with the latter—tend to be depleted.

The mechanism of the exchange standard may however, provide automatically a certain substitute for the gold brake, although an unreliable and a weak one. Suppose an expansion takes place in the reserve countries, and their balance of payments vis-à-vis the exchange-standard countries becomes unfavourable in consequence. The latter will find their central-bank reserves increased accordingly. Much will then depend on the precise form in which these reserves are kept. If they are held as demand deposits in the reserve countries, the latter—while suffering no reduction in their own gold, or other, reserves—will nevertheless experience se me deflation. Money will have been withdrawn from circulation, as it were, and sterilised in the form of demand deposits. This deflationary effect will be attenuated almost to vanishing-point, if the extra reserves of the exchange-standard countries are invested on the bill market or in securities. In any case, the expansion in the reserve countries will not experience to the full the usuall “braking” effect of the rise of the adverse trade balance—namely, a fall in the gold reserve and a consequent credit restriction by the banking system.

On the other hand, under a gold standard, if one country expands and loses gold to others, it exerts an expansionary effect on the latter by strengthening their gold reserves. With the exchange standard in operation, this expansionary influence ceases to be effective in the direction from the exchange-standard countries to the reserve countries. If an exchange-standard country expands, the reserve countries do not experience an increase in their basic money supply. On the other hand, this expansionary influence still operates in the opposite direction. When the reserve countries expand, the exchange-standard countries will find themselves with an increased money supply and will be tempted to expand also.

From this argument, it would seem to follow that an upswing (or downswing) starting in a reserve country will be likely to spread more easily to other parts of the world, and go farther than it would under gold-standard conditions, because the exchange-standard countries will benefit (suffer) both in respect of their trade and in respect of their reserves while the reserve countries will not, as under the gold standard, lose (increase) their reserves. Similarly, an upswing (downswing) starting with the exchange-standard countries will be less likely to spread, and will go less far, than under a gold standard.

So much, however, cannot be said without qualification, at any rate when we are considering a gold-standard system where localisation of credit is not complete. Suppose, for example, an expansion in reserve country A. A’s trade balance with exchange-standard country B deteriorates; but capital movements from B to A may be induced in such quantities that A’s balance of payments with B actually improves. Under gold-standard conditions, A’s gold reserve will rise in spite of the adverse trade balance; and this will help to increase liquidity and the supply of funds through the machinery of the banking system in A. The effect of the exchange standard may well be such as to counteract the influence of these capital movements. When capital moves from B to A—that is, when B’s citizens are buying A’s equities—the central bank in B will be forced to realise on its reserves. It may, e.g., sell A’s Government securities if its reserves are invested in such securities. The favourable effect on A of the capital movement from B will thus be largely offset.

Variations in exchange rates.

We may now return to the discussion of the point raised earlier in this section—viz., the influence on the cyclical movement of systems which either use variations in the exchange rate as instruments of policy or allow the exchanges to vary whenever the forces of the market tend to bring about a change in the rate.

We have seen that a most important—and, we may say, very disturbing—consequence of systems in which stability of the exchanges is no longer regarded as axiomatic is to be found in the extensive and irregular capital movements to which such systems give rise. By “irregular capital movements” we mean movements which are not induced by differences in the interest rate and do not therefore necessarily proceed from the rich countries to the poor countries, but on the contrary (so to say) “up-stream”, and—what is perhaps the most disturbing feature of all—are subject to rapid fluctuations and abrupt changes of direction.

Naturally, there are different degrees of uncertainty as to the future of the exchanges. Different people will react to a prospective change in the exchange rate with different intensity. In the case of small countries where exchange transactions are familiar, or populations (e.g., in Central Europe) where the memory of drastic depreciation of the currency is still fresh, a slight change or the danger of such a change will mean more, and will induce a more violent reaction, than in other countries. Furthermore, the effect of changes in the exchange rate on international capital movements frequently cannot be separated from other factors often alternative to changes in the exchange rate, such as transfer moratoria, partial defaults and the like. Therefore, so far as the details and the magnitude of the reaction are concerned, it is impossible to generalise: each case must be considered on its own merits. In a general way, we can only say that unstable exchanges unquestionably hamper normal international lending. They are one of the most powerful obstacles in the way of equalisation of interest rates between countries. The irregular capital movements to which they give rise introduce an erratic factor which may considerably disturb the cyclical movement, giving it sometimes a quite unexpected turn.

After these general considerations, we shall now discuss two problems: (1) the consequences on the business cycle of a definite act of devaluation—that is, of a deliberate and substantial change of the exchange rate, and (2) certain peculiarities (not to say paradoxes) arising under a system of “free exchanges”—that is, under a system where the exchanges are allowed to vary with the variations of supply and demand in the market and no attempt is made to keep them stable.

Currency devaluation.

Recent years have provided many examples of deliberate and substantial changes in exchange rates. Since the gold value of a currency is still regarded as the norm, and since the initiative is almost invariably taken by the country whose currency is depreciated, these changes in the exchange rate are commonly referred to as a depreciation or devaluation of a currency in terms of the other currencies, although the depreciation of one currency necessarily implies the appreciation of the others. The consequences of these changes on the international and domestic trade of all the different countries involved have been extensively discussed in connection with recent experiences.15 It is not proposed to reproduce all the arguments which may be, or have been, advanced for or against devaluation under the various possible circumstances. It is proposed, instead, to apply our analysis of the cyclical movement in order to trace the main channels through which alterations in exchange rates are likely to exert an expansionary or depressing influence on the national economies concerned, and to indicate the relevant circumstances on which the resulting effect will depend.

We assume that, before and after the devaluation, the countries concerned will pursue a policy of stabilising the existing rate, at any rate for the time being. If the exchanges are allowed to fluctuate freely with the changes of supply and demand, we have the system of “free exchanges” which will come up for discussion later. In order to make it easier for the reader to follow the analysis, we shall refer to the country or countries whose currency has been devalued as “D countries” or simply “D” and to the country or countries whose currency has appreciated as “A countries” or “A”.

Effects on exchange of goods.

We have first the effect of an act of devaluation on the flow of goods—i.e., on international trade. (We shall disregard for the moment effects due to the stimulation of capital movements.) In the case with which we are concerned, the influence is clearly expansionary for the D country. Exports are stimulated; imports are made more difficult. Export industries and industries which compete with imports will benefit. Their demand for investible funds will rise, or cease to fall off, or cease to fall off so rapidly; and this will have favourable repercussions on other trades. The fact that imported raw material rise in price in terms of the domestic currency is unlikely to nullify altogether the benefits referred to. So far as these raw materials enter into export goods, their rise in price will offset only a part of the export premium afforded by the depreciation of the currency. So far as they are used for domestic purposes, the adverse influence may possibly be more potent.

Devaluation has a favourable effect, not only on the demand for, but also on the supply of, investible funds. The augmentation in the supply is due to the increased gold reserve resulting, not merely from the improvement in the balance of trade, but also from the marking-up of the value of the existing reserve in terms of the local currency. If there was a pressure on the gold reserve of the central bank, it will be lessened or removed; and so an obstacle to recovery may be eliminated.

For similar reasons, in so far as the influences on exports and imports of goods and services are concerned, the effect of a variation in the exchange rate on the A country or countries will tend to be depressing.

Influence on the world as a whole.

What will be the influence on the world as a whole? Will the combined effect on both the D and the A countries be expansionary or deflationary? So far as the influence exerted through the supply of investible funds is concerned, it is possible to make some generalisations. If, as is likely, the devaluation takes place under the pressure of a declining gold supply, and if the A countries have an ample gold reserve, the combined effect will be expansionary. The result will be an alleviation in the D countries and no particular “tightness” in the A countries. If the rôles of the two groups are changed, the result will be the opposite.

We may also put it this way. The result will be expansionary if the devaluation constitutes a movement towards an “international equilibrium”, and deflationary if it leads away from equilibrium—the criterion for an international equilibrium being the absence of persistent gold movements and of abnormal capital movements motivated by an anticipation of a fall or rise in the exchange rate. Again, it will be expansionary when it corrects an “over-valuation” of the depreciated, and an “under-valuation” of the appreciated, currency: it will be deflationary when such a disparity is accentuated.16 The criterion of over- and under-valuation is the divergence from the equilibrium level as defined above.17 Naturally, the devaluation may be so strong as to create a disparity in the opposite sense. It is common knowledge that this has in fact frequently occurred.

It is much more difficult to say anything definite on the world effect, so far as the influence on the demand for investible funds is concerned. In the D country, owing to the encouragement of exports and discouragement of imports, the demand for investment funds will be stimulated. In the A countries, the demand will be unfavourably influenced, even if (owing to the existence of ample reserves) the supply of investible funds is not affected at all. It is impossible to say whether the expansionary effect in D or the deflationary effect in A will be stronger. Much will depend on certain lags. If, for example, a cumulative expansion process in D has time to develop before a contraction in A has got under way, it will have favourable repercussions on A, so that A may be relieved from the initial pressure produced by the devaluation.

Effect on capital movements.

It is, however, probable that the total result will be decisively influenced by other factors to which we must turn now. We are thinking of the influences which a variation in the exchange rate may exert through capital movements and possibly through “psychology”. (In practice, there are, of course, still other factors to be considered—viz., the probability of retaliatory measures in the sphere of currency manipulation or of commercial policy. There is also the effect on the international economic policy of the D country itself to be considered. The devaluation may enable a country to relax impediments to international trade such as quotas, tariffs or exchange restrictions. These considerations may sometimes be of vital importance: but they fall outside the scope of the present study.)

A devaluation is bound to have a strong influence on the movement of capital; and the fundamental effect on the trade currents may be blurred as a result. Since it is not probable that a devaluation will come quite unexpected out of the blue, it may be assumed that it will be preceded by capital outflows from the D country. After the operation has been accomplished, it is likely that these capital flows will cease or even be reversed. It will be apparent, if this happens, that the operation of these developments does not run counter to the fundamental influence exerted on the D and A countries through the effect on the export and import of goods and services, but, on the contrary, accentuates and anticipates it. In this case, the devaluation will be regarded as successful from the point of view of the D country. This result depends, however, on certain expectations being created—in particular, the expectation that the devaluation will be definitive for a considerable time to come. It does not necessarily follow that this expectation will be created. The devaluation may be regarded as no more than a first step, to be followed by others in the same direction. In that case, capital movements away from the D countries may be induced, and the favourable effect on the supply of investible funds in the D economy will be postponed.

While ordinarily the effects of devaluation in a single country on the world situation—through changes in the trade balances and revaluation of the gold reserves of the countries affected—may be said to be on the whole inflationary, the capital movements which may be induced will probably have a deflationary effect on the world as a whole; and the deflationary effect may be stronger on balance than the inflationary effect.

Deflationary effects of capital flints.

Ordinary capital movements—i.e., movements induced by disparities in interest rates or profit rates in different countries—must be counted as expansionary, because money which may have been in part hoarded in the country of origin owing to its lower rates of interest will be invested to a greater extent in the capital-importing country because of its higher rates of interest.

This presumption does not hold good of capital movements motivated by the desire to profit by, or to avoid losses from, expected exchange movements. It is even likely to be reversed if the movement of funds assumes large proportions. The potential extent of such “abnormal” capital movements, when people are thoroughly scared, is much larger than any “normal” capital movement could be; and they may expose the capital-exporting country to a much more serious drain of gold than is likely to develop in a short period of time from an adverse movement in the trade balance. Consequently, the funds will in all probability tend to move from a country with a high rate of interest to one with a low rate.

This in itself would render probable the view that the capital movement is deflationary: but, in addition, there is the attitude of the receiving country to the extraordinary import of capital to be taken into account. It will be realised that funds of this nature are liable to be withdrawn as quickly as they appear. Banks with which foreign balances are deposited regard them as “bad” or “hot” money, and will not re-lend more than a relatively small proportion of them. If the banks are incautious, the central bank will probably realise that the increase in its gold reserve occasioned by the afflux of foreign funds is liable to disappear at short notice, and will refrain from expanding central-bank money accordingly. Thus, while the flow of funds will cause a considerable reduction in investment in the countries from which it comes, it will be largely sterilised in those to which it goes.

Free exchanges.

We turn now to the discussion of an extreme case in our scale of possible relationships between the currencies of different countries—viz., the case where the different national currencies are completely independent of one another. This is the exact opposite of a completely unified world monetary system. This system of “free exchanges”, as we may call it, gives rise to a number of peculiar reactions, which stand in sharp contrast to our familiar gold-standard experience. It is not suggested that such a system has ever existed in a pure form. It is nevertheless instructive to enquire into its probable consequences: first, because there are monetary arrangements which come near (and tendencies which would bring us near) to such a system and, secondly, because certain implications of familiar views derived from gold-standard experience are brought out very clearly by contrast.18

Let us first give a precise definition of what we understand by “complete independence of two national currencies”. Independence implies, of course, the absence of an international standard. The exchanges are allowed to vary according to the situation of demand and supply in the market. No central bank or other institution interferes in order to stabilise the exchange at any particular level. While, under the gold standard, a disparity between demand and supply in the exchange market leads to a flow of gold from one country (or region) to the other, no such money flows are possible under the “free-exchange system”. While, under the gold standard, equilibrium in the balance of payment is eventually restored by contraction in the amount and flow of money in one country and expansion in the other, with free exchanges this equilibrating function is assumed by variations in the exchange rates. The free-exchange system may also be described in the following manner. The money circulating in any given country is strictly confined to the territory of that country. There is no arrangement to enable money in one country to be transferred to another country and used there for paying debts and buying goods, whether directly or indirectly through the intermediary of a central bank or an Equalisation Fund with a stock of foreign money which it sells at a more or less fixed price against domestic money, thereby contracting the circulation of the one, and expanding the circulation of the other, currency.19 Anyone who wishes to buy foreign means of payment for the purpose of buying foreign goods or making investment abroad must secure them through the market from those who desire, for similar reasons, to sell foreign means of payment.

The “impact” rate of exchange.

When considering a state of affairs where variations in the exchange rate are used to restore equilibrium in the foreign-exchange market, we are confronted at the outset with a difficulty.20 At any given moment, there is a volume of international payments to be made under existing contracts. If there is a deficit in country A’s balance at a certain point of time, it is by no means certain that it can be wiped out by any variation in the exchange rate. Whether this is possible or not depends on the currencies in which the debts falling due at a given moment are expressed. “If all payments contracted for between two countries are fixed in terms of the currency of one of them, it is clear that no variation in the exchange rate can alter the relation between the two sides of the account”.21 If all the credit items of country D are expressed in D’s currency and all debit items in A’s currency, a deficit in D’s account will for the moment be aggravated by a depreciation in D’s currency (although, if the depreciation had time to exert its influence on exports and imports, it might restore equilibrium). The deficit could immediately be wiped out by an appreciation in D’s currency; but it is difficult to see how the market mechanism can produce such an appreciation under the assumed circumstances: for, if there is a deficit in D’s balance, D’s demand for A’s money will rise and A’s currency will appreciate—which, as we have seen, aggravates the situation. (This is what GRAHAM calls a “self-inflammatory” exchange variation.) It is only when D’s debit items are fixed in D’s currency and its credit items in A’s currency that we can expect the exchange market to achieve a smooth adjustment automatically through a depreciation of D’s currency.

Transfer of demand under “free exchanges”.

We may, however, get round this difficulty (which is probably of no practical importance) by relaxing our assumptions a little, so as to allow of some private or official transactions with the object of preventing these short-term fluctuations. Suppose, then, that there are no capital movements at all other than those involved by the ephemeral transactions just mentioned. In these circumstances, a switch-over of demand from country D to country A occurs22 by reason (say) of a change in the taste of the consumers in A and / or D, or the introduction of a new tariff in A, or a rise in cost of production in an export industry of D, or a reduction in cost in a competing industry in A. In the assumed conditions, the value of D’s currency must fall relatively to that of A’s currency. The farther it falls the cheaper will D goods become in terms of A’s currency and relatively to A goods. If the elasticity of demand for imports in terms of the local currency can be assumed to be greater than unity both in A and in D, D will spend less D money on imports from A and A will spend more A money on imports from D. The rate of exchange will be such as to equilibrate the value of D’s import (A’s exports) and A’s imports (D’s exports). Thus, the more elastic the reciprocal demand of A and D for each other’s products, the less the need for D’s currency to fall in value relatively to A’s currency.23

What will be the consequence of this change on the internal situation in A and D? Under the system of “free exchanges”, there is no flow of money between countries. D’s banking system is not any less liquid, or A’s any more liquid, in consequence of the change in demand than before. There is thus no reason for a change in the supply of investible funds in the two countries. Nor is it clear how the demand for investible funds will be affected. The initial transfer of demand meant greater profitability in the A industries and less profitability in the D industries directly affected; but the modification in the exchange rate provided an exactly equivalent stimulus to the D industries and a setback to the A industries. The conclusion must be that, if the transfer of demand from D to A has any effect whatever of a stimulating or depressing nature on either D or A, it must be because of some peculiarities in the industries involved. In both countries, there is a horizontal shift in demand; and the outcome will depend on a number of factors which have been analysed in an earlier chapter. The only a priori justification we might have for expecting an upswing in A and a downswing in D is that the initial switch-over in demand may be anticipated by the industries concerned to a greater extent than the counter-effects on export industries as a whole due to exchange variations.

Comparison with gold standard.

It will be noted that this is very different from what we are accustomed to expect under a gold-standard regime. We have, e.g., argued that, under the gold standard, the imposition of a tariff has an expansionary effect on the country which imposes the tariff and a deflationary effect on the country whose goods are shut out from the market of the former. This rule does not hold good under a system of free exchanges. The difference between the two systems may become clearer, if we put it in yet another way. Assuming no capital movements, an increase in exports from country A to country D under a free-exchange system will produce an immediate equal increase in imports. Under the gold standard, some time will elapse before the effect is apparent. In the meantime, money will flow from D to A—or rather, under a one-sided or two-sided exchange standard, money will not flow physically, but the central bank in A will expand on the basis of increased balances in D. This intermediate step is cut out under a system of free exchanges; and thus the necessity for expanding in the one, and contracting in the other, country is eliminated.24

Localisation of prosperity and depression complete.

By reasoning not essentially different from the above, it can be shown that, under free exchanges without capital movements, there will be no tendency for prosperity or depression to communicate itself from country to country. On the other hand, they will tend to spread more thoroughly throughout all the industries within the country than they do under gold-standard conditions.

Suppose an expansion process is started in country D. Prices and incomes rise. Imports will go up, and D’s currency will fall relatively to A’s currency. But, pari passu with the rise in imports, exports will grow, so that the boom in D will develop unweakened by a drain of money abroad. Country A, on the other hand, will experience an increase in exports no less than in imports. Whether on balance these two changes will be expansionary or deflationary will depend on the same set of circumstances as the expansionary or deflationary character of a horizontal shift in demand. Under a system of free exchanges, the powerful factor which under a gold standard dips the balance on the side of expansion—viz., the inflow of money—is lacking. By analogous reasoning, it can be shown that contractions also lose much of their contagious character. The free-exchange system eliminates from the economic interchange of different countries the most important carrier of the boom and depression bacillus—namely, the flow of money across frontiers.

Capital movements under free exchanges.

Let us now consider the effect of capital movements under a system of free exchanges. Suppose people in D seek to invest money in A for any reason, or people in A seek to borrow money from D. No money can move; but the demand for A money rises, and D’s currency falls in value accordingly. D’s exports rise, and/or imports fall, by the amount which is being invested abroad. The capital movement at once brings about an export surplus in D’s balance of trade, which is an import surplus from A’s point of view.

The effect of this movement on D, the capital-exporting country, is very likely to be expansionary. Demand for goods as a whole has certainly not fallen: but it may well have risen if even a small part of the money which seeks investment abroad comes out of hoards, or would have been hoarded if the transfer abroad had not been possible.

In the capital-importing country A, the effects are the contrary—viz., deflationary. The money which people in D want to invest in A can be made available only by an import surplus in A—that is, it is withdrawn from the sales of A products. More goods are offered for sale in A: but total demand has not risen. It will be seen that this deflationary effect obtains even on the most favourable assumption: viz., the assumption that the money made available in A for investors in D is spent on goods—i.e., is really invested. If—as may be the case with speculative movements of capital—a part of the money is kept in liquid form, the deflationary effect is accentuated.

Contrast with gold standard.

From the point of view of our gold-standard experience, it appears highly paradoxical that the capital-exporting country should be stimulated and the capital-importing country depressed as a result of capital movements !

The difference between the modus operandi of the two systems may again be put this way. Under a gold standard, capital export will usually not produce an immediate corresponding movement of goods.25 It will first lead to a money flow, which will then induce a flow of goods. This intermediate phase is cut out under the operation of a system of free exchanges.

In the light of this analysis of the effects of capital movements under free exchanges, we may reconsider the case of a switch-over of demand from D goods to A goods. D’s currency will depreciate. This may induce speculative capital movements. Suppose the movement of the exchange is believed to be temporary and likely to be reversed—as it will be, e.g., in the case of seasonal movements. In that case there will be a movement out of A values (money, debts and bonds) into D values. This flow of funds will run counter to the initial transfer of demand and will to some extent obviate a fall in D’s money. It will also produce an import surplus in D. The result—in accordance with familiar gold-standard experience—will therefore be that the transference of demand stimulates business in the country to which the demand is transferred, and depresses it in the country from which the demand is transferred. The role of gold movements is thus taken over by speculative capital movements.

It is, however, clear that things may take an entirely different turn, and that the gold-standard reactions may be, not reproduced, but reversed under free exchanges. People in D may become fearful of their currency’s falling still lower. In that case, capital movements from D to A will set in, and D’s currency will be depressed still more. The result, as explained above, will be that D, the country which lost the trade in the first instance, will be stimulated by the export of capital, while depression will spread in the country which originally gained the trade.

Capital movements induced by the cycle.

In the foregoing pages, we have assumed a capital movement to take place however occasioned, and have investigated its influence on the general economic situation and the cyclical fluctuations in the two countries concerned. But the cyclical variations themselves are likely to give rise to capital movements which in turn will react on the cycle in those countries. An analysis of these reciprocal influences leads us to reconsider a case discussed a few pages earlier.26 Arguing under the assumption that no capital movements were taking place, we there reached the conclusion that, under the system of free exchange, the most important channels through which prosperity and depression spread from country to country are blocked. This result must now be modified through the application of our analysis of the consequences of capital movements.

Suppose that a boom flares up in country D because new investment opportunities have appeared. If this attracts foreign capital, the expansionary stimulus is at once transmitted to the other (capital-exporting) countries, while the expansion is hampered in the country D, where the stimulation first arose.27 If, on the other hand, the expansion in D is brought about or fostered by a cheap-money policy and if thereby capital is driven out of the country D (to take advantage of the higher interest rates abroad), the expansion in D is still further intensified by the outward capital movement. The outside world, instead of basking in the rays of prosperity cast by D, feels a chilling wind from that quarter and may even be thrown into a vicious spiral of deflation.28

It would not be difficult to construct other cases and to analyse them along the lines indicated. But the general conclusion already stands out clearly: our previous result that under free exchanges the cyclical movement in different countries is independent needs modification if capital moves freely. It is, however, not quite correct to say without qualification (as has sometimes29 been said) that capital movements tend to reproduce gold-standard conditions. On the contrary, they may produce exactly the opposite result from what we would expect under an international gold standard. Under free exchanges with free flow of capital, the cyclical movements in different countries are not independent of each other; in that respect, the system of free exchanges with free mobility of capital resembles gold-standard conditions. While, however, under a gold standard an expansion (contraction) in one country tends to produce expansion (contraction) in the other, under free exchanges with capital movements expansion (contraction) in one country may just as well induce a contraction (expansion) abroad as an expansion (contraction).

Limitation of foregoing analysis.

The short-run nature of the preceding analysis should be kept in mind. We have been concerned with the effects of temporary fluctuations in capital movements, not with the ultimate effects on the economic development of a country of a long-continued flow of capital imports or exports. Moreover, even the short-run effect of individual items in a continuous flow to which the countries concerned have already adapted themselves is a quite different matter from the effects of extraordinary fluctuations.

The classical contention that capital exports from the industrial countries of Western Europe and the United States to the other parts of the world were indispensable for the rapid development of the latter and beneficial to the whole world, including the capital-exporting countries themselves, is not in the least invalidated or made conditional upon the existence of an international gold standard30 by our somewhat paradoxical result to the effect that, under free exchanges, capital imports and, under an international standard, capital exports are likely to have a deflationary influence. It should be remembered furthermore that this deflationary influence is relative to the situation which would otherwise prevail. If a rapid monetary expansion is in progress, the deflationary check which an inflow of capital provides may be very wholesome. This will be the case especially if the supply of unemployed factors of production is small and inelastic, as it is likely to be in poor and industrially undeveloped countries. Once again the reader must be requested not to ascribe indiscriminately a positive value to expansionary and a negative value to deflationary effects.

Possible extension of preceding analysis.

The reader would do well to regard this chapter as containing an exposition of a method of analysis rather than a presentation of definite results which can be applied without further investigations to concrete cases. With this caution, it is possible to apply the analysis of the effects of capital movements, mutatis mutandis, to other types of unilateral payments such as interest and dividend payments reparations payments, war debts and the like. But this extension of the argument must be made with great care, keeping in mind all the assumptions, especially those as to the elasticity of supply of investible funds from inflationary sources, on which the results of our analysis were based.31

 

 

________________

32 In addition to the book by H. Neisser, Some International Aspects of the Business Cycle (Philadelphia, 1936), two articles may be mentioned which deal expressly with the international aspects of the business cycles, viz.: O. Morgenstern, “International vergleichende Konjunkturforschung” in Zeitschrift für die gesamte Staatswissenschaft, 1927, Heft 2 ; and A. v. Mühlenfels; Internationale Konjunkturzusammenhänge” in Jahrbücher für Nationalökonomie und Statistik, 130, Band III, Folge 75, 1929 I. Moreover, the literature on international trade has become more “cycle conscious” in recent times and contains frequent references to cycle problems. Cf. B. Ohlin, Interregional and International Trade (1933); R. Nurkse, Internationale Kapitalbewegungen (1935) ; R. F. Harrod, International Economics (1933) ; C. Iversen, Aspects of the Theory of Capital Movements (1935) ;J. Viner, Studies in the Theory of International Trade, New York, 1937, especially Chapter VII, Section V.

33 Cf. the interesting article by F. W. Paish, “Banking Policy and the Balance of International Payments”, in Economica, Vol. III (New Series), November 1936.

34 There need not in all cases be an absolute contraction in the capital-exporting country. A slowing-down of the expansion may be sufficient. There are also cases conceivable where no contraction—not even a relative one—is required from the capital-exporting country—e.g., if the proceeds of the loan are spent directly on goods of that country.

35 Cf. Iversen, loc. cit., page 47.

36 Here the Neo-Marxian Theory of Imperialism referred to on page 85 comes to the mind.

37 Cf. especially Viner, loc. cit.

38 This factor, which is probably of very great practical importance, has been analysed with great force by Dr. Thomas Balogh, “Some Theoretical Aspects of the Central European Credit and Transfer Crisis” in International Affairs (Journal of the Royal Institute of International Affairs), Vol. 11, May 1932.

39 Professor John H. Williams has attempted a similar analysis: “International Monetary Organisation and Policy”, in Lessons of Monetary Experience, New York, 1937. cf. also Viner, loc. cit.

40 The same problem arises in a “spaceless” economy, if there are several banks of issue, or in a “cashless” economy (as imagined by some writers) where the circulating medium consists solely of bank deposits.

41 Cf. Paish, loc. cit., who introduces the concept of “the Marginal Propensity to Import”.

42 This new element clearly may arise without the previous introduction of a variety of national monetary units. But it would seem convenient to introduce it together with the latter.

43 The term “gold-exchange standard” is a little too narrow, because it suggests that the “reserve countries” keep their reserve in gold or exchange their currency on demand into gold. This need not be the case, as the example of the “sterling group” (“sterling bloc”) shows.

44 A two-sided or reciprocal exchange standard would be an arrangement whereby each member of the group undertakes to treat claims on all the others (foreign exchanges) as reserve. Under such a system, clearly the country which pursues the most inflationary policy would set the pace for all the others and would force them to inflate too.

45 A policy of “offsetting” influences operating through the balance of international payments on the internal situation which has been pronounced to be the main object of the various equalisation accounts (cf., e.g., N. F. Hall, The Exchange Equalisation Account (1935), passim) can be pursued and has frequently been pursued without a separate fund by the central bank. It must, however, be admitted that the psychological, legal and administrative reasons for and advantages of a separate account may be very important. On the policy of the British fund compare also F. W. Paish: “The British Exchange Equalisation Fund in 1935”, Economica, 1936. Idem, 1935-1937, Economica, 1937. S. E. Harris, in his Exchange Depreciation, 1936, discusses also the American experience. On various technical points compare also Th. Balogh: “Some Theoretical Aspects of the Gold Problem”, Economica, 1937, and the Memorandum on Money and Banking, Vol. I, published annually by the Economic Intelligence Service of the League of Nations.

46 Compare the exhaustive treatment by S. E. Harris, Exchange Depreciation (cambridge, Mass.), 1936.

47 Compare P. B. Whale: “The Theory of International Trade in the Absence of an International Standard” in Economica, London, February 1936, pages 33 and 34, for a discussion of the terms “over-valuation” and “under-valuation”, and Harris, loc. cit., passim.

48 Measurements of “purchasing-power-parity” based on comparisons of price levels or of changes in price levels in both countries afford only very rough and unreliable criteria of over- and under-valuation.

49 Compare the very illuminating article by P. B. Whale, op. cit., pages 24 and 38.

50 We shall see that it would be incorrect or, rather, that it would beg important issues and exclude important eventualities if we were to conclude from this that, in any given country, the total demand for goods in terms of money (MV) remains constant in face of changes in the international transactions (owing to fluctuations in commodity trade or capital movements).

51 F. D. Graham has called attention to this difficulty in his article “Self-limiting and Self-inflammatory Movements in Exchange Rates” in Quarterly Journal of Economics, Vol. 43, February 1929, pages 221-249. See also by the same author: Exchange, Prices and Production in Hyperinflation: Germany 1920-1923 (1930), pages 136 et seq. Compare also P. B. Whale, op. cit., pages 27 and 28.

52 P. B. Whale, op. cit., page 27.

53 We call the two countries A and D in order to keep in mind that A is the country the currency of which will appreciate, and D the country the currency of which will depreciate.

54 If we suppose the two countries to have close trading connections, with competing industries and potential export and import capacity, we may safely assume an elasticity greater than unity. This is still truer of one country vis-à-vis the rest of the world.

55 It is interesting to note that, frequently, free traders use arguments which are appropriate (as a short-run proposition) only to a free-exchange system and not to a gold standard—e.g., when they point out that a decrease in imports must be followed by a decrease in exports and vice versa.

56 Under exceptional circumstances, it may happen that the money which D lends to A is spent in A entirely on D’s or A’s export goods, so that the change in the balance of trade is brought about without friction—that is, without a relative or absolute contraction in the lending, and a relative or absolute expansion in the borrowing, country. (Compare R. Nurkse, Internationale Kapitalbewegungen, Vienna, 1935, pages 121, 122 and 144.) Owing, however, to transport cost and the resulting localisation of demand for goods, this will rarely happen to the extent of 100% of the sum transferred.

57 See above, page 446.

58 It is impossible in this case to decide on general grounds whether D’s currency will appreciate or depreciate, because there are two conflicting forces at work. The inflow of capital tends to push up the value of D’s money, the rise in prices and incomes tends to depress it. We may perhaps suppose that the first factor is likely to exert its influence first, so that the currency will appreciate. The result is, however, in principle independent from the direction in which the exchange rate moves. Compare next footnote.

59 It should be noted that this is not because D’s currency has fallen in value, but because of the export of capital from D. The same result that prosperity in one country spreads depression to others could obtain with the D currency appreciating. Suppose the present case is complicated by a fortuitous shift in demand from A- to D-goods, strong enough to over-compensate the influence on the exchanges exerted by the capital outflow from D, so that D’s currency actually appreciates. It follows from our preceding analysis that, abstracting from fortuitous circumstances which may work out either way, this shift in demand is neutral; it does not tend to stimulate the country to which demand has shifted and to depress the other from which it was drawn away. It goes without saying, however, that exchange fluctuations may become relevant by inducing speculative capital movements. Unfortunately, there is no possibility of telling in general which way these speculative capital movements will go.

60 Cf.i e.g., Whale, loc. ext.

61 It is, of course, another question whether the absence of an international standard would not irtcrease the risk of foreign lending so much as to restrict it considerably.

62It is quite likely that, say, reparation payments from one country to another will affect the “propensity to consume” or the “propensity to save” (to borrow these expressions from Mr. Keynes) in a different way from ordinary commercial capital movements. In the receiving country, e.g., the propensity to consume might be stimulated. If that is the case, we must expect results different from those resulting from capital movements.

• 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.
• 6See his book: Strategic Factors in the Business Cycle, passim.
• 7The Lessons of Monetary Experience, page 131.
• 8Currency and Credit, 3rd ed., London, 1928, page 153.
• 91913, page 186.
• 10Monetary Reconstruction, 2nd ed., London, 1926, page 135.
• 11See his paper “Money and Index-Numbers” in Journal of the Royal Statistical Society, 1930, reprinted in The Art of Central Banking, pages 303-332.
• 12It 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).
• 13For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
• 14The 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).
• 15Kapital und Produktion, Vienna, 1934, page 195, and “Die Produktion unter dem Einfluss einer Kreditexpansion”, in Schriften des Vereins für Sozialpolitik, Vol. 173, 1928.
• 16Banking Policy and the Price Level, 1932 ed., page 48.
• 17Op. cit., page 171.
• 18See 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.
• 19Cf. 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.
• 20Since 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.
• 21Currency and Credit, 3rd ed., page 155.
• 22Such 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.
• 23See below Ch. 3, §§ 8,16, and Part II, Ch. 11.
• 24This 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.
• 25HAYEK: Prices and Production, 2nd ed., London, 1934, page 57.
• 26In 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).
• 27If competition in the labour market and the mobility of labour are imperfect, the condition of full employment can, of course, be relaxed.
• 28A. H. Hansen and H. Tout, in “Investment and Saving in Business Cycle Theory,” Econometrica, April 1933, have pointed out the underlying assumptions.
• 29No attempt has been made to establish priorities or to trace the various lines of thought to their historical origins.
• 30The 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.
• 312nd ed., pages 55 et seq.
• 32The 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.
• 33It 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.
• 34One 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.
• 35The 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).
• 36“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.”
• 37With 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).
• 38In 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.
• 39The 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.”
• 40In his earlier writings Mr. HAWTREY had already mentioned the theoretical possibility of a complete credit deadlock arising. That is a situation where even exceedingly low interest rates fail to evoke a new demand for credit. In such a situation, the ordinary means of bank policy prove wholly ineffective. In his Good and Bad Trade he ascribes this phenomenon to the fact that “the rate of depreciation of prices” may be so rapid that “nothing that the bankers can do will make borrowing sufficiently attractive” to lead to a revival in the flow of money.
• 41But even so, Mr. HAWTREY thinks, the recurrence of the breakdown is not inevitable. The expansion could go on indefinitely, if there were no limits to the increase in the quantity of money. The gold standard is, in the last resort, responsible for the recurrence of economic breakdowns. Under the gold standard, it is the slow response of people’s cash balances which prevents the banks from stopping expansion or contraction in time. “If an increase or decrease of credit money promptly brought with it a proportionate increase or decrease in the demand for cash, the banks would no longer either drift into a state of inflation or be led to carry the corresponding process of contraction unnecessarily far.” Given, however, this slow response of the people’s cash balances, “so long as credit is regulated with reference to reserve proportions, the trade cycle is bound to recur”.
• 42To 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.
• 43If 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.
• 44One 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.
• 45This 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.
• 46Treatment 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.
• 47Apart, 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.”
• 48“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.”
• 49Professor 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.
• 50In 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.
• 51But 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.
• 52Under 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”.
• 53Furthermore, 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.
• 54With 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.
• 55The 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.
• 56An 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.
• 57There 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.
• 58It 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.
• 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.
• 60A feature of particular interest in Mr. HAWTREY’S monetary theory of the business cycle is the demonstration and analysis of the cumulative nature of the process of expansion and contraction. In this respect, there is, as we shall see, much agreement between theorists of different schools of thought. Mr. HAWTREY’S propositions on this point, largely taken over from MARSHALL and the Cambridge tradition, have found a place in the theory of a great number of writers.
• 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.