2. The Purely Monetary Theory

CHAPTER 2 THE PURELY MONETARY THEORY

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§ 1. PRELIMINARY REMARKS

Cyclical fluctuations of MV.

Money and credit occupy such a central position in our economic system that it is almost certain that they play an important rôle in bringing about the business cycle, either as an impelling force or as a conditioning factor. During the upswing, the physical volume of production and of transactions grows while prices rise or, in some rather exceptional cases, remain constant.1 This means that the money volume of transactions rises. During depression, the money volume of transactions falls. In other words, the work which money must and does perform rises and falls with the ups and downs of the business cycle.2 It follows, then, that the product (MV) of the quantity of money (M) and its velocity of circulation (V) rises and falls. This does not necessarily mean that the rise and fall of M and /or V is in all cases the active cause of changes in business activity: it may equally well be a passive condition or even a mere symptom. It is conceivable that MV may adjust itself automatically to changes in the volume of business without exerting any influence by itself. But, in any case, the analysis of a theory which puts the monetary factor at the centre of its scheme of causation will almost certainly reveal important features of the business cycle which no adequate synthesis can afford to neglect.

§ 2. THE THEORY OF MR. R. G. HAWTREY:
GENERAL CHARACTERISTICS

Importance of consumers’ outlay.

The purely monetary explanation of the business cycle has been most fully and most uncompromisingly set out by Mr. R. G. HAWTREY.3 For him the trade cycle is “a purely monetary phenomenon” in the sense that changes in “the flow of money” are the sole and sufficient cause of changes in economic activity, of the alternation of prosperity and depression, of good and bad trade. When the demand for goods in terms of money (that is, the flow of money) grows, trade becomes brisk, production rises and prices go up. When demand falls off, trade slackens, production shrinks and prices sag. The flow of money—i.e., the demand for goods in terms of money—is proximately determined by “consumers’ outlay”, that is, by expenditure out of income.4 Consumers’ outlay comprises, however, not only expenditure on consumers’ goods, but also expenditure on new investment goods—that is to say, that part of consumers’ income that is saved and invested. (For consumers’ outlay, one can substitute MV, if one defines “V” as “income velocity”, in contradistinction to “transaction velocity” as it figures in IRVING FISHER’S famous equation of exchange. But, V being thus defined as the ratio of consumers’ outlay to the quantity of money, the two magnitudes—MV and consumers’ outlay—are by definition the same; and not much is gained by the substitution of one expression for the other.)

Non-monetary factors such as earthquakes, wars, strikes, crop failures, etc., may produce a general impoverishment: others, such as harvest changes, over-development of certain industries (e.g., over-investment in constructional industries), may produce a partial depression in particular branches of industry. But a general depression in the sense of the trade cycle—i.e., a situation in which unused resources and unemployment are general—cannot be induced by non-monetary forces or events except in so far as they give rise to a fall in consumers’ outlay—i.e., in the flow of money.

Instability of money and credit.

Changes in consumers’ outlay are principally due to changes in the quantity of money. Everyone agrees that a sudden diminution in the quantity of money, an outright deflation, has a depressing influence on economic activities, and that an increase of the circulating medium, an inflation, has a stimulating influence.

If the quantity of money diminishes, demand falls off, and producers who have produced in anticipation of the usual demand will find that they cannot sell the usual output at the anticipated prices. Stocks will accumulate; losses will be incurred; production will fall; unemployment will be rife; and a painful process in which wages and other incomes are reduced will be necessary before equilibrium can be restored.

Inflation has the opposite effect. Demand exceeds anticipations, stocks decrease, dealers give larger orders to producers, and prices rise. Production increases and unemployed factors of production are gradually absorbed.

This is the familiar picture of a “Government deflation or inflation”. According to Mr. HAWTREY, the trade cycle is nothing but a replica, on a small scale, of an outright money inflation and deflation. Depression is induced by a fall in consumers’ outlay due to a shrinkage of the circulating medium, and is intensified by a decline in the rapidity of the circulation of money. The prosperity phase of the cycle, on the other hand, is dominated by an inflationary process.

If the flow of money could be stabilised, the fluctuations in economic activity would disappear. But stabilisation of the flow of money is no easy task, because our modern money and credit system is inherently unstable. Any small deviation from equilibrium in one direction or the other tends to be magnified.

Mr. HAWTREY starts with the assumption that, in the modern world, bank credit is the principal means of payment. The circulating medium consists primarily of bank credit, and legal tender money is only subsidiary. It is the banking system which creates credit and regulates its quantity. The means of regulation are the discount rate and open-market purchases and sales of securities. The power to expand credit is not, of course, vested in each individual bank, but in the banking system as a whole. A single bank cannot go very far in expanding credit on its own account; but the banking system as a whole can, and there is a tendency to make the whole system move along step by step in the same direction. If one bank or group of banks expands credit, other banks will find their reserves strengthened and will be induced, sometimes almost forced, to expand too. In this way a single bank or group of banks may carry with it the whole system.

(These are familiar propositions of modern banking theory. It does not seem necessary at this point to work them out in detail with all necessary qualifications.)5

§ 3. THE UPSWING

Driving force of bank expansion.

The upswing of the trade cycle is brought about by an expansion of credit and lasts so long as the credit expansion goes on or, at least, is not followed by a credit contraction. A credit expansion is brought about by the banks through the easing of conditions under which loans are granted to the customer. Borrowing may be encouraged in various ways. The banks can apply a less severe standard to security offered; they can increase the maximum period for which they are willing to lend; they can refrain from discriminating as to the purpose for which the borrower wants the loan. But the principal instrument of expansion is a reduction of the discount rate; and each of the other measures is equivalent in some way to a reduction in the costs of credit.

The strategic position of the merchant.

Mr. HAWTREY is aware of the objection, which has been raised very frequently, that a reduction of 1 or 2% in the interest on bank advances is too unimportant an item in the profit-and-loss account of the average business-man to induce him to expand his business and to borrow more. His answer to this objection is that there exists one class of business-men which is very sensitive even to small changes of the rate of interest—namely, the merchants. The merchant buys and sells large quantities of goods compared with his own capital, and he adds to what he buys the relatively small value which represents the dealer’s profit. To him, a change in interest charges of 1 or 2% is not negligible, as it is perhaps to the manufacturer. It is not denied, of course, that there are other considerations besides the rate of interest which might induce a merchant to borrow more (or less) and to increase (or reduce) his stocks of goods. If prices are expected to rise, or if a fall is anticipated, a reduction in the interest rate may be unnecessary or insufficient. But a general rise or fall in prices sufficient to induce the majority of merchants to increase or decrease their borrowing, irrespective of minor changes in the rate of interest, is unlikely to occur except as a consequence of an expansion or contraction of credit and will be discussed later.

Thus, according to Mr. HAWTREY, the merchant is in a strategic position. If the rate of interest is sufficiently reduced—and in ordinary circumstances a slight reduction is sufficient—merchants are induced to increase their stocks. They give larger orders to the producer. Increased production leads to an enlargement of consumers’ income and outlay. This “means increased demand for goods in general, and traders find their stocks diminishing. There result further orders to producers, a further increase in productive activity, in consumers’ income and outlay, and in demand, and a further depletion of stocks. Increased activity means increased demand, and increased demand means increased activity. A vicious circle is set up, a cumulative expansion of productive activity”,6 which is fed and propelled by a continuous expansion of credit.

Effects of rising prices.

“Productive activity cannot grow without limit. As the cumulative process carries one industry after another to the limit of productive capacity, producers begin to quote higher and higher prices.”7 When prices rise, dealers have a further inducement to borrow. Rising prices operate in the same way as falling interest charges: profits are increased and traders stimulated to hold larger stocks in order to gain from a further rise in prices. In the same way, the producer is stimulated to expand production and to borrow more freely in order to finance the increased production. The cumulative process of expansion is accelerated by a cumulative rise in prices.

Instability of the velocity of circulation.

There is yet another accelerating element. In addition to the expansion of the circulating medium, there is an increase in its velocity of circulation. When prices rise and trade is brisk, merchants and producers not only borrow more: they use up any idle balances which may be at their disposal. Idle balances are the inheritance of the previous depression. If they exist to a large extent, “it may be that an enlargement of the consumers’ income and outlay is brought about with little or no expansion of the outstanding bank credit”.

“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.”8

To sum up, expansion is a cumulative process—that is to say, once started, it proceeds by its own momentum. No further encouragement from the banks is required. On the contrary, banks have then to be careful not to let the expansion get out of hand and degenerate into wild inflation. They should raise the rate of interest drastically: slight increases will not deter people from borrowing if prices rise and are expected to rise further. That is what is meant in saying that the process has gained momentum. A discount rate which would have sufficed to nip the expansion in the bud would later be much too low to stop it.

§ 4. THE UPPER TURNING-POINT

Credit restriction responsible.

Prosperity comes to an end when credit expansion is discontinued. Since the process of expansion, after it has been allowed to gain a certain speed, can be stopped only by a jolt, there is always the danger that expansion will be not merely stopped but reversed, and will be followed by a process of contraction which is itself cumulative. (There are other reasons for this, which will be discussed presently.)

“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.”9

The wage-lag, the cash drain and the gold standard.

Man-made limitations on the amount of the circulation—that is, limitations imposed by law and custom—constitute the barrier which prevents our present economic system from getting rid of its cyclical movement with all its bad consequences. So long as there is a gold standard, or other restriction in the supply of legal tender money (e.g., that involved in the attempt to stabilise the exchange rate vis-à-vis another country which does not itself expand credit), the banks are sooner or later forced to stop expansion and even to contract.

Cash—i.e., legal tender money—is predominantly used for small and retail transactions, because for these purposes credit has no greater convenience to compensate for its inferior security. The amount of cash which passes into circulation depends largely on the incomes, expenditures and hoards of working-men. An expansion leads sooner or later to a drain of cash out of the holdings of the banks while, as earnings and wage rates rise, an increasing amount will be retained in cash balances. This, however, is a slow process, because the rise in wages lags considerably behind the expansion of credit and the rise in prices and profits. Meanwhile, the central bank, in its anxiety to maintain exchange stability, declines to supply cash to the commercial banks indefinitely. The latter are therefore forced to put the brake on and to stop the expansion. When they start to do this, the cash holdings of the working population still continue to increase—by reason of their lag behind the credit expansion—and go on rising after the expansion has come to an end. This induces the banks, not merely to stop expanding, but actually to contract; and so the depression is given its start.

§ 5. THE DOWNSWING

The reverse of the upswing.

The 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.”10

The process is cumulative for the following reason. When prices are falling, merchants expect them to fall further. They try accordingly to reduce stocks, and give smaller orders, or no orders at all, to producers. Consumers’ income and outlay decrease; demand flags; stocks accumulate in spite of endeavours to reduce them; borrowing is reduced further—and so on in a long and painful process. All the factors which tended to stimulate the upswing conspire now to push contraction further and further. The vicious spiral downward is in all respects the negative counterpart of the vicious spiral upward. The details need not be repeated.

§ 6. REVIVAL

Sufficiency of credit expansion.

During a depression, loans are liquidated and gradually money flows back from circulation into the reserves of the banks. The reserve ratio becomes normal, and reserves above normal are slowly built up. Interest is by this time fallen to an abnormally low level; but, with prices sagging and with a prevalence of pessimism, it may be that even an exceedingly low level of interest rates will not stimulate people to borrow. According to Mr. HAWTREY, however, there are almost always some people who are willing to increase their borrowing; and this should enable the banks to get over the dead point. But if, as happens in abnormally deep depressions, pessimism is so widespread that no rate above zero will induce an expansion, the central bank has another weapon for overcoming the reluctance of the business community to make use of existing credit facilities—and that is the purchase of securities in the open market.

When the central bank buys securities in the open market, cash is pumped into the banks and their liquidity increases. For a time, the new money may be used to repay debts to the banks, so that the only result is a change in the composition of the assets of the banks (cash increases, loans decrease). But Mr. HAWTREY is confident that eventually, if only the purchases of securities are carried far enough, the new money will find an outlet into circulation, consumers’ income and outlay will begin to rise, and a self-reinforcing process of expansion will be started. Mr. HAWTREY believes that the ordinary measures of banking policy—discount policy and open-market operations—may be trusted to bring about a revival and that it is therefore not necessary to have recourse to more drastic methods (such as public works) to start an expansion. This attitude of his is closely connected with his theory that changes in the rate of interest must operate through influencing working capital rather than through stimulating investment in fixed capital. We shall have to come back to this proposition because it conflicts sharply with the theories of many other writers, with which we shall have to deal.

A credit deadlock.

In 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 Trade11 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.

In more recent publications, under the impression of the slump of the nineteen-thirties, Mr. HAWTREY has modified his views to some extent.12 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”13 and that such a condition of stagnation is not possible except in the course of a reaction from a riot of inflation.14

He still believes that “a failure of cheap money to stimulate revival” is “a rare occurrence” but he admits that “since 1930, it has come to plague the world and has confronted us with problems which have threatened the fabric of civilisation with destruction”.15

These admissions and qualifications go a long way to meet the objections of those who do not share Mr. HAWTREY’S unshakable optimism regarding the efficacy of the traditional methods of banking policy for bringing about a revival.

Wage-lag and bank policy.

Apart, however, from such a contingency, and for a typical trade cycle under the gold standard before the war, Mr. HAWTREY describes the transition from depression to prosperity in the following way. During the depression, money begins to flow back to the banks. But, again, there is that lag of the flow of cash behind the movement of credit. As the outflow of cash does not at once follow the expansion of credit, the inflow of cash lags behind the contraction. The consequence is that, when the banks come to the conclusion that they can stop contracting, because their reserves have reached the desirable level, the process of inflow of cash has not yet come to an end. People’s cash balances respond slowly. Cash continues to flow in for a considerable time after contraction of credit has been arrested. Surplus reserves accumulate, and these excessive reserves tempt the banks later on to over-expand and so begin another cycle.

§ 7. RHYTHM AND PERIODICITY

Rigid reserve proportions.

Mr. HAWTREY’S theory explains why there are not merely small oscillations around the equilibrium, but big swings of the pendulum in the one or the other direction. The reason is the cumulative, self-sustaining nature of the process of expansion and contraction. The equilibrium line is like a razor’s edge. The slightest deviation involves the risk of further movement away from equilibrium.

But 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”.16

Under 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”.17

No trade cycle since the war.

Since 1914, the automatically working gold standard has ceased to exist. After the war and postwar inflations, the gold standard—a managed gold standard—was once more restored; but the first major shock upset it. Therefore, according to Mr. HAWTREY, the former marked regularity and periodicity in the alternation of periods of prosperity and depression, of expansion and contraction, can no longer be expected and do not, in fact, any longer exist. “For the time being there is no trade cycle” if by “cycle” is meant a periodic movement of marked regularity. There are, of course, periods of prosperity and depression; for the credit system is still inherently unstable and there are forces more powerful than ever, the operation of which makes for expansion or contraction. But the intricate mechanism which produced the former regularity in the alternation of expansion and contraction is completely dislocated.

Periodicity is not, however, essential for the purposes of Mr. HAWTREY’S theory. On the contrary, he is entitled to claim for his theory that it does not postulate exclusively movements of a definite length and regularity. The regular cycle can always be interrupted by non-cyclic forces. It must be admitted that an explanation which is flexible in this respect is preferable—if it is tenable in other respects—to a more rigid one.

§ 8. SPECIAL FEATURES OF THE THEORY

Fluctuations in investment in fixed capital.

As has been mentioned, Mr. HAWTREY’S theory stands in contradiction to many other related theories in that it contends that a change in the rate of interest influences the economic system, not through a direct influence on investment in fixed capital, but through the provision of working capital and particularly stocks of goods. The alternative view will be discussed later. Here it must be asked how Mr. HAWTREY’S theory can account for the undoubted fact that the instrumental industries experience greater cyclical fluctuations than the consumption industries. The explanation offered is that activity brings a more than proportional increase in profits; and, as profits (whether reinvested by corporations or distributed to shareholders) are the principal source of savings, the funds available from savings for capital outlay are similarly increased. The disproportionate fluctuations in the instrumental industries are therefore a consequence of changes in consumers’ income and outlay, and are not due (as many writers believe) to any repercussions which credit expansion may have—directly, or indirectly through changes in long-term-interest rates—on investment in fixed capital. That credit expansion has a certain effect on investment in fixed capital is not altogether denied by Mr. HAWTREY; but he holds it to be unimportant as compared with the direct influence on the merchant and on working capital.

Implications for policy.

To 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.18

§ 9. INTERNATIONAL COMPLICATIONS

With 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.19

§ 10. CONCLUDING REMARKS

A 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.20

Other features of Mr. HAWTREY’S theory are more questionable. His contention that the reason for the breakdown of the boom is always a monetary one and that prosperity could be prolonged and depression staved off indefinitely, if the money supply were inexhaustible, would certainly be challenged by most economists.

These and other features of the purely monetary explanation of the cycle will be referred to, explicitly or implicitly, in connection with the discussion of the non-monetary theories.

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21 The outstanding example of a boom without a rise in prices is the American boom of 1926-1929. The stability of prices was, however, confined to the wholesale-price level. A more general price index (as constructed by Mr. Carl Snyder) shows a marked rise.

22 It should be noted that this is not implied by the definition of prosperity and depression. It is conceivable that the rise and fall of the volume of production might be accompanied by an opposite movement of prices, so that the money value of the volume of production or of transactions in general would remain constant or even vary inversely with the physical volume.

23 See Good and Bad Trade, London, 1913; Monetary Reconstruction, 1923, 2nd ed., 1926; Currency and Credit, 1919. 1923, 1928; Trade and Credit, 1928; Trade Depression and the Way out, 1931, 1933; The Art of Central Banking, 1932; The Gold Standard in Theory and Practice, 3rd ed., 1933; Capital and Employment, 1937.

24 See, especially. The Art of Central Banking, London, 1932, Chapter III.

Independently, very similar ideas have been expressed by Professor Albert Hahn in his earlier writings. See his Volkswirtschaftliche Theorie des Bankkredits, 1st ed., 1924 (3rd ed., 1930). Since then he has, however changed his view considerably.

Many of the propositions advanced by Mr. Hawtrey and reviewed in the following pages, especially those on the relation between interest rates and prices, have had a long history and were given an early expression in A. Marshall’s evidence before the Gold and Silver Commission, 1887. (See Official Papers of A. Marshall, 1926, pages 52 and 131, reproduced and elaborated in his Money, Credit and Commerce, pages 75-76 and 254-257.)

25 Cf., e.g., the exposition in Keynes’ Treatise on Money. The history of thought on this subject has been written in great detail by V. Wagner, Geschichte der Kredittheorien, Vienna, 1936, and A. W. Marget, The Theory of Prices: A Re-examination of the Central Problems of Monetary Theory, Vol. I., New York, 1938.

26 The Art of Central Banking, page 167.

27 Op. cit., page 171.

28 Trade and Credit, London, 1928, page 98.

29 Currency and Credit, 3rd ed., London, 1928, page 153.

30 1913, page 186.

31 Cf. 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.

32 The Lessons of Monetary Experience, page 131.

33 Ibid., page 131, and Monetary Reconstruction, page 133.

34 Capital and Employment, page 86.

35 Monetary Reconstruction, 2nd ed., London, 1926, page 135.

36 Currency and Credit, 3rd ed., page 155.

37 See his paper “Money and Index-Numbers” in Journal of the Royal Statistical Society, 1930, reprinted in The Art of Central Banking, pages 303-332.

38 See below Ch. 3, §§ 8,16, and Part II, Ch. 11.

39 No attempt has been made to establish priorities or to trace the various lines of thought to their historical origins.

1Cf. J. M. Clark, Strategic Factors in Business Cycles, New York, 1935. pages 4-5 and passim.
2See his book: Strategic Factors in the Business Cycle, passim.
3See especially Tinbergen: “Suggestions on Quantitative Business Cycle Theory” in Econometrica, Vol. Ill, No. 3, July 1935, page 241.
4For this reason, anything like perfect regularity in respect of the amplitude, length, intensity and concomitant symptoms of the cyclical movement is a priori improbable.
5What 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.
6This special purpose explains the difference between the following exposition and the classification of theories and theorists given in such works as A. H. Hansen: Business Cycle Theories, Boston, 1927; W. M. Persons: “Theories of Business Fluctuations” (Quarterly Journal of Economics, Vol. 41, reprinted in Forecasting Business Cycles, New York, 1931); F. A. Hayek: Monetary Theory and the Trade Cycle, London, 1933; Macfie: Theories of the Trade Cycle, London, 1934.
7This 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.
8Op. cit., page 171.
9Trade and Credit, London, 1928, page 98.
10Currency and Credit, 3rd ed., London, 1928, page 153.
111913, page 186.
12Cf. 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.
13The Lessons of Monetary Experience, page 131.
14Ibid., page 131, and Monetary Reconstruction, page 133.
15Capital and Employment, page 86.
16Monetary Reconstruction, 2nd ed., London, 1926, page 135.
17Currency and Credit, 3rd ed., page 155.
18See his paper “Money and Index-Numbers” in Journal of the Royal Statistical Society, 1930, reprinted in The Art of Central Banking, pages 303-332.
19See below Ch. 3, §§ 8,16, and Part II, Ch. 11.
20No attempt has been made to establish priorities or to trace the various lines of thought to their historical origins.
21The 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.
22With 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).
23It 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.
24One 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.
25One 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.
26The 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).
27“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.”
28“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.”
29The 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.”
30In 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.
31In 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.
32In 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.
33In 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.
34He still believes that “a failure of cheap money to stimulate revival” is “a rare occurrence” but he admits that “since 1930, it has come to plague the world and has confronted us with problems which have threatened the fabric of civilisation with destruction”.
35But 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”.
36Under 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”.
37To 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.
38With 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.
39A 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.

Prosperity and Depression